AC3059 Financial Management Subject Guide 2012

F i n a n ci a l m a n a g e m e n t
L. Fung
AC3059
2 0 1 2
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This subject guide is for a 300 course offered as part of the University of London
International Programmes in Economics, M anagement, Finance and the Social Sciences.
This is equivalent to Level 6 within the Framework for Higher Education Q ualications in
England, Wales and Northern Ireland ( FHEQ ) .
For more information about the University of London International Programmes
undergraduate study in Economics, M anagement, Finance and the Social Sciences, see:
www.londoninternational.ac.uk
The 2012 edi t i on of t hi s gui de was prepared f or t he Uni versi t y of London Int ernat i onal
Programmes by:
Dr L. Fung, Lect urer i n Account i ng and Fi nance, Bi rkbeck, School of Busi ness, Economi cs and
Inf ormat i cs
It i s a revi sed edi t i on of previ ous edi t i ons of t he gui de prepared by J. Dahya and R.E.V. Groves,
and draws on t he work of t hose aut hors.
Thi s i s one of a seri es of subj ect gui des publ i shed by t he Uni versi t y. We regret t hat due t o
pressure of work t he aut hor i s unabl e t o ent er i nt o any correspondence rel at i ng t o, or ari si ng
f rom, t he gui de. If you have any comment s on t hi s subj ect gui de, f avourabl e or unf avourabl e,
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Cont ent s
i
Cont ent s
I nt roduct ion ............................................................................................................ 1
Ai ms and obj ect i ves ....................................................................................................... 1
Syl l abus ......................................................................................................................... 2
Readi ng ........................................................................................................................ 4
How t o use t he subj ect gui de ......................................................................................... 4
Onl i ne st udy resources ................................................................................................... 5
Exami nat i on advi ce........................................................................................................ 6
Summary ....................................................................................................................... 7
Abbrevi at i ons ................................................................................................................ 7
Chapt er 1: Financial management f unct ion and environment ............................... 9
Essent i al readi ng ........................................................................................................... 9
Furt her readi ng .............................................................................................................. 9
Works ci t ed ................................................................................................................... 9
Ai ms ............................................................................................................................. 9
Learni ng out comes ........................................................................................................ 9
Two key concept s i n f i nanci al management .................................................................... 9
The nat ure and purpose of f i nanci al management ........................................................ 11
Corporat e obj ect i ves .................................................................................................... 14
The agency probl em .................................................................................................... 15
A remi nder of your l earni ng out comes .......................................................................... 15
Pract i ce quest i ons ........................................................................................................ 16
Sampl e exami nat i on quest i ons ..................................................................................... 16
Chapt er 2: I nvest ment appraisals ......................................................................... 17
Essent i al readi ng ......................................................................................................... 17
Furt her readi ng ............................................................................................................ 17
Works ci t ed ................................................................................................................. 17
Ai ms ........................................................................................................................... 17
Learni ng out comes ...................................................................................................... 17
Overvi ew ..................................................................................................................... 17
Basi c i nvest ment apprai sal t echni ques ......................................................................... 18
Pros and cons of i nvest ment apprai sal t echni ques ........................................................ 21
Non-convent i onal cash f l ows ....................................................................................... 22
Advanced i nvest ment apprai sal s .................................................................................. 23
Pract i cal consi derat i on ................................................................................................. 33
Chapt er 3: Risk and ret urn ................................................................................... 37
Furt her readi ng ............................................................................................................ 37
Works ci t ed ................................................................................................................. 37
Ai ms ........................................................................................................................... 37
Overvi ew ..................................................................................................................... 38
Int roduct i on of ri sk measurement ................................................................................. 38
59 Fi nanci al management
ii
Di versi f i cat i on of ri sk and port f ol i o t heory .................................................................... 40
Appl i cat i ons of t he capi t al market l i ne (CML) ............................................................... 45
Deri vat i on of capi t al asset pri ci ng model (CAPM) ......................................................... 46
Al t ernat i ve asset pri ci ng model s ................................................................................... 51
Pract i cal consi derat i on of CAPM .................................................................................. 51
Chapt er 4: Capit al market ef f iciency .................................................................... 55
Furt her readi ng ............................................................................................................ 55
Ai ms ........................................................................................................................... 55
Capi t al market s ........................................................................................................... 55
Types of ef f i ci ency ....................................................................................................... 56
Ef f i ci ent market hypot hesi s (EMH) ................................................................................ 56
Chapt er 5: Sources of f inance .............................................................................. 63
Furt her readi ng ............................................................................................................ 63
Ai ms ........................................................................................................................... 63
Int roduct i on ................................................................................................................ 63
Int ernal f unds .............................................................................................................. 63
Ext ernal f unds ............................................................................................................. 64
Fl ot at i on ..................................................................................................................... 64
Share i ssues ................................................................................................................ 65
Ri ght s i ssues ............................................................................................................... 67
Pri vat e i ssues ............................................................................................................... 68
The rol e of st ock market s ............................................................................................. 68
Debt f i nance ................................................................................................................ 68
The i ssue of l oan capi t al .............................................................................................. 69
Chapt er 6: Capit al st ruct ure ................................................................................. 71
Furt her readi ng ............................................................................................................ 71
Works ci t ed ................................................................................................................. 71
Ai ms ........................................................................................................................... 71
Int roduct i on ................................................................................................................ 72
Modi gl i ani and Mi l l ers t heory ...................................................................................... 72
Modi gl i ani and Mi l l ers argument wi t h corporat e t axes ................................................. 74
Personal t axes ............................................................................................................. 75
Ot her t ax shi el d subst i t ut es .......................................................................................... 76
Fi nanci al di st ress ......................................................................................................... 76
Trade-of f t heory ........................................................................................................... 77
Cont ent s
iii
Si gnal l i ng ef f ect ........................................................................................................... 78
Agency cost s on debt and equi t y ................................................................................. 79
Pecki ng order t heory .................................................................................................... 81
Concl usi on .................................................................................................................. 81
Chapt er 7: Dividend policy ................................................................................... 83
Furt her readi ng ............................................................................................................ 83
Works ci t ed ................................................................................................................. 83
Ai ms ........................................................................................................................... 83
Int roduct i on ................................................................................................................ 84
Types of di vi dend ........................................................................................................ 84
Di vi dend cont roversy ................................................................................................... 85
Modi gl i ani and Mi l l ers argument ................................................................................. 85
Cl i ent el e ef f ect ............................................................................................................ 86
Inf ormat i on cont ent of di vi dend and si gnal l i ng ef f ect ................................................... 87
Agency cost s and di vi dend ........................................................................................... 88
Empi ri cal evi dence ....................................................................................................... 89
Concl usi on .................................................................................................................. 90
Chapt er 8: Cost of capit al and capit al invest ment s ............................................. 93
Furt her readi ng ............................................................................................................ 93
Ai ms ........................................................................................................................... 93
Int roduct i on ................................................................................................................ 93
Cost of capi t al and equi t y f i nance ................................................................................ 93
Cost of capi t al and capi t al st ruct ure ............................................................................. 94
Sampl e exami nat i on quest i on ...................................................................................... 98
Chapt er 9: Valuat ion of business .......................................................................... 99
Furt her readi ng ............................................................................................................ 99
Works ci t ed ................................................................................................................. 99
Ai ms ........................................................................................................................... 99
Int roduct i on ................................................................................................................ 99
Approaches t o busi ness val uat i on ................................................................................ 99
Val uat i on of debt / bonds ............................................................................................ 102
Val uat i on of equi t y .................................................................................................... 103
Concl usi on ................................................................................................................ 106
A remi nder of your l earni ng out comes ........................................................................ 106
Pract i ce quest i ons ...................................................................................................... 106
Sampl e exami nat i on quest i on .................................................................................... 106
iv
Chapt er 10: M ergers ........................................................................................... 109
Essent i al readi ng ....................................................................................................... 109
Furt her readi ng .......................................................................................................... 109
Ai ms ......................................................................................................................... 109
Learni ng out comes .................................................................................................... 109
Int roduct i on .............................................................................................................. 109
Mot i ves f or mergers ................................................................................................... 110
Concl usi on ................................................................................................................ 118
Sampl e exami nat i on quest i on .................................................................................... 119
Chapt er 11: Financial planning and working capit al management ................... 121
Ai ms ......................................................................................................................... 121
Int roduct i on .............................................................................................................. 121
Fi nanci al anal ysi s ....................................................................................................... 121
Cash based rat i os ...................................................................................................... 123
Fi nanci al pl anni ng ..................................................................................................... 128
Short -t erm versus l ong-t erm f i nanci ng ....................................................................... 131
Worki ng capi t al management .................................................................................... 132
Trade recei vabl es management .................................................................................. 133
Worki ng capi t al and t he probl em of overt radi ng ......................................................... 136
Sampl e exami nat i on quest i ons ................................................................................... 139
Chapt er 12: Risk management ........................................................................... 141
Furt her readi ng .......................................................................................................... 141
Works ci t ed ............................................................................................................... 141
Ai ms ........................................................................................................................ 141
Int roduct i on .............................................................................................................. 141
Reasons f or managi ng ri sk ......................................................................................... 142
Inst rument s f or hedgi ng ri sk ...................................................................................... 143
Some si mpl e uses of opt i ons ...................................................................................... 144
Put -cal l pari t y ............................................................................................................ 145
Corporat e uses of opt i ons .......................................................................................... 145
Opt i on pri ci ng ........................................................................................................... 146
Fut ures and f orward cont ract s .................................................................................... 147
Ri sk management ...................................................................................................... 148
Concl usi on ................................................................................................................ 150
Sampl e exami nat i on quest i ons ................................................................................... 151
Appendix 1: Sample examinat ion paper ............................................................ 153
Exampl e of 8-col umn account i ng paper...................................................................... 157
Int roduct i on
1
Int roduct ion
59 Financial management is a 300 course offered on the degrees and
diplomas in Economics, Management, Finance and the Social Sciences
(EMFSS) suite of programmes awarded by the University of London
International Programmes.
Financial management is part of the decision-making, planning and
control subsystems of an enterprise. It incorporates the:
treasury function, which includes the management of working capital
and the implications arising from exchange rate mechanisms due to
international competition
evaluation, selection, management and control of new capital
investment opportunities
raising and management of the long-term financing of an entity
need to understand the scope and effects of the capital markets for a
company, and
need to understand the strategic planning processes necessary to
manage the long and short-term financial activities of a firm.
The management of risk in the different aspects of the financial activities
undertaken is also addressed.
Studying this course should provide you with an overview of the problems
facing a financial manager in the commercial world. It will introduce
you to the concepts and theories of corporate finance that underlie the
techniques that are offered as aids for the understanding, evaluation and
resolution of financial managers problems.
This subject guide is written to supplement the Essential and Further
reading listed for this course, not to replace them. It makes no
assumptions about prior knowledge other than that you have completed
25 Principles of accounting. The aim of the course is to provide
an understanding and awareness of both the underlying concepts and
practical application of the basics of financial management. The subject
guide and the readings should also help to build in your mind the ability
to make critical judgments of the strengths and weaknesses of the theories,
just as it should be helping to build a critical appreciation of the uses and
limitations of the same theories and their possible applications.
Aims and object ives
This course aims to cover the basic building blocks of financial
management that are of primary concern to corporate managers, and all
the considerations needed to make financial decisions both inside and
outside firms.
This course also builds on the concept of net present value and addresses
capital budgeting aspects of investment decisions. Time value of money
is then applied to value financial assets, before extensively considering
the relationship between risk and return. This course also introduces the
theory and practice of financing and dividend decisions, cash and working
capital management and risk management. Business valuation and
mergers and acquisitions will also be discussed.
2
By the end of this course and having completed the Essential reading and
activities, you should be able to:
Subject-specific objectives
describe how different financial markets function
estimate the value of different financial instruments (including stocks
and bonds)
make capital budgeting decisions under both certainty and uncertainty
apply the capital assets pricing model in practical scenarios
discuss the capital structure theory and dividend policy of a firm
estimate the value of derivatives and advise management how to use
derivatives in risk management and capital budgeting
describe and assess how companies manage working capital and short-
term financing
discuss the main motives and implications of mergers and acquisitions.
Intellectual objectives
integrate subject matter studied on related modules and to demonstrate
the multi-disciplinary aspect of practical financial management
problems
use academic theory and research to question established financial
theories.
Practical objectives
be more proficient in researching materials on the internet and Online
Library
be able to use Excel for statistical analysis.
Syllabus
The subject guide examines the key theoretical and practical issues
relating to financial management. The topics to be covered in this subject
guide are organised into the following 12 chapters:
Chapter 1: Financial management function and environment
This chapter outlines the fundamental concepts in financial management
and deals with the problems of shareholders wealth maximisation and
agency conflicts.
Chapter 2: Investment appraisals
In this chapter we begin with a revision of investment appraisal
techniques. The main focus of this chapter is to examine the advantages of
using the discounted cash flow technique and its application in complex
investment scenarios: capital rationing, replacement decision, project
deferment and sensitivity analysis.
Chapter 3: Risk and return
We formally examine the concept and measurement of risk and return
in this chapter. We also look at the necessary conditions for risk
diversification, portfolio theory and the two fund separation theorem.
Asset pricing models are discussed and practical considerations in
estimating beta will be covered. Empirical evidence for and against the
asset pricing models will also be illustrated.
Int roduct i on
3
Chapter 4: Capital market efficiency
This chapter discusses the concepts and implications of market efficiency
and the mechanism of equity and debt issuance.
Chapter 5: Sources of finance
In this chapter we focus on how companies raise funds from both the stock
and bond markets and discuss the advantages and disadvantages of each
type of financing method.
Chapter 6: Capital structure
This chapter critically reviews the existing leading theories of capital
structure. Specifically, the trade-off theory, signalling effect, agency cost of
equity and debt and the pecking order theory will be examined. We will
also evaluate the practical considerations of capital structure decisions
made by corporate managers.
Chapter 7: Dividend policy
This chapter aims to explore how the amount of dividend paid by
corporations would affect their market values. The tax, signalling and
agency effects of dividend will be discussed.
Chapter 8: Cost of capital and capital investments
In this chapter we discuss how the cost of capital can be adjusted when
firms are financed with a mixture of debt and equity.
Chapter 9: Valuation of business
We introduce the valuation of equity, debt, convertibles and warrants in
this chapter.
Chapter 10: Mergers
This chapter focuses on the theory and motives of mergers and
acquisitions. The determination of merger value and the defensive tactics
against merger threats will also be covered. The empirical evidence of
using financial ratios to predict mergers and acquisitions will be discussed.
Chapter 11: Financial planning and working capital
management
The importance of managing cash and short-term financing will be
discussed in this chapter.
Chapter 12: Risk management
This chapter provides an introduction to risk management including:
hedging, futures, options and derivatives and their uses in both long-term
and short-term situations.
Changes t o t he syllabus
The material contained in this subject guide reflects the syllabus for the
year 20122013.
The field of accounting changes regularly, and there may be updates to
the syllabus for this course that are not included in this subject guide. Any
such updates will be posted on the virtual learning environment (VLE). It
is essential that you check the VLE at the beginning of each academic
year (September) for new material and changes to the syllabus. Any
additional material posted on the VLE will be examinable.
4
Reading
Essent ial reading
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York:
McGraw-Hill, 2010) tenth edition [ISBN 9780071314268]. Hereafter called
BMA, this textbook deals with most of the topics covered in this subject
guide.
Detailed reading references in this subject guide refer to the edition of the
set textbook listed above. New editions of this textbook may have been
published by the time you study this course. You can use a more recent
edition of this book or of any of the books listed below; use the detailed
chapter and section headings and the index to identify relevant readings.
Also check the VLE regularly for updated guidance on readings.
Furt her reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and
by thinking about how these principles apply in the real world. To help
you read extensively, you have free access to the VLE and the University of
London Online Library (see below).
Other useful texts for this course include:
Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice
Hall, 2008) fourth edition [ISBN 9780273719069]. Hereafter called ARD,
this textbook also covers most of the topics in this subject guide. It is less
technical than BMA.
Copeland, T.E., J.F. Weston and K.S. Shastri Financial theory and corporate
policy. (Harlow: Pearson-Addison Wesley, 2004) fourth edition [ISBN
9780321127211].This is a classic finance textbook pitched at an advanced
level. You may use this textbook for reference as it contains some useful
updates of empirical studies in the field of corporate finance.
Watson, D. and A. Head Corporate finance passnotes. (Harlow: Pearson
Education, 2010) first edition [ISBN 9780273725268].This concise version
of a passnote neatly summarises the key concepts in financial management.
You might find it useful as a revision tool.
Apart from the above textbooks, this subject guide also refers to some of
the original articles from which the financial management theories are
developing. You should refer to the works cited in each chapter for the full
reference of these articles.
How t o use t he subject guide
This subject guide is meant to supplement but not to replace the main
textbook. You should use it as a guide to devise a plan for your own study
of this subject. Suggested here is one approach in how to use this subject
guide.
Approach financial management in the same order as the chapters in
this subject guide. It is specifically designed to help you build up your
understanding of the subject.
1. For each chapter (apart from this Introduction) you should familiarise
yourself with the aim and outcomes before reading the materials.
2. Read the introductory section of each chapter to identify the areas you
need to focus on.
Int roduct i on
5
3. Carefully read the suggested chapters in BMA, with the aim of gaining
an initial understanding of the topics.
4. Read the remainder of the chapter in the subject guide. You may then
approach the Further reading suggested in the subject guide and BMA.
5. The subject guide is designed to set the scope of your studies of this
topic as well as attempting to reinforce the basic messages set out
in BMA. Therefore you should pay careful attention to the examples
in both the texts and the subject guide to ensure you achieve that
basic understanding. By taking notes from BMA, and then from other
books you should have obtained the necessary material for your
understanding, application and later revision.
6. Pay particular attention to the practice questions and the examples
given in the subject guide. The material covered in the examples and
in the activity exercises complements the textbook and is important in
your preparation for the examination.
7. Ensure you have achieved the listed learning outcomes.
8. Attempt the Sample examination questions at the end of each chapter
and the quizzes on the virtual learning environment (VLE).
9. Check you have mastered each topic before moving on to the next.
10. At the end of your preparations, attempt the questions in the Sample
examination paper at the end of the subject guide. Then compare
your answers with the suggested solutions, but do remember that they
may well include more information than the Examiner would expect
in an examination paper, since the guide is trying to cover all possible
angles in the answer, a luxury you do not usually have time for in an
examination.
Online st udy resources
In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal at:
http://my.londoninternational.ac.uk
You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave on
your application form. You have probably already logged in to the Student
Portal in order to register. As soon as you registered, you will automatically
have been granted access to the VLE, Online Library and your fully
functional University of London email account.
If you have forgotten these login details, please click on the Forgotten
your password link on the login page.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
Self-testing activities: Doing these allows you to test your own
understanding of subject material.
6
Electronic study materials: The printed materials that you receive from
the University of London are available to download, including updated
reading lists and references.
Past examination papers and Examiners commentaries: These provide
advice on how each examination question might best be answered.
A student discussion forum: This is an open space for you to discuss
interests and experiences, seek support from your peers, work
collaboratively to solve problems and discuss subject material.
Videos: There are recorded academic introductions to the subject,
interviews and debates and, for some courses, audio-visual tutorials
and conclusions.
Recorded lectures: For some courses, where appropriate, the sessions
from previous years Study Weekends have been recorded and made
available.
Study skills: Expert advice on preparing for examinations and
developing your digital literacy skills.
Feedback forms.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.
Making use of t he Online Library
The Online Library contains a huge array of journal articles and other
resources to help you read widely and extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login:
http://tinyurl.com/ollathens
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please see the online help pages:
www.external.shl.lon.ac.uk/summon/about.php
Examinat ion advice
Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Regulations
for relevant information about the examination, and the VLE where you
should be advised of any forthcoming changes. You should also carefully
check the rubric/instructions on the paper you actually sit and follow
those instructions.
The examination paper consists of eight questions of which you must
answer four questions. Each question carries equal marks and is divided
into several parts. The style of question varies but each question aims to
test the mixture of concepts, numerical techniques and application of each
topic. Since topics in financial management are often interlinked, it is
inevitable that some questions might examine overlapping topics.
Int roduct i on
7
Remember when sitting the examination to maximise the time spent
on each question and although, throughout, the subject guide will give
you advice on tackling your examinations, remember that the numerical
type questions on this paper take some time to read through and digest.
Therefore try to remember and practise the following approach. Always
read the requirement(s) of a question first before reading the body of the
question. This is appropriate whether you are making your selection of
questions to answer, or when you are reading the question in preparation
for your answer.
In the question selection process at the start of the examination, by
reading only the requirements, which are always placed at the end of a
question, you only read material relevant to your choice, you do not waste
time reading material you are not going to answer. Secondly, by reading
the requirements first, your mind is focused on the sort of information you
should be looking for in order to answer the question, therefore speeding
up the analysis and saving time.
Remember, it is important to check the VLE for:
up-to-date information on examination and assessment arrangements
for this course
where available, past examination papers and Examiners commentaries
for the course which give advice on how each question might best be
answered.
Summary
Remember this introduction is only a complementary study tool to help
you use this subject guide. Its aim is to give you a clear understanding of
what is in the subject guide and how to study successfully. Systematically
study the next 12 chapters along with the listed texts for your desired
success.
Good luck and enjoy the subject!
Abbreviat ions
AEV Annual equivalent value
AIM Alternative investment market
APM Arbitrage pricing model
ARD Arnold, 2008
ARR Accounting rate of return
BMA Brealey, Myers and Allen
CAPM Capital asset pricing model
CFs Cash flows
CME Capital market efficiency
CML Capital market line
CPI Consumer price index
DFs Discount factors
DPP Discounted payback period
DPS Dividend per share
EMH Efficient market hypothesis
EPS Earnings per share
8
EVA Economic value added
IPO Initial public offer
IRR Internal rate of return
LSE London Stock Exchange
MM Modigliani and Miller
MVA Market value added
NCF net cash flow
NPV Net present value
NYSE New York Stock Exchange
PE Price earnings ratio
PI Profitability index
PP Payback period
ROA Return on assets
ROC Return on capital
ROE Return on equity
S&P Standard and Poors
Std dev Standard deviation
VLE Virtual learning environment
WACC Weighted average cost of capital
Chapt er 1: Fi nanci al management f unct i on and envi ronment
9
Chapt er 1: Financial management
f unct ion and environment
Essent ial reading
McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters 1 and 2.
Furt her reading
Hall; 2008) fourth edition [ISBN 9780273719069]. Chapter 1.
Works cit ed
Fisher, I. The theory of interest. (New York: MacMillan, 1930).
Aims
This chapter paves the foundation for you to understand what financial
management is about. In particular, we will examine the roles of financial
management, the environment in which businesses are operated, and
agency theory. More importantly we explain the two key concepts which
underpin much of the theory and practice of financial management.
Learning out comes
By the end of this chapter, and having completed the Essential reading and
outline the nature and purpose of financial management
describe the general environment in which businesses operate
explain the relationship between financial objectives and corporate
strategies
assess the impact of stakeholders on corporate strategies
discuss the time value for money concept and the risk and return
relationship.
Two key concept s in f inancial management
Before we look at what financial management is about, it is essential for us
to understand two key concepts which lay the foundation of this subject.
The two key concepts are:
i. Risk and return.
ii. Time value of money.
Risk and ret urn
Financial markets seem to reward investors of riskier investments
1
with a
higher return.
2
The following graph indicates this relationship.
3

1
Risk is oft en measured
as a dispersion of t he
possible ret urn out comes
from t he expect ed mean.
In Chapt er 3 of t his
subject guide, we will
more formally dene
t he concept of risk in
nancial management
and discuss t he different
met hods t o quant ify risk.
2
Ret urn refers t o t he
nancial reward gained
as a result of making
an invest ment . It is
oft en dened as t he
percent age of value gain
plus period cash ow
received t o t he init ial
invest ment value.
3
The graph has been
rescaled in log t o t t he
page. You should not e
t he vast differences of
t he cash ret urns from
each invest ment t ype.
10
T Bill (14)
(Approximate values)
Corp. Bonds (55)
Long Bonds (39)
S&P (1800)
Small Cap. (5500)
1997
0.1
1925
Index
10
1
1000
Year
end
Figure 1.1: The cash ret urn f rom f ive dif f erent invest ment s.
Source: BMA.
Suppose we invested $1 in 1925 in each of the following five portfolios:
i. the largest quoted companies in the US, Standard & Poors (S&P)
ii. the smallest quoted companies measured by market capitalisation in
the US, Small Capitalisation (Small Cap)
iii. corporate bonds
iv. long-term US government bonds, Long Bonds
v. short-term US government bonds, T Bill.
These portfolios have different levels of perceived risk. Arguably, smaller
companies have higher varying returns than larger companies. Bonds,
on the other hand, are a safer investment to investors. Over time, these
portfolios generate cash returns which seem to follow the same order
as their respective perceived risk. This leads us to one of the axioms in
financial management:
The higher the risk, the higher the expected return.
Companies and investors should therefore only consider undertaking
a riskier investment provided that they are suitably and sufficiently
compensated by a higher return.
Act ivit y 1.1
What are t he mai n reasons f or smal l er compani es havi ng hi gher percei ved ri sk? What are
t he speci f i c ri sks we are ref erri ng t o?
See VLE f or di scussi on.
Time value of money
4

Money (i.e. cash) has different values over time. Holders of money can
either spend a sum of money now or delay their consumption by investing
the money in different investment opportunities until it is required.
Suppose an investor can deposit a sum of money in a bank and earn an
annual interest of 5%. The value of money to this investor would then be
5% per annum. If the same investor can invest the same sum of money in
a financial asset which gives a return of 10% annually, then the value of
money to this investor would be 10% per annum. The future return from
4
BMA, Chapt er 2 deals
wit h t he concept of t ime
value for money and
covers in det ail how t o
calculat e present and
fut ure values.
11
the money invested now is based on the duration of time, the risk of the
investment and inflation.
For example, $100 invested today will earn 10% per annum of return (i.e.
$110 in one years time and $121 in two years time). An investor who
assumes a 10% return will be indifferent between receiving $100 today
and $110 in one years time as the two cash flows have identical value to
the investor. In the time value of money terminology, the present value
of $110 received in one years time is exactly $100. Similarly, the present
value of $121 received in two years time is exactly $100, too.
This concept can be applied to convert future cash flows into their present
values. Denote the present value of a cash flow as PV and future (t-period)
value of a cash flow as FV
t
. The general relationship between the present
and future value is:
FV
t
= PV(1+r)
t
where r is the time value of money measured as a
percentage
Re-arranging the above equation, we have:

PV =
FV
t
1+ r ( )
t
= FV
t
1
1+ r ( )
t
where
1
1+ r ( )
t
is the t-period discount factor
The nat ure and purpose of f inancial management
Having discussed the two key concepts in financial management, we
can now turn our attention to the function of financial management.
In general, there are three main tasks that financial managers need to
undertake:
i. Investing decisions this is how financial managers select the right
investments. This can be examined in two stages. First we look at how
financial managers invest in and manage short-term working capital
(this is covered in Chapter 11 of this subject guide) and then we
examine how financial managers may appraise long-term investment
projects.
ii. Financing decisions this involves the choice of particular sources of
funds which provide cash for investments. The key issues that financial
managers should address are how:
these sources of funds can be raised (covered in Chapter 5)
the value of the business may be affected through the combination
of different sources of funds (covered in Chapter 6)
the sources of funds may affect the relationship between different
stakeholders (covered in Chapter 6).
iii. Dividend policy this concerns the return to shareholders (covered in
Chapter 7).
So in theory and in practice, how are these decisions being considered by
financial managers?
Link bet ween invest ing, f inancing and dividend decisions
In a perfect and complete capital market where there are no transaction
costs and information is widely available to everyone, it is argued that a
firms investing, financing and dividend decisions are not interlinked. This
is known as Fishers separation theorem (Fisher, 1930). This is illustrated
in the following diagram.
12
C
1
C
0
C
1, a
Y
1
C*
1
CF
1
C
1, b
X
a
b
C*
0, a
C*
0
Y
0
C
0, b
W
0
Individual 2
Individual 1
I
1
Figure 1.2: Fishers Separat ion Theorem
Suppose a firm is operating in a two-period environment (period 0 now
and period 1 in one years time) with an initial cash flow of Y
0
. It has
the opportunity to invest in two types of investments. The first type of
project relates to investments which require an initial investment outlay
(I
i
) and deliver CF
i
in the next period for each investment (i). For example,
investing I
i
in period 0 will produce CF
i
in period 1. Hereafter these types
of projects are referred to as production investment projects. The second
type of investment is essentially financial, which allows the firm to borrow
and lend an unlimited amount at an interest rate of r. In this case, if a firm
borrows (or lends) W
0
in period 0, it will pay back with interest (or receive
with interest) W
1
= W
0
(1+r).
Invest ing decision
What should the firm do in terms of its investments? A firm will logically
rank and invest in investment projects in descending order of their
profitability (R
i
for each i). A production opportunity frontier can be
obtained (such as the curve Y
0
Y
1
). A firm will invest up to the point where
the marginal investment i* yields a return that equals the return from
the capital market (i.e. interest rate r). The total investment outlays - the
amount represented by C
0
Y
0
- is the sum I
i
for all i (i = 1 to i*). Once the
investment plan is fixed, the firm will have C*
0
in period 0 remaining and
a cash return of C*
1
in period 1.
13
Dividend policy
In this setting, how much should the firm give out as dividend to its
shareholders in each period? The answer is simple. It should give out
C*
0
and C*
1
in period 0 and 1 respectively. However, would shareholders
be satisfied with these amounts in each period? Suppose we have two
individual shareholders 1 and 2. Each of them has their unique utility
function of consumption in each period. This can be represented by the
indifference curves in Figure 1.2 above. Individual 1 prefers to consume
less in period 0 and more in period 1 (the combination at a). Given the
current firms dividend policy, how would he be satisfied? There are two
ways to achieve it:
i. The firm will pay C
0,a
and invest any excess cash flow (i.e. C*
0
C
0,a
)
at r in period 0 and give out C*
1
+ (C*
0
C
0,a
)(1 + r). Mathematically,
it can be proved that it is equal to C
1,a
. Therefore the firm will pay the
exact dividend in each period to individual 1 as he prefers.
ii. Alternatively, the firm pays C*
0
to individual 1 and he can invest any
excess cash flow after his consumption in period 0 in the financial
investment earning a return of r and receive the same combined cash
flow of C
1,a
in period 1.
This reasoning applies to any individual shareholders with any unique
utility functions. Take Individual 2 as an example. Her consumption
pattern does not match the firms dividend payout. Similarly there are two
ways we can satisfy her consumption pattern:
i. The firm will borrow C
0,b
C*
0
at r in period 0 and pay out C
0,b
to
Individual 2. In period 1, the firm will pay out C*
1
(C
0,b
C*
0
)
(1 + r). Mathematically, it can be proved that it is equal to C
1,b
.
Therefore the firm will pay the exact dividend in each period to
Individual 2.
ii. Alternatively, the firm pays C*
0
to Individual 2 and she borrows any
shortfall to make up to her consumption C
0,b
in period 0. In period 1,
she will receive C*
1
less the loan and interest she takes out in period
0. This will leave her with a net amount exactly equal to C
1,a
.
The above argument indicates that financial managers do not need to
consider shareholders consumption patterns when fixing the investment
plan or the dividend policy. The easiest way is to maximise the firms
cash flows and distribute the spare cash flows as dividends. Shareholders
will use the capital markets to facilitate their consumption patterns
accordingly.
Financing decision
In the beginning, we assume that the firm has an initial cash flow of
Y
0
and requires a total investment outlay of C
0
Y
0
. If any part of Y
0
is
not contributed by shareholders, the firms dividend in period 1 will
be reduced by the funds raised from borrowing (at a cost of r) and the
interest. However, shareholders can offset this shortfall of dividend in
period 1 by investing the fund not contributed in the firm to the capital
market and earn a return exactly equal to r.
The above argument illustrates the Fisher separation in which investing,
financing and dividend decisions are all unrelated. However, if the capital
market is imperfect in such a way that external funding is restricted, the
Fisher separation might not apply. The following scenarios highlight the
practical considerations that financial managers would need to take.
14
I nvest ment
A company woul d l i ke t o
undert ake a l arge number
of prof i t abl e i nvest ment
proj ect s.
Financing
It wi l l need t o rai se f unds
i n order t o t ake up t hese
proj ect s.
Dividends
If t he company f ai l s t o
rai se suf f i ci ent f unds f rom
out si de t he company,
i t woul d need t o cut
di vi dends i n order t o
i ncrease i nt ernal f undi ng.
Dividends
A company want s t o
pay a l arge di vi dend t o
sharehol ders
Financing
A l ower l evel of avai l abl e
i nt ernal cash f l ows mi ght
f orce t he company t o seek
ext ra f unds vi a ext ernal
f i nanci ng.
I nvest ment
If ext ernal f i nanci ng i s
rest ri ct ed t hrough part i al l y
f i nanci ng t he di vi dend,
t he company mi ght need
t o post pone some of t he
i nvest ment proj ect s.
Financing
A company has been usi ng
a hi gher l evel of ext ernal
f undi ng.
I nvest ment
Due t o t he hi gh cost of
f i nanci ng, t he number
of at t ract i ve i nvest ment
proj ect s mi ght be reduced.
Dividends
The companys abi l i t y t o
pay di vi dends i n t he f ut ure
may be adversel y af f ect ed.
Act ivit y 1.2
i . Why woul d a f i rm i nvest up t o t he poi nt where t he ret urn of t he margi nal
i nvest ment equal s t he ret urn f rom t he capi t al market ?
i i . What woul d happen t o t he Fi shers separat i on t heorem i f t he borrowi ng rat e di f f ers
f rom t he l endi ng rat e?
See VLE f or sol ut i ons.
Corporat e object ives
BMA, Chapter 1, pp.3740 discuss the goals of corporation. The general
assumption in financial management is that corporate managers will
try their best to maximise the value of the shareholders investment
in the corporation (i.e. shareholders wealth maximisation (SHWM)).
Maximisation of a companys ordinary share price is often used as a
surrogate objective to that of maximisation of shareholder wealth. In
order to achieve this objective, it is argued that corporate managers will
maximise the value of all investments undertaken by the firm. This can be
illustrated in the following diagram:
Corporate net present value
(sum of individual Projects NPVs)
NPV 1
NPV A NPV 3
NPV 2
NPV 4
Share price SHWM
(1)
(2)
(3)
(4)
Figure 1.3: Shareholders wealt h maximisat ion
Source: BMA.
However, in practice, corporate objectives vary. For example, HP, a US-
based computer corporation, has the following objectives listed on its
website:
5
5
(ht t p://welcome.
hp.com/count ry/uk/en/
companyinfo/corpobj.
ht ml)
15
customer loyalty
profit
growth
market leadership
leadership capability
employee commitment
global citizenship.
While profit maximisation, social responsibility and growth represent
important supporting objectives, the overriding objective of a company
must be that of shareholders wealth maximisation. The financial wealth of
a shareholder can be affected by a companys financial managers action.
Arguably, when good investment, financing and dividend decisions are
made, a companys market value will increase. The rest of this subject
guide will explore how financial managers decisions can increase a firms
value.
Act ivit y 1.3
Al t hough sharehol ders weal t h maxi mi sat i on seems t o be t he overri di ng obj ect i ve,
corporat e managers st i l l f ace a number of const rai nt s t o i mpl ement mul t i pl e obj ect i ves
si mul t aneousl y.
Ident i f y t he t ypes of const rai nt t hat corporat e managers f ace when assessi ng l ong-t erm
f i nanci al pl ans.
The agency problem
The agency problem occurs when financial managers make decisions
which are not consistent with the objectives of the companys stakeholders.
It arises because:
1. There is a separation of ownership and control: agents (financial
managers) are given the power to manage and control the company by
the principals (stakeholders: shareholders, creditors and customers).
2. The goals of agents are different from those of the principals.
6
3. Principals do not get full information about their company from the
agent or the market (asymmetric information).
Act ivit y 1.4
What are t he si gns of an agency probl em? What possi bl e act i ons can be t aken t o mi t i gat e
such a probl em?
A reminder of your learning out comes
Having completed this chapter, as well as the Essential reading and
outline the nature and purpose of financial management
describe the general environment in which businesses operate
explain the relationship between financial objectives and corporate
strategies
assess the impact of stakeholders on corporate strategies
6
For example,
agent s may want t o
increase t he size of
t he company (empire
building), st rengt hen
t heir managerial
power, secure t heir
jobs, improve t heir
remunerat ion and
pursue ot her personal
object ives. These
object ives may not
necessarily be enhancing
t he value of t he
company.
16
discuss the time value for money concept and the risk and return
relationship.
Pract ice quest ions
1. Compute the future value of $1,000 compounded annually for:
a. 10 years at 5%
b. 20 years at 5%
How would your answer to the above question be different if interest is
paid semi-annually?
2. Compare each of the following examples to a receipt of $100,000
today:
a. Receive $125,000 in two years time.
b. Receive $55,000 in one years time and $65,000 in two years time
c. Receive $31,555.7 for the next 4 years, receivable at the end of each
year.
d. Receive $10,000 for each year for an infinite period.
Assume the interest rate is 10% per year for the foreseeable future.
Sample examinat ion quest ions
1. We need to maximise our profit in order for us to maximise the
shareholders wealth Executive at OverHill Plc.
Critically comment on the statement above.
2. Explain, with the aid of a diagram, how a firms dividend policy is
independent from its investment policy in a perfect and complete
world.
3. Identify five different stakeholder groups of a public company and
discuss their financial and other objectives.
Chapt er 2: Invest ment apprai sal s
17
Chapt er 2: Invest ment appraisals
Essent ial reading
McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters 5
and 6.
Furt her reading
Hall, 2008) fourth edition [ISBN 9780273719069] Chapters 26.
Works cit ed
Graham, J.R. and C.R. Harvey The theory and practice of corporate finance:
evidence from the field, J ournal of Financial Economics, 60, 2001, pp.187
243.
Aims
This chapter focuses on the techniques commonly used for investment
appraisals in practice. In particular, we concentrate on the pros and cons of
the following techniques:
Accounting rate of return (ARR)
Payback period (PP)
Discounted payback period (DPB)
Internal rate of return (IRR)
Net present value (NPV).
Learning out comes
describe the commonly used investment appraisal techniques
apply the discounted cash flow technique in complex scenarios
evaluate the investment decision process.
Overview
As mentioned in Chapter 1, financial managers make decisions about
which investment they should invest in to maximise their shareholders
value. In order to do so, they need to understand how to measure the
value of investments they undertake and how these investments help to
improve the value of the firm. First, we will examine the basic techniques
and evaluate their pros and cons in investment appraisals. We will then
compare the relative merits of using NPV over IRR. Thirdly, we consider
some of the scenarios when NPV can be applied to deal with the selection
of investments. Finally, we discuss the problems relating to the application
of these investment appraisal techniques.
18
Basic invest ment appraisal t echniques
BMA, Chapter 5 reviews the appraisal techniques and explains them at
great length. You should read the relevant sections of the chapter before
you carry on with the rest of the material covered here.
Here we summarise these commonly used techniques.
Account ing rat e of ret urn (ARR)
The method is also known as return on capital employed (ROCE)
or return on investment (ROI). It relates accounting profit to the capital
invested. One widely used definition is:
ARR =
Average annual profit
Average investment outlays
100 %
Average investment takes into consideration any scrap value. It can be
expressed as follows:
Average Investment
=
Investment - Scrap value
2
It measures the average net investment outlay of the project.
1
Accounting
profit is defined as before-tax operating cash flows after adjustment for
depreciation. The decision rule is to accept investments with ARR higher
than a predetermined target rate of return.
Payback period (PP)
Payback period measures the shortest time to recover the initial investment
outlay from the cash flows generated from the investment. A company will
accept an investment if the PP is less than or equal to a target period.
Discount ed payback period (DPP)
This is similar to PP except that the cash flows from the investment are
first discounted to time 0 and the shortest time to recover the initial
investment outlay will then be measured.
Int ernal rat e of ret urn (IRR)
The internal rate of return on an investment or project is the annualised
effective compounded return rate or discount rate that makes the net
present value (NPV) of all cash flows (both positive and negative)
generated from a particular investment equal to zero. The decision rule
is to accept a project or investment if its IRR is higher than the cost of
capital.
Net present value (NPV)
NPV combines the present values of all future cash flows and compares
the total to the initial investment. If the NPV of a project is positive, it
indicates that it earns a positive return over the cost of capital and will
therefore increase the shareholders value. A firm should invest in all
positive NPV projects, so the market value of the firm will increase by the
total of the NPVs, once they are announced to the market.
To illustrate how these techniques are applied in investment appraisal, lets
look at the following example.
1
Some t ext books prefer
t o calculat e ARR by
referring t o t he average
level of invest ment .
Consequent ly, t he
average invest ment will
be dened as (init ial
invest ment + scrap
value)/2.
19
Example 2.1
Suppose we have two mutually exclusive projects, A and B. Each project
requires an initial investment in a machine, payable at the beginning of year 0.
There is no scrap value for these machines at the end of the project. Suppose
the cost of capital (discount rate) is 20% per annum. The following before-tax
operating cash flows are also known:
Bef ore-t ax operat ing
cash f lows ($)
Year
Project 0 1 2 3 4
A (25,000) 5,000 10,000 15,000 20,000
B (2,500) 2,000 1,500 250
Accounting rate of return
Suppose the profit before depreciation for each year is identical to the annual
cash flow. The ARR can be determined as follows:
Project
I nit ial
invest ment
Average
invest ment
Tot al prof it af t er
depreciat ion
Average
prof it
ARR
A 25,000 12,500 25,000 6,250 50%
B 2,500 1,250 1,250 417 33%
Payback period
We can look at the cumulative cash flow at the end of each year to determine
the PP.
Cumulat ive cash f lows
Project 0 1 2 3 4 PP
A (25,000) (20,000) (10,000) 5,000 25,000 2.67 years
B (2,500) (500) 1,000 1,250 1.33 years
Discounted payback period
Year
Project A 0 1 2 3 4
Cash f l ows ($) (25,000) 5,000 10,000 15,000 20,000
Di scount f act or (DF) (20% ) 1 0.833 0.694 0.578 0.482
Present val ue (25,000) 4,165 6,940 8,670 9,640
Cumul at i ve cash f l ows (25,000) (20,835) (13,895) (5,225) 4,415
Year
Project B 0 1 2 3 4
Cash f l ows ($) (2,500) 2,000 1,500 250
Present val ue (2,500) 1,666 1,041 144.5
Cumul at i ve cash f l ows (2,500) (834) 207
For Project A, the payback period occurs in Year 4. If we assume that cash flows
arrive evenly throughout the year, we can determine the approximated payback
period at 5,225/9,640 = 0.54 year (i.e. PP at 3.54 years). Similarly, for Project
B, the PP occurs in 1.8 years.
20
Net present value
The NPV can be determined as:
Year
Project A 0 1 2 3 4
Cash f l ows ($) (25,000) 5,000 10,000 15,000 20,000
Present val ue (25,000) 4,165 6,940 8,670 9,640
NPV 4,415
Year
Project B 0 1 2 3 4
Cash f l ows ($) (2,500) 2,000 1,500 250
Present val ue (2,500) 1,666 1,041 144.5
NPV 351.5
Internal rate of return
To find the IRRs of these two projects, we can use the extrapolation method.
First, we recalculate the NPV of each of the two projects with a higher discount
rate. For example, we choose 30% and 35% as the discount rate for Project A
and B respectively. This gives, in both cases, negative NPVs.
Year
Project A 0 1 2 3 4
Cash f l ows ($) (25,000) 5,000 10,000 15,000 20,000
Present val ue (25,000) 3,845 5,920 6,825 7,000
NPV (1,410)
Year
Project B 0 1 2 3
Cash f l ows ($) (2,500) 2,000 1,500 250
Di scount f act or (DF) (35% ) 1 0.741 0.549 0.407
Present val ue (2,500) 1,482 824 102
NPV (93)
We then substitute the relevant figures into the following equation:
IRR = R
+
+
NPV
R
+
NPV
R
+
NPV
R
R
+
( )
R
+
is the discount rate which gives a positive NPV, NPV
R+
R
is the discount rate which gives a negative NPV, NPV

R
Consequently, the IRRs for Project A and B are 27.6% and 31.9% respectively.
Act ivit y 2.1
At t empt Quest i on 1, BMA Chapt er 5.
See VLE f or sol ut i on.
21
Pros and cons of invest ment appraisal t echniques
Example 2.1 highlights the potential problems of using some of these
techniques in investment appraisals. Recall the results for Projects A and B
respectively:
Proj ect s NPV IRR PP ARR
A 4,415* 27.6% 2.67 years 50% *
B 351.5 31.9% * 1.33 years* 33%
* Indicat es t he project t hat will be chosen under t he specic appraisal met hod.
Suppose the main objective is to maximise shareholders value. Financial
managers would prefer Project A as it provides a higher NPV, and hence
it gives the greatest increase to the shareholders value. However, if we
choose projects based on a higher value of IRR or PP, Project B will be
selected. But this project clearly does not produce the greatest value to the
company. So why are these techniques still being used in practice?
ARR
Advantages:
It gives a value in percentage terms which is a familiar measure of
return.
It is relatively easy to calculate compared to NPV or IRR.
It considers the cash flows (but only after adjustment for depreciation
in profit) arising from the lifetime of the project (unlike PP).
It can be used in selecting mutually exclusive projects.
Disadvantages:
It is very much based on the accounting profits and hence technically it
does not deal with the actual cash flows arising from the project.
It ignores the timing of the cash flows and hence it does not take into
consideration the time value of money.
It is expressed in percentage terms and therefore it does not measure
the absolute value of the project. It does not indicate how much wealth
the project creates.
PP
Advantages:
It is computationally straightforward.
It considers the actual cash flows, not profits, arising from a project.
Disadvantages:
It ignores cash flows beyond the PP and hence it does not provide a full
picture of a project.
It does not consider the time value of money (even though the
discounted payback period takes care of that).
The target payback period is somehow arbitrary.
IRR
Advantages:
It uses all relevant cash flows, not accounting profits, arising from a
project.
It takes into account the time value of money.
22
The difference between the IRR and the cost of capital can be seen as a
margin of safety.
Disadvantages:
The main limitations of using IRR in investment appraisals are that it may
not give the correct decision in the following scenarios:
when comparing mutually excusive projects
when projects have non-conventional cash flows
when the cost of capital varies over time
It discounts all flows at the IRR rate not the cost of capital rate.
Mut ually exclusive project s
Referring to Example 2.1, Project Bs IRR is higher than that of Project A.
One would rank Project B as more desirable than Project A. However, if
we consider the NPV of these projects, there is no doubt that Project A is,
by far, more valuable than Project B.
Non-convent ional cash f lows
A typical investment project has an initial cash outflow followed by
positive cash flows in subsequent years. However, in some cases, a project
(such as oil drilling or mining) may have negative cash flows during its
lifetime. Mathematically, each time the cash flow stream of a project
changes sign, there is a possibility that multiple IRRs might arise.
Example 2.2
Suppose a project requires $100 as an initial investment. Its Year 1 and Year 2
cash flows are $260 and $165 respectively. Based on this projects cashflows, it
produces two possible IRRs (10% or 50%):
DF PV DF PV
Year Cash f l ows 50% 10%
0 100 1 100 1 100
1 260 0.667 173 0.909 236
2 165 0.445 73 0.826 136
Net Present Val ue 0 0
Suppose the cost of capital for this project is 20%. According to the IRR rule,
the project should be accepted (as the cost of capital is less than the higher IRR
of 50%). However, it should also be rejected as the cost of capital is higher than
the lower IRR of 10%. So for a project with non-conventional cash flows, the
IRR decision is sensitive to the cost of capital. Therefore it is argued that IRR
does not give an unambiguous decision when dealing with non-conventional
projects.
To further illustrate this problem, lets look at the NPV profile of the project.
This depicts the relationship of the NPV of the project and its discount rate. In
the above example, we know that the NPV of the project is zero at both 10%
and 50%.
Suppose the cost of capital is 5%, 25% or 70%. The NPV of the project will
become $2, $2 and $4 respectively. The following diagram shows the NPV
profile of the project. We can see that, due to the non-conventional cash flow
pattern, the projects NPV varies at different discount rates. It only provides a
positive NPV if the discount rate for the projects cash flows is between 10%
and 50%.
23
-5
-4
-3
-2
-1
0
1
2
3
0% 10% 20% 30% 40% 50% 60% 70% 80%
Discount rates
NPVs

Figure 2.1: NPV prof ile
However, if the project we have been examining has the reversed cash flow
pattern (i.e. receiving $100 and $165 in year 0 and year 2 while paying $260 in
year 1), we would only accept it if the cost of capital is either lower than 10%
or higher than 50%. Why? This project with the reversed cash flow pattern has
the same IRRs (10% and 50%) as the original project. You can verify this result
by discounting the cash flows at 10% and 50% separately. However, the NPV
profile of this project will be as below.
Time-varying cost of capit al
If the cost of capital changes over time, NPV can easily accommodate this.
Suppose the cost of capital is r
t
for the t
th
year. The NPV of a project with
different cost of capital over its lifetime can be given in the following equation:
NPV = I
0
+
C
1
1+ r
1
( )
+
C
2
1+ r
1
( ) 1+ r
2
( )
+
C
3
1+ r
1
( ) 1+ r
2
( ) 1+ r
3
( )
+...
NPV assumes that cash flows can be reinvested at the cost of capital whereas
IRR assumes that cash flows can be reinvested at the IRR which is not a realistic
assumption in the real world.
The superiority of NPV:
It takes into consideration all cash flows and time value of money.
It can be applied to deal with mutually exclusive projects.
It can deal with non-conventional cash flows.
It has realistic assumptions about how the capital markets work in real life.
Act ivit y 2.2
Advanced invest ment appraisals
In this section, we look at some of the applications of the discounted cash
flow technique in investment appraisals. In particular, we focus on the
following scenarios:
capital rationing
inflation and price changes
taxation
replacement decision
24
sensitivity analysis.
BMA, Chapter 5, pp.14347 deals with capital rationing and Chapter 6
deals with the remaining advanced topics. Before you proceed with the
following section, it would be advisable to skim through those sections in
the textbook.
Capit al rat ioning
A company may have insufficient funds to undertake all positive NPV
projects. Due to the shortage of funds, this restriction is more commonly
known as capital rationing. There are two types of capital rationing.
Hard capit al rat ioning
This is where the shortage of funds is imposed by external factors. This
might happen in three different ways:
1. Capital markets are depressed.
2. Investors are too risk adverse.
3. Transaction costs are too high.
Sof t capit al rat ioning
This may arise when financial managers impose internal restrictions on:
issuing equity to avoid dilution of original shareholders value
issuing debt to avoid fixed interest obligation and transaction cost
investing activities in order to maintain a constant growth.
In any case, ranking projects by absolute NPV in these situations may
not necessarily give the optimal strategy. Some combinations of smaller
projects may give a higher NPV.
For each type of capital rationing we can further sub-divide it into two
categories.
Single period capit al rat ioning
If the shortage of funds is only restricted in the first year, the ranking of
projects can be done by using the profitability index. Profitability index
is defined as the present value of the future cash flows generated by a
project divided by its initial investment. It is also called the Present Value
Index (PVI) by some authors.
Profitability index, PI =
Present value of future cash flows
Initial investment
Example 2.3
Lion plc has the following projects:
Proj ect s Ini t i al Invest ment ($) NPV ($)
A 1,000,000 100,000
B 1,500,000 250,000
C 750,000 50,000
D 500,000 60,000
The company has only $2,500,000 available at year 0. There is no other
investment opportunity for the firm with any spare cash which is not invested
in the above four projects.
25
What would be the best way to allocate the $2,500,000 funding among these
four projects?
To answer this question, we first convert the NPV into PV (Initial investment +
NPV) for each project. We then calculate the PI using the above formula.
Proj ect s Ini t i al Invest ment ($) NPV ($) PV ($) PI Ranki ng
A 1,000,000 100,000 1,100,000 1.10 3
B 1,500,000 250,000 1,750,000 1.17 1
C 750,000 50,000 800,000 1.07 4
D 500,000 60,000 560,000 1.12 2
In this case, the ranking of the projects profitability is simple and
straightforward. The PI suggests that for every $1 invested in Project B, it
produces a present value of $1.17. When this is compared to Project As PI, it
is obvious that for any $1 available, it is more profitable to invest in Project B
than in Project A.
When projects are infinitely divisible
The optimal plan is to invest all the available cash in the projects according
to the ranking of PI. In this case, we will invest in the whole of Project B and
Project D (with a combined total initial investment of $2,000,000) and in
half of Project A with the remaining $500,000. The maximum NPV of this
investment plan is:
000 , 360 $
000 , 100 $
2
1
The optimal NPV = $250,000 + $60,000 +
=
When projects are not infinitely divisible

When projects are not infinitely divisible, the above investment plan might
not necessarily be optimal as the spare cash of $500,000 would no longer
be investable in only half of Project A. The optimal investment plan would
therefore involve a strategy which gives the highest PI to the investment plan.
Note that any unused cash in the investment plan, by definition, has a PI = 1
(the present value of the unused cash is the same as the amount of the unused
cash itself). We can define the weighted average of the investment plan as:
WAPI =
i
PI
i
i=1
N
+
j
where
i
is the percentage of project is initial investment to the total
PI
i
is the profitability index of project i, and
j
is the percentage of unused cash to the total cash available.
cash available,
Wei ght Pl an
Proj ect A+ B A+ C A+ C+ D B+ C B+ D C+ D
A 0.4 0.4 0.4 0 0 0
B 0.6 0 0 0.6 0.6 0
C 0 0.3 0.3 0.3 0 0.3
D 0 0 0.2 0 0.2 0.2
Unused cash 0 0.3 0.1 0.1 0.2 0.5
WAPI 1.14 1.06 1.09 1.12 1.13 1.05
26
The highest combination is to undertake both Projects A and B. This gives a
weighted average PI of 1.14. It means for every $1 we invest, we will receive
$1.14 of future cash measured at todays value.
Mult iple periods capit al rat ioning
When a firm is facing multiple periods of capital rationing, it would not
be easy to resolve the optimal investment plan by using the profitability
index. In this case, linear programming technique might be useful.
Act ivit y 2.3
Changing prices and inf lat ion
The accuracy of NPV depends on the accuracy of the cash flow estimates.
In practice, prices change for the following reasons:
inflationary effect
demand and supply
technological changes
manufacturing learning effect
stamp duties, value-added tax and other transaction costs.
The easiest way to deal with these external effects is to incorporate the
specific changes in the NPV calculation, i.e. the forecast for each periods
flows will be based on each flow item adjusted by its specific inflation to
give the project actual net flow for each period.
Example 2.4
Suppose Leopard plc has a project that produces 10,000 units of a digital diary
per year for the next four years. Each unit sells for $200. The unit production
cost is $110. The production requires a brand new machine at year 0. It costs
$2,000,000 with a scrap value of $20,000 at the end of year 4. The NPV of this
project (assuming no inflation) is determined as follows:
Year
0 1 2 3 4
Machi ne (2,000,000) 20,000
Revenue 2,000,000 2,000,000 2,000,000 2,000,000
Product i on cost s (1,100,000) (1,100,000) (1,100,000) (1,100,000)
NCF bef ore t ax (2,000,000) 900,000 900,000 900,000 920,000
DF 1 0.909 0.826 0.751 0.683
PV (2,000,000) 818,100 743,400 675,900 628,360
NPV 865,760
Example 2.5
Suppose the production cost for each unit will rise by 10% per year from year 2
onward. The revised NPV of this project can be determined by incorporating the
price changes to the production costs in Example 2.4.
27
Year
0 1 2 3 4
Machi ne (2,000,000) 20,000
Revenue 2,000,000 2,000,000 2,000,000 2,000,000
NCF bef ore t ax (2,000,000) 900,000 790,000 669,000 555,900
DF (10% ) 1 0.909 0.826 0.751 0.683
Present val ue (PV) (2,000,000) 818,100 652,540 502,419 379,680
Net present val ue (NPV) 352,739
The effect of this price change to the manufacturing costs reduces the NPV from
$865,760 to $352,739. If financial managers fail to recognise and take this price
change into consideration, it is very likely that the projects NPV will be grossly
misstated and an incorrect decision might be reached.
Taxat ion
When a firm is making a profitable investment, it is likely that it will be
liable for corporate tax. When evaluating a project, the tax effect must be
considered. There are two issues relating to the after-tax NPV of a project:
The amount of t ax payable
Different countries have different tax rules. Generally, corporate tax is
payable as a percentage of the taxable profit determined by the tax authority.
In principle, most items that are charged to the Statement of Comprehensive
Income (more commonly known as a Profit and Loss Account in the UK) are
tax deductible. However, in some countries, the accounting depreciation for
capital expenditure is not a recognised expense for tax purposes. If such a
depreciation charge is not allowed, the tax authority might give an allowance
for capital expenditure. For the purpose of this course, we assume that the
taxable profit before capital allowance is identical to the annual net cash
flow. Capital allowance is then determined as a percentage of the written
down value of the capital expenditure (i.e. initial investment).
Example 2.6
Suppose Leopard plc in Example 2.4 pays corporate tax at 45% on taxable
profits after capital allowances. We are told that the annual capital allowance
is determined at 25% of the written down value at the beginning of each year.
Any unrelieved written down value in the final year of the project is given out as
capital allowance in full in that year. The following table shows the calculations
of the annual capital allowance and tax payable.
Year
0 1 2 3 4
Taxabl e prof i t bef ore capi t al
al l owances
900,000 790,000 669,000 555,900
Wri t t en down val ues (WDVs) 2,000,000 1,500,000 1,125,000 843,750
Capi t al al l owances (CAs) (500,000) (375,000) (281,250) (843,750)
Taxabl e prof i t af t er capi t al
al l owances
400,000 415,000 387,750 (287,850)
Tax (45% ) (180,000) (186,750) (174,488) 129,533
Net Cash Flow
Income Statement
(25% WDVs)
(45% Taxable profit after capital allowances)
tax relief from initial
Investment
unrelieved written down value
*
28
The first years capital allowance is calculated as 25% of the written down
value of the initial investment (i.e. 25% $2,000,000 = $500,000). This is
then deducted from the taxable profit before capital allowances (i.e. the net
cash flow of year 1) to arrive at the taxable profit after capital allowances
(i.e. $900,000 $500,000 = $400,000). The tax charge for the first year is
calculated as 45% of $400,000 (i.e. $180,000).
For years 2 and 3, the same approach for the calculation of capital allowances
and tax charges applies. However, at the beginning of year 4, the unrelieved
written down value of the initial investment ($843,750) will be treated as
the capital allowance for that year. This gives rise to a negative figure for the
taxable profit after capital allowances. If Leopard plc has sufficient profits
from its other operations, it can use this tax relief to reduce the tax charge
for the other parts of its operations, saving the company from paying taxes of
$129,533 (45% of $287,850). Given that this tax saving is generated as a result
of this project, it should therefore be considered as a relevant cash flow for this
projects NPV.
The t iming f or t ax payable
In Example 2.6, we determined how much tax Leopard had to pay.
However, we did not discuss the second issue of when tax should be paid.
Why is it important to determine the timing of tax payable? Recall the
concept of time value of money. Cash flows, whether positive or negative,
arising at different time periods would have an effect on a projects NPV.
Regarding tax payables, the further away from today we settle the tax
liabilities, the less impact the tax will have on the projects NPV. To see this
effect, let us consider the following two cases:
Case 1: Tax payable in the same year as the profit to which it is related
Year
0 1 2 3 4
Machi ne (2,000,000) 20,000
Revenue 2,000,000 2,000,000 2,000,000 2,000,000
NCF bef ore t ax (2,000,000) 900,000 790,000 669,000 555,900
Tax (180,000) (186,750) (174,488) 129,533
NCF af t er t ax (2,000,000) 720,000 603,250 494,513 685,433
DF 1 0.909 0.826 0.751 0.683
PV (2,000,000) 654,480 498,285 371,379 468,150
NPV (7,706)
In this case, taxes are paid in the same year as the profits to which they are
related. The amount of taxes paid reduces the net cash flow of the project. Note
that the tax saving in year 4 is included as a positive cash flow. The after-tax
NPV of this project (after discounting) is now $7,706, suggesting that it should
not be accepted. We can clearly see in this case that the tax effect on a projects
acceptability cannot be ignored as it turns the positive NPV into negative.
29
Case 2: Tax payable one year in arrears
Year
0 1 2 3 4 5
Machi ne (2,000,000) 20,000
Revenue 2,000,000 2,000,000 2,000,000 2,000,000
NCF bef ore t ax (2,000,000) 900,000 790,000 669,000 555,900
Tax (180,000) (186,750) (174,488) 129,533
NCF af t er t ax (2,000,000) 900,000 610,000 482,250 381,413 129,533
DF 1 0.909 0.826 0.751 0.683 0.621
PV (2,000,000) 818,100 503,860 362,170 260,505 80,440
NPV 25,074
In this case, tax is payable one year after the profit to which it is related. The
first years tax is payable at the end of year 2 and the second years tax is
payable at the end of year 3 and so on. Despite this being a four-year project
it now has cash flow (tax savings) arising in year 5. As we can see from
Case 2, paying tax in arrears helps improve the after-tax NPV of the project.
Consequently, the project should be accepted.
The timing of when tax is paid is therefore crucial for the evaluation of a
projects acceptability.
Act ivit y 2.4
Replacement decision
When considering a scenario where we have to select mutually exclusive
projects with different life spans and where each project can be replicated
in exact cash flow patterns, the simple NPV rule might not necessarily give
the correct advice. To see why this might be the case, let us consider the
following example.
Example 2.7
Lion plc is considering two different machines in an operation. The following
net operating cash outflows for these two machines are given:
$ Year
Machi nes 0 1 2 3 4
A (100,000) (10,000) (10,000) (10,000) (10,000)
B (75,000) (15,000) (15,000) (15,000)
In this example, both machines have different life spans and cash flow patterns.
How do we compare the value of using these two machines in the operations?
Suppose Lion plc has a cost of capital of 10% per annum. The NPV of running
these two machines can be calculated as follows:
Tax Saving
AEV
30
$ Year
Machi ne A 0 1 2 3 4
NCF (100,000) (10,000) (10,000) (10,000) (10,000)
DF 1 0.909 0.826 0.751 0.683
PV (100,000) (9,090) (8,260) (7,510) (6,830)
NPV (131,690)
$ Year
Machi ne B 0 1 2 3
NCF (75,000) (15,000) (15,000) (15,000)
DF 1 0.909 0.826 0.751
PV (75,000) (13,635) (12,390) (11,265)
NPV (112,290)
On the basis of the NPV calculations, it seems to cost the company less to run
Machine B ($112,290 compared to $131,690). However, if the operation is a
going concern and we have to replace the machine once it has expired, how do
we know if Machine B still gives the best value to the company?
To answer this question, we need to find a way to compare the two machines
cash flows in a consistent manner. This can be done by converting a projects
NPV into its annual equivalent value (AEV).
Suppose we can hire a machine, C, for $x each year for the next four years.
It has the same functionalities as Machine A and the hiring company is
responsible for all the running cost of Machine C. What would be the equivalent
hiring cost we would be willing to pay if both machines (A and C) have the
same value to the company?
For these two machines to have the same value to the company, their total
running costs (measured at todays value, i.e. present value) must be identical.
Consequently this means:
( )
556 , 41
169 . 3
690 , 131 690 , 131
690 , 131
690 , 131
1 . 1
1
1 . 1
1
1 . 1
1
1 . 1
1
690 , 131
1 . 1 1 . 1 1 . 1 1 . 1
4 %, 10
4 %, 10
4 3 2
4 3 2
years
years
A
x
A x
x
x x x x
= = =
=
= |
.
|
\
|
+ + +
= + + +
where A
10%, 4 years
is the annuity factor at 10% for 4 years
If we are indifferent between paying the annual hiring cost of $41,556 for
Machine C and paying the purchase cost and annual running costs for Machine
A, then the hiring cost of $41,556 must be the annual equivalent value of
Machine A. From the above calculation, we can define the annual equivalent
value of a project as:
project the duration of for the Annuity
NPV s Project'
= AEV
We can now convert Machine Bs NPV into its AEV in the same way as the
calculation above:
169 , 45
486 . 2
290 , 112
AEV s B Machine = =
31
As long as Machines A and B have identical risk to the company, it would be
more advantageous for Lion plc to invest in Machine A since it has a lower
annual cost than Machine B.
However, we need to apply AEV in project appraisal with care. The comparison
of two projects AEV is only valid provided that:
Projects can be replicated in exactly the same cash flow patterns whenever
they expire.
Projects have similar risk to the company.
Technological changes are unlikely to affect the efficiency of either project.
The expiration of the project will be many years hence (in theory, infinitely).
If these conditions are not met, then AEV would not be a sensible method to
determine the replacement policy.
Delaying project s
In some cases it might be more advantageous for a company to delay the
commencement of a project. This might be a result of one of the following:
There might be uncertainty about the outcomes of the project. Delaying
its commencement might allow the company to obtain vital information
to revise future cash flows which might give a higher NPV.
There might be capital rationing in the current period and the company
needs to postpone the project due to shortage of funding.
In deciding whether a project should be postponed, we can treat the delay
of each project as separate and mutually exclusive. We can then evaluate
each options NPV accordingly.
Example 2.8
Rooster Ltd. is considering a new product, a roast chicken stand. It allows
a chicken to be roasted on all sides while maintaining its juiciness. The
production requires a new machine which has a purchase price of $100,000
with four years of economic life and no residual value by the end of the
fourth year. Each unit of the roast chicken stand is expected to generate a net
contribution of $5 (selling price minus variable costs). Market research, which
costs $25,000, indicates that future demand will be subject to the state of the
economy. If the economy is strong, the demand will be 10,000 units per year
for the next five years. However, if the economy is weak, the demand will fall
to only 5,000 units per annum. There is an equal chance for each state of the
economy to materialise. It is also expected that once the state of the economy is
set, it will stay that way for the next four years.
Rooster has a choice to delay the production until the end of the year. If it
does so, the whole production cycle will be shortened to three years. The same
machine will still be required by the end of the year at the same expected
purchase price. However, it can be sold for $25,000 at the end of the production
process (i.e. three years after the commencement of production). But more
importantly, delaying the commencement of production will allow the company
to know exactly which way the economy is going to unfold for the next few
years.
Advise the management on what action should be taken regarding this project.
Approach:
Introducing probability theory we can calculate the expected net present value,
E(NPV), for the project.
If Rooster Ltd. commences the production now:
Expected demand in the next 4 years = 50% 5,000 units + 50% 10,000
units = 7,500 units
32
Contribution per year = 7,500 units $5 = $37,500
Year
No delay 0 1 2 3 4
Machi ne (100,000)
Cont ri but i on 37,500 37,500 37,500 37,500
E(NCF) (100,000) 37,500 37,500 37,500 37,500
DF 1 0.909 0.826 0.751 0.683
E(PV) (100,000) 34,088 30,975 28,163 25,613
E(NPV) 18,838
This is the expected NPV that the production could generate. However, the
economy is weak, Rooster can only sell 5,000 units per year. What, then, would
be the outcome of this state?
If Rooster is to face a weak economy for the next four years, the revised NPV
will be as follows:
Year
Weak st at e 0 1 2 3 4
Machi ne (100,000)
Cont ri but i on 25,000 25,000 25,000 25,000
NCF (100,000) 25,000 25,000 25,000 25,000
DF 1 0.909 0.826 0.751 0.683
PV (100,000) 22,725 20,650 18,775 17,075
NPV (20,775)
In other words, there is a 50% chance that Rooster will suffer a negative NPV of
$20,775. (If the good state had occurred at the outset then the NPV would have
been $58,450. (NB. 0.5 $58,450 + 0.5 ($20,775) = $18,838.) Should the
company delay the project and wait for the economic situation to materialise
before committing to production? If the company delays the production by a
year, there are two possible actions that the company will take by the end of the
year. It could abandon production if a weak economy materialises. It would not
be advantageous to produce if the company could only sell 5,000 units per year
in a weak economy. You can check the NPV under this option. However, if a
strong economy materialises in year 1, the company will commence production
in that year with the following NPV:
Year
Delay 0 1 2 3 4
Machi ne (100,000) 25,000
Cont ri but i on 50,000 50,000 50,000
NCF 0 (100,000) 50,000 50,000 75,000
DF 1 0.909 0.826 0.751 0.683
PV 0 (90,900) 41,300 37,550 51,225
NPV 39,175
The expected NPV of delaying production would then be $19,587.5 (50% 0
+ 50% $39,175). On the basis of the NPV consideration, it seems to be more
advantageous for the company to delay production by one year.
In this example, deferring the project allows the company to eliminate the
possibility of facing a loss in a weak economy. Even though the financial return
33
to delay the project seems low ($19,587.5 vs. $18,838), the risk elimination
might be treated as more valuable by a more risk-averse company.
Sensit ivit y analysis
This method evaluates the impact of changes in a projects variables on its
NPV. In a single variable situation, we can assess by how much a variable
needs to change before a project returns a loss. For example, referring to
the data in Example 2.4, we can ask:
1. By how much does the selling price need to drop before the projects
NPV disappears?
2. By how much does the production cost per unit need to rise before the
projects NPV disappears?
3. By how much does the discount rate need to rise before the projects
NPV disappears?
To answer any of the above questions, we can use a trial-and-error
method. With the aid of a spreadsheet and changing the parameters
accordingly, we can see how the NPV will change. See the spreadsheet on
the VLE of the demonstration.
Alternatively, we can observe the relationship of the variable with the
overall NPV. Recall from Example 2.4 that each unit of the product sells
at $200 and the NPV of the project stands at $865,760. Lets assume that
the selling price of each unit drops by $x. To make the NPV disappear, the
present value of the loss in revenue (or contribution) must be identical to
the NPV. We, therefore, can equate the PV of the loss in contribution to the
projects original NPV as follows:
10,000x
1.1
+
10,000x
1.1
2
+
10,000x
1.1
3
+
10,000x
1.1
4
= 865, 760
10,000x A
10%,4
= 865, 760
10,000x 3.169 = 865, 760
x = 27.32
If the selling price drops by $27.32, the NPV will disappear. This gives
a safety net for the company as to how much it can afford to reduce the
selling price before incurring a loss. You can test each variable using the
approach outlined above and determine how sensitive the NPV is to each
of the variables considered. This is of benefit to management in both the
decision-making phase and the project management phase.
Pract ical considerat ion
Graham and Harvey (2001) surveyed 392 chief financial officers (CFOs)
in the USA. They asked each CFO to rank the importance of each appraisal
method in practice. Figure 2.2 below shows the findings of their survey.
Watson and Head (2010) summarise the findings as follow:
Discounted cash flow methods appear to be more popular than non-
DCF methods.
Payback is used in large organisations in conjunction with other
investment appraisal methods.
IRR is more popular than NPV in small companies but NPV is the most
popular investment appraisal method in large companies.
ARR, the least popular investment appraisal method, continues to be
used with other methods.
change in price
34
Companies tend not to use sophisticated methods to account for project
risk.
Most companies allow for inflation when considering projects future
cash flows.
Almost all companies use sensitivity analysis, an increasing minority of
companies use profitability analysis, very few companies use the capital
asset pricing model.
Appraisal t echnique Popularit y, % always or
almost always
Int ernal rat e of ret urn 75.61
Net present val ue 74.93
Payback peri od 56.74
Sensi t i vi t y anal ysi s 51.54
Di scount ed payback peri od 29.45
Account i ng rat e of ret urn 20.29
Prof i t abi l i t y i ndex 11.87
Table 2.1: Popularit y of evaluat ion t echniques
Source: Graham and Harvey (2001)
Having completed this chapter, as well as the Essential readings and
describe the commonly used investment appraisal techniques
apply the discounted cash flow techniques in complex scenarios
evaluate the investment decision process.
1. BMA Chapter 5, Questions 1015.
BMA Chapter 6, Questions 22, 26, 28 and 29.
1. Rabbit Inc. is considering the production of Product X and Y.
Product X
It can only be produced on a new machine, which has an expected
cost of $200,000 and a four-year life span. The annual cash savings
are expected to be $50,000 in the first year, rising at 20% per annum
thereafter until the end of the production. The new machine will attract
a capital allowance of 25% on the written down value of the machine
in each year. The company can claim any unrelieved capital allowance
at the end of the production.
Product Y
Production of Product Y is expected to last for three years. Sales are
expected to be 1,000 units in the first year, 1,200 units in the second
year, and 800 units in the third year. Each unit can be sold for $20.
It can be produced on an existing machine which has been idle for some
time. This existing machine can be sold immediately for $10,000. If the
production does go ahead, a one-off modification on the machine will be
needed at a cost of $15,000 payable at the beginning of the first year.
35
Each unit of Product Y requires 1 kg of material at $4 per kg and one
hour of skilled labour at $4 per hour. These costs are expected to rise in
line with inflation.
The company has a choice to defer the production of Product Y until
the beginning of the second year. If the company defers this production,
the first year sales contribution will be lost irrevocably.
The company also has an option to purchase a brand new machine for
the production of Product Y. It will cost the company $50,000 now or
$30,000 in one years time. This machine does not qualify for capital
allowance.
The companys policy is to depreciate machines over their useful
economic life on a straight-line basis. No machine is expected to have
any value at the end of its life.
The inflation rate is expected to be 5% per annum. The companys
after-tax cost of capital is 10% per annum. Corporate tax rate is 30%,
payable one year in arrears. Apart from the cash flows mentioned
above, the company can raise an additional fund of $190,000 only at
the beginning of year 1. There is no capital restriction in subsequent
years.
Required:
Advise Rabbit Inc. of the best investment plan in the above situation.
2. Assume that you have been appointed as the finance director of Dragon
plc. The company is considering investing in the production of an
electronic security device, with an expected market life of five years.
The previous finance director has undertaken an analysis of the
proposed project; the main features of his analysis are shown below. He
has recommended that the project should not be undertaken because
the estimated annual accounting rate of return is only 12.3%.
Proposed elect ronic securit y device project
Year 0
(000)
Year 1
(000)
Year 2
(000)
Year 3
(000)
Year 4
(000)
Year 5
(000)
Invest ment i n
depreci abl e f i xed asset s
4,500
Cumul at i ve i nvest ment
i n worki ng capi t al
300 400 500 600 700 700
Sal es 3,500 4,900 5,320 5,740 5,320
Mat eri al s 535 750 900 1,050 900
Labour 1,070 1,500 1,800 2,100 1,800
Overhead 50 100 100 100 100
Int erest 576 576 576 576 576
Depreci at i on 900 900 900 900 900
3,131 3,826 4,276 4,276 4,276
Taxabl e prof i t 369 1,074 1,044 1,014 1,044
Taxat i on 129 376 365 355 365
Prof i t af t er t ax 240 698 679 659 679
Total initial investment is 4,800,000.
Average annual after-tax profit is 591,000.
All the above cash flow and profit estimates have been prepared
36
in terms of present day costs and prices (i.e. no inflation), since
the previous finance director assumed that the sales price could be
increased to compensate for any increase in costs.
You have available the following additional information:
a. Selling prices, working capital requirements and overhead expenses are
expected to increase by 5% per year.
b. Material costs and labour costs are expected to increase by 10% per
year.
c. Capital allowances (tax depreciation) are allowable for taxation
purposes against profits at 25% per year on a reducing balance basis.
d. Taxation on profits is at a rate of 35%, payable one year in arrears.
e. The fixed assets have no expected salvage value at the end of five years.
f. The companys real after-tax weighted average cost of capital is
estimated to be 8% per year, and nominal after-tax weighted average
cost of capital 15% per year.
Assume that all receipts and payments arise at the end of the year to which
they relate, except those in year 0, which occur immediately.
Required:
a. Estimate the net present value of the proposed project. State clearly any
assumptions that you make.
b. Calculate by how much the discount rate would have to change to result
in a net present value of approximately zero.
c. Compare and contrast the NPV and IRR approaches to investment
appraisal.
Chapt er 3: Ri sk and ret urn
37
Chapt er 3: Risk and ret urn
Essent ial reading
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance.
(New York: McGraw-Hill, 2010) tenth edition [ISBN 9780071314268]
Chapters 7 and 8.
Furt her reading
Works cit ed
Banz, Rolf W. The relationship between return and market value of common
stocks, J ournal of Financial Economics 9, 1981, pp.318.
Basu, Sanjoy The relationship between earnings yield, market value and
return for NYSE Common Stocks: Further Evidence, J ournal of Financial
Economics 12, 1983, pp.12956.
Chen, Nai-Fu, Richard Roll and Stephen A. Ross Economic forces and the stock
market, J ournal of Business 59(3) 1986, pp.383403
Daves, Phillip R., Michael C. Ehrhardt and Robert A. Kunkel Estimating
systematic risk: the choice of return interval and estimation period, J ournal
of Financial and Strategic Decisions, 13(1) 2000, pp.713.
Fama, Eugene F. and Kenneth R. French The cross-section of expected stock
returns, J ournal of Finance47(2), 1992, pp.42765.
Fama, Eugene F. and Kenneth R. French Multifactor explanations of asset
pricing anomalies, J ournal of Finance51(1), 1996, pp.5584.
Ferson, Wayne E. Theory and empirical testing of asset pricing models, Centre
of security prices (University of Chicago) 352, 1992.
Graham, John R. and Campbell R. Harvey The theory and practice of corporate
finance: evidence from the field, J ournal of Financial Economics 60, 2001,
pp.187243.
Kim, Dongcheol The errors in the variables problem in the cross-section of
expected stock returns, J ournal of Finance50(5), 1995, pp.160534.
Kothari, S.P., Jay Shanken and Richard G. Sloan Another look at the cross-
section of expected returns, J ournal of Finance50(1), 1995, pp.185224.
Markowitz, Harry M. Portfolio selection, J ournal of Finance7(1), 1952, pp.7791.
Reinganum, Marc R. Misspecification of capital asset pricing: empirical
anomalies based on earnings yields and market values, J ournal of Financial
Economics 9(1), 1981, pp.1946.
Roll, Richard A critique of the asset pricing theorys tests, Part I: on past and
potential testability of the theory, J ournal of Financial Economics 4(2),
1977, pp.12976.
Shanken, Jay On the estimation of beta pricing models, Review of Financial
Studies 5(1), 1992, pp.133.
Aims
In this chapter we formally examine the concept and measurement of
risk and return. In particular, we look at the necessary conditions for risk
diversification, the portfolio theory and the two fund separation theorem.
Asset pricing models are also discussed and practical considerations in
estimating beta will be covered. Empirical evidence for and against the
asset pricing models will be illustrated.
38
Learning out comes
describe the meaning of risk and return
calculate the risk and return of a single security
discuss the concept of risk reduction/diversification and how it relates
to portfolio management
calculate the risk and return of a portfolio of securities
discuss the implications of the capital market line (CML)
discuss the theoretical foundation and empirical evidence of the capital
asset pricing model (CAPM) and its application in practice.
Overview
In Chapter 1, we mentioned that one of the key concepts in financial
management is the relationship between risk and return. So how does
this concept link to the value creation and project appraisal? In Chapter
2, we discussed the selection of suitable investment projects that would
create value for a firm and its shareholders. We assume that those projects
cash flows are given with certainty. However, in reality, cash flows from
an investment project seldom materialise as expected. So how might the
variation of the realised cash flows affect an investments value?
To be able to answer these questions, we will first need to understand
what we mean by risk and how corporate managers can measure such risk.
Int roduct ion of risk measurement
What is risk? For the purpose of financial management, risk is defined as
the deviation of realised return from its expectation. If the returns of an
investment follow a normal distribution, then risk can be proxied by its
standard deviation. Mathematically, we denote this as:

(3.1)
where R
t
is the return of an investment at time t (1 to T) and R is the mean
return.
Example 3.1
Suppose we have an investment that has the following historic returns:
Year Ret urn (% )
1 10
2 2
3 0
4 5
5 7
What is the risk of this investment?
39
Answer:
This investment has an average return of 4% for the last five years. We can
assume that the historic mean return of this investment is 4% (our best estimate
in the absence of any further information about this investment). We can
calculate the standard deviation of the returns by taking the square root of
the average of the squared deviation of each annual return to its mean. The
following table lists the results.
Year Ret urn (%) Deviat ion = Ret urn M ean Ret urn Squared deviat ion
1 10 6 36
2 2 6 36
3 0 4 16
4 5 1 1
5 7 3 9
Sum 20 98
Average 4 24.5
St d dev 4.95
Based on the calculation above, we can say that this investment on average
provides a return of 4% per annum. However, none of the past five years
returns meet the expected return. In years 1, 4 and 5, the realised returns
are higher than expected (upside risk). Whereas in years 2 and 3, returns are
lower than expected (downside risk). This kind of deviation from the mean
(expectation) constitutes the concept of risk in financial management. As long
as (i) the returns of an investment follow the normal distribution and (ii)
investors have no preference toward the upside and downside risks, standard
deviation will be a neat measurement of risk for this type of investment.
Act ivit y 3.1
At t empt Quest i on 3 of BMA, Chapt er 7.
Implicat ions of using st andard deviat ion as a risk measure
Using standard deviation as a proxy for risk allows us to explore the
statistical property of a given investment. It enables us to estimate the
probability of obtaining a particular return. Take a look at the following
example.
Example 3.2
a. In Example 3.1, what is the probability that an investor will receive
a return of 10% from the investment?
b. What is the probability that an investor will not suffer a loss in the
investment?
Answers
a. The probability of a outcome from a normal distribution can be
expressed as:

(3.2)
where is the mean, is the standard deviation and x is the
outcome of the function.
40
Given in Example 3.1 that we have x = 10%, = 4% and
o = 4.95, we have:

Prob x ( ) =
1
2
2
e
x ( )
2
2
2
=
1
2 3.1416 24.5
e
104 ( )
2
224.5
= 0.038
b. The probability for an investor not suffering from a loss is equal to

the probability that the return is equal to or larger than 0%. Given
that a normal distribution curve is symmetrical at the mean value,
we can easily see that the probability of returns equal to and larger
than 4% would be 50%. So what is the probability that a return is
between 0% and 4%?
To answer this, we first define the z-value as:

In this example, z = (0 4)/4.95 = 0.808.
Using the table Area under the standardised normal distribution
1
,
we can determine the probability of return between 0% and 4% as
0.291.
Therefore the probability for an investor not suffering from a loss in
this case would be equal to 0.791 (0.5 + 0.291).
Act ivit y 3.2
What woul d be t he probabi l i t y f or an i nvest or t o earn a ret urn of 8% i n Exampl e 3.1?
Diversif icat ion of risk and port f olio t heory
What can we do about the risk of an investment?
If we put all our money in one single investment, we will be facing the entire
risk of that investment. Consequently, if the investment turns out to be loss-
making, there is not much we can do about it. However, if we spread our
money across different investments in the first place, there might be a chance
that one investments loss is compensated by another investments gain. The
overall variation of the realised return on a portfolio of investments might
therefore be reduced. This is the concept of risk diversification.
Markowitz (1952) argues that combining different investments in a
portfolio can reduce the overall standard deviation below the level obtained
from a simple weighted average calculation provided that the investments
are not all positively correlated. In general, the expected return on a
portfolio with N investments and its variance can be expressed as follows:
where E(.) is the expectation function,
i
is the weight in investment i,
ij

is the covariance of returns between investment i and j.
1
This t able can be
found in Arnold (2008),
Appendix 5.
(3.3a)
(3.3b)
and
41
Two-asset port f olio
Lets first examine how the risk of a portfolio with two securities can be
calculated.
Example 3.3
Suppose that you are considering an investment portfolio with two stocks, Rose
Plc and Thorn Plc. The returns of these two stocks for the last five years are in
columns 1 and 2 of the table below.
1 2 3 4 5 6 7
Year Rose, R
x
Thorn, R
y
R
x
E(R
x
) [ R
x
E(R
x
)]
2
R
y
E(R
y
) [ R
y
E(R
y
)]
2
[ R
x
E(R
x
)] [ R
y
E (R
y
)]
1 4 2 0 0 1 1 0
2 11 2 7 49 5 25 35
3 13 6 9 81 3 9 27
4 8 1 12 144 4 16 48
5 0 10 4 16 7 49 28
Sum 20 15 290 100 12
Mean 4 3 Vari ance 72.5 Vari ance 25 Covari ance = 3
St andard devi at i on 8.5 5
Coef f i ci ent of
correl at i on
0.07
Note that the variance and covariance are calculated using the following
formulas:
T
T
T
t =1
t =1
t =1
2
2
y
x
To see the diversification effect, we first calculate the standard deviation of the
two companies and their covariance. Covariance measures the co-movement
of the two stocks. At first glance, Rose and Thorn are not moving in the same
direction all the time, suggesting that they are not perfectly correlated. To see
the extent of their co-movement, we compute the covariance and coefficient of
correlation.
Next, we combine the two stocks with different weights in a portfolio. Using
equations 3.3a and 3.3b we can compute the portfolios risk and expected
return based on different weights as follows:
(3.4a)
(3.4b)
(3.4c)
42
Wei ght i n Rose Wei ght i n Thorn Port f ol i os ri sk Port f ol i os E(Rp)
1 0 8.5 4
0.9 0.1 7.7 3.9
0.8 0.2 7 3.8
0.7 0.3 6.2 3.7
0.6 0.4 5.6 3.6
0.5 0.5 5.1 3.5
0.4 0.6 4.7 3.4
0.3 0.7 4.5 3.3
0.2 0.8 4.5 3.2
0.1 0.9 4.6 3.1
0 1 5 3
The portfolios expected return is simply the weighted average of the two
companies returns. The portfolios risk is determined by using the general formula
and we can see that it gradually decreases as the weight in the lower risk company
(i.e. Thorn) increases. We should also note that the portfolios risk falls below 5%
when the weight in Thorn exceeds 0.5.
We could plot the portfolios risk against the expected return at different weights
(see Figure 3.1). The solid line represents the efficient frontier which consists of
all efficient portfolios that can be formed between Rose and Thorn.
2
Investors can
decide which composition they want to take.
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
0 1 2 3 4 5 6 7 8 9
Risk (standard deviation)
R
e
t
u
r
n

(
%
)
Rose
Thorn
Figure 3.1: Ef f icient f ront ier of port f olios f ormed by t wo asset s.
Act ivit y 3.3
Suppose we have t wo st ocks, A and B wi t h t he f ol l owi ng charact eri st i cs:
Ret urn Ri sk
A 10 10
B 5 5
Sket ch t he ef f i ci ent f ront i er of a port f ol i o whi ch consi st s of st ock A and B, assumi ng t hat
t he coef f i ci ent of correl at i on equal s:
a. 1
b. 0
c. 1
2
An ef f i ci ent port f ol i o
i s one t hat maxi mi ses
expect ed ret urn f or a
gi ven ri sk.
43
Mult i-asset port f olio
The above analysis can be extended to a multi-asset scenario. Suppose it
is free to buy and sell assets to form a portfolio. An investor may want to
combine more assets in her portfolio if more risk can be diversified. To see
how this may work, lets take a look of the analysis below.
Recall equations 3.3a and 3.3b
where o
2
i
is the return variance of stock i
and o
ij
is the covariance between returns on stock i and j.
Suppose we put equal weight in each asset, the portfolios risk will be
reduced to

(3.5a)
Define
2
as the average variance and

ij

as the average covariance,

o
p
2
=
1
N
o
2
+ 1
1
N
|
\

|
.
| o
ij

(3.5b)
If N is sufficiently large (i.e. N ), then
1
N
o
2
0 and 1
1
N
|
\

|
.
| o
ij
o
ij
That implies
o
p
2
= o
ij

(3.5c)
The portfolios risk is therefore determined by the average covariance
among the stocks in the portfolio.
Implicat ions
There are a few key implications from the above analysis worth noting.
i. As an investor combines more assets in a portfolio, the limiting
portfolios risk will gradually be reduced as both the first and second
term in equation 3.5a will slowly disappear. Consequently, the shape of
the efficient frontier will change and move more to the north-western
quadrant of the mean-variance space.
In Figure 3.2, each half-egg shell represents the possible weighted
combinations for two assets. The composite of all assets constitutes the
efficient frontier. The area underneath the efficient frontier consists of
feasible but not efficient portfolios.
44

Standard Deviation
Expected Return (%)
Figure 3.2: Ef f icient f ront ier of port f olios f ormed by mult iple asset s.
ii. The portfolios risk will be minimised when a sufficiently large number
of assets are included in the portfolio.
iii. If there is no transaction cost involved in portfolio forming, then a
rational and sensible investor will combine all possible assets in her
portfolio. Ultimately, the portfolio is composed of and reflects the entire
market. The risk of such a portfolio must be the same as the risk of the
market. Using equation 3.5c, the markets risk must be equal to the
average covariance of the assets in the market:

market ij
2
=
iv. If one can lend or borrow at some risk-free rate of interest, an investor,
who previously holds a risky portfolio on the efficient frontier, may
now combine the risk-free asset with the market portfolio. This can be
represented graphically:
Standard Deviation
Expected
Return (%)
r
f
L
e
n
d
i
n
g

B
o
r
r
o
w
i
n
g
M
Figure 3.3: Ef f icient f ront ier and risk-f ree asset .
This is known as the two fund separation theorem. No matter what risk
attitude an investor has, he or she will always seek to form a portfolio
by combining the risk-free and a risky market portfolio on the efficient
frontier. Given the two fund separation theorem and the implications of
the portfolio theory, any efficient portfolio will lie on the capital market
line (CML), which has the following form:
45
E R
p ( )
= R
f
+
E R
m
( ) R
f
o
m
o
p

(3.6)
Act ivit y 3.4
Equat i on 3.6 requi red t hat t here i s a si ngl e ri sk-f ree rat e i n t he capi t al market s. In
pract i ce, i nvest ors coul d sel dom borrow and l end at t he same ri sk-f ree rat e. How woul d
t hi s af f ect t he capi t al market l i ne?
Applicat ions of t he capit al market line (CML)
The CML equation gives investors an idea of how much return should be
expected for any given portfolio risk.
Example 3.4
It is expected that the market has an average return of 10% and the risk-free
asset has a return of 5%. The standard deviation of returns on the market has
been 7% in the past. What is the expected return of a portfolio with a standard
deviation of 10%?
Using equation 3.6, we have
E R
p
( )
= R
f
+
E R
m
( )
R
f
o
m
o
p
= 5+
105
7
10
=12.14

Act ivit y 3.5
In the above analysis, we address the issue of risk and return relating to a
portfolio. We now turn our attention to individual assets. At the beginning
of the chapter, we defined risk and return for a single investment. When
an investor holds a single investment (or asset), he or she faces the entire
variation of returns of that asset. Consequently, the standard deviation
will be a good proxy for risk to such an investor. However as we have seen
in the discussion of portfolio theory and diversification of risk, a sensible
investor should form portfolios with many assets in order to eliminate
risk. The relationship between the number of assets and portfolio risk is
depicted in Figure 3.4.
46

Market risk (non-diversiable)
Unique risk reduces as
the number of securies
increases
15 0 Number of securies
Porolios
standard
deviaon
Figure 3.4: Risk diversif icat ion and t he number of securit ies.
Figure 3.4 depicts two types of risk: risk that can be diversified (specific
or unique risk) and risk that cannot be diversified (market or systematic
risk). Empirically, an investor who holds 15 or more stocks in a portfolio
would probably hedge most of the specific risk. Arguably the only risk in
the portfolio would be from the market (the undiversifiable risk).
If transaction costs are negligible, investors would combine all assets in
their portfolios. Ultimately, everyone will hold the same most diversified
portfolio (the market portfolio). If this is the case, then how would
investors price a new asset in the market?
Act ivit y 3.6
Gi ven Fi gure 3.4, what i s t he i mpl i cat i on f or smal l i nvest ors who have onl y a smal l
amount of capi t al t o i nvest ?
Derivat ion of capit al asset pricing model (CAPM)
BMA does not deal with the theoretical derivation for the capital asset
pricing model. Here you can find a simple numerical derivation.
Suppose an investor holds a portfolio which combines a% of an asset i
and (1a)% of the market portfolio. The expected return and standard
deviation of the portfolio p are

(3.7)
and
(3.8)
where o
2
i

is the variance of the return on the risky asset i; o
m
2
is the variance
of the return on the market portfolio; and o
im
is the covariance of returns
between asset i and the market portfolio. The marginal rate of substitution
(MRS) between the expected return and risk of the market portfolio is
47
defined as the ratio of the partial differentiation of its expected return over
the partial differentiation of its expected risk of the portfolio with respect to a.
In equilibrium, all marketable assets are included in the market portfolio and
there is no excess demand or supply for any individual asset. This implies that:

(3.9)
Also note that the MRS at the point of the market portfolio on the efficient
frontier is the same as the slope of the capital market line (CML) at the
point of tangency to the efficient frontier. It can be shown that:
f
Rearranging the equation 3.10, we have:
[
[

where |
i
= o
im
/ o
m
. Equation 3.11, also known as the equation of CAPM
or security market line, shows that there is an exact linear relationship
between an assets return and its beta. This beta measures the risk of an
asset relative to the market. We can from now on call it the market risk of
an asset.
Risk Free
Return
Efcient Portfolio
Return
= R
f
BETA
1.0
Figure 3.5: The CAPM and t he securit y market line.
Act ivit y 3.7
Est imat ion of bet a
Equation 3.11 depicts that there is a linear relationship between risk
and return on individual assets. The risk is measured in terms of its risk
relative to the market (beta) and return is what investors and the market
would expect to receive given this level of market risk. Consequently
knowing beta would allow us to estimate the expected return on an asset
or security.
How do we estimate the beta for a company? The following example
demonstrates a simple approach which can be used in practice.
(3.10)
(3.11)
48
Example 3.5
SpringTime plc is an all-equity financed company on the London Stock
Exchange. For the last five years, its stock returns and the returns on FTSE100
are as follows:
Year
Ret urns on
Spri ngTi me (% )
Ret urns on
FTSE100 (% )
1 10 8
2 6 1
3 -4 10
4 24 12
5 19 14
The risk-free rate is 5% per annum.
Using the above information, we can estimate beta and the expected return on
SpringTime. The approach is as follows:
1. Compute the mean return of SpringTime and FTSE100 (Column I and II).
2. Determine the deviation of each observation from its mean (Column III and
IV).
3. Calculate the covariance of returns between SpringTime and FTSE100 by
averaging the sum of the products of each pair of deviations (Column V).
4. Calculate the variance of returns on FTSE100 (being the average of the sum
of the squared deviations of Column VI).
5. Estimate the beta.
6. Substitute beta into the CAPM equation.
I II III IV V VI
Year
Spri ngTi mes
ret urn
FTSE100s ret urn DEV, S DEV, M III IV IV IV
% % % % % %
1 10 8 -1 -1 1 1
2 6 1 -5 -8 40 64
3 -4 10 -15 1 -15 1
4 24 12 13 3 39 9
5 19 14 8 5 40 25
Sum 55 45 105 100
Mean 11 9 Covari ance 21
Vari ance 20
Beta is defined as the market risk of a company. This implies that we
measure the covariance of the return relative to the risk of the market. In
other words, beta can be calculated as follows:

Covariance
Substituting in the CAPM equation we have

= 5 + 1.05 (9 5)
= 9.2
49
Act ivit y 3.8
There are a few aspects of estimating beta worth noting here:
i. In the absence of any information about the expected return on the
market (i.e. the return on FTSE100 in the above example), the average
historic return will be the only sensible proxy for the expected return.
ii. In the above analysis, we have not adjusted for the small sample error.
If we do, the analysis will be as follows:
I II III IV V VI
Year
Spri ngTi mes
ret urn
FTSE100s ret urn DEV, S DEV, M III IV IV IV
% % % % % %
1 10 8 -1 -1 1 1
2 6 1 -5 -8 40 64
3 -4 10 -15 1 -15 1
4 24 12 13 3 39 9
5 19 14 8 5 40 25
Sum 55 45 105 100
Mean 11 9 Covari ance 26.25
Vari ance 25
You can see that the differences lie on the calculation of the covariance
and variance. We re-calculate the covariance and variance using
equations 3.4a 3.4c. However, the beta remains unchanged (26.25/25
= 1.05).
iii. The estimation of beta is sensitive to both the return intervals and the
sample periods. Daves, Ehrhardt and Kunkel (2000) have the following
conclusion:
Financial managers can estimate the cost of equity via the
CAPM approach. If the financial manager estimates the firms
beta... then the financial manager must select both the return
interval and the estimation period. Regarding return interval...
the financial manager should always select daily returns because
daily returns result in the smallest standard error of beta or
greatest precision of the beta estimate. However, regarding
estimation period, the financial manager faces a dilemma. While
a longer estimation period results in a tighter standard error for
the estimate of beta, a longer estimation period also results in
a higher likelihood that there will be a significant change in the
beta. Thus, the beta estimated over longer estimation periods
is more likely to be biased and of little use to the financial
manager.
Concept ual issues wit h CAPM
The CAPM implies relationships between ex ante (expected) risk
premia and betas that are not directly observable. However, in most
empirical work, we implicitly assume that the realised returns on assets
in a given time are drawn from the ex ante probability distribution of
returns on those assets under rational expectations.
50
Empirical tests use time-series data to calculate mean excess rates of
return and betas; however, it is unlikely that risk premia and betas
of individual assets are stationary over time. This issue is addressed
by explicitly forming portfolios that are stationary over time or
conditioning risk premia and betas on information sets.
Many assets are not marketable and tests of the CAPM are inevitably
based on proxies for the market portfolio. The test of the CAPM becomes
a test whether the proxy is mean-variance efficient (Roll, 1977).
Empirical evidence and evaluat ion
Both BMA Chapter 8 (pp.22327) and Arnold Chapter 8 (pp.29599)
discuss the empirical evidence of the CAPM. The key question one must
ask is whether the CAPM is indeed the true model for explaining the risk
and return of individual companies. The summary of empirical evidence
from the textbooks and the text given in this section both indicate that the
cross-sectional returns are not explained solely by the market risk factor,
beta. There appear to be other risk factors which explain the expected
returns of individual companies.
It is advised that you read and make notes from BMA Chapter 8 (pp.223
27) and Arnold Chapter 8 (pp.29599) before proceeding with the rest of
this section.
An extensive body of empirical research has provided evidence
contradicting the prediction of the CAPM. This research documents that
deviations from the linear CAPM risk-return trade-off are related to,
among other variables, firm size (defined as the natural logarithm of the
market value of a firm), earnings yield (defined as the earnings per share
of a firm over its share price value), leverage (measured as the ratio of
debt to equity) and the book-to-market ratio (defined as the net book
value of a firm over its market value). Ferson (1992) provides an extensive
summary of these empirical tests on the CAPM and its anomalies up to 1991.
Other notable works include:
Banz (1981), Basu (1983), and Reinganum (1981) show that the firm size
and earnings yield can explain the cross-sectional returns in conjunction
with the market beta, suggesting that beta is not the only risk factor.
Fama and French (1992) show that by employing a new approach for
portfolio grouping, there is only a weak positive relation between average
monthly stock returns and market betas over the period from 1941 to
1990. This relation virtually disappears over a shorter period from 1963
to 1990. However, firm size and the book-to-market equity ratio have
considerable power. The findings in this paper cast serious doubt over the
validity of the CAPM as the true cross-sectional asset pricing model and
has stirred up a new wave of empirical attention on the CAPM.
However in any CAPM test, there are two issues that need to be resolved:
i. Is the data for measuring or testing the expected returns taken from a
complete set which has no bias? Kothari, Shanken and Sloan (1995)
argued that if portfolios are formed from a data set which contains only
the surviving firms, the CAPM test might not be conclusive.
ii. How can we be sure that the betas were correctly estimated in Fama
and French (1992) if significant estimation errors are found in the
estimated betas? If such estimation errors exist, then the tests on
the significance of the betas in cross-section regression would be
undermined (Kim, 1995).
Debate about whether the CAPM is the true pricing model is still going on.
51
The following section outlines the alternative pricing models.
Alt ernat ive asset pricing models
BMA Chapter 8 (pp.22731) discusses the alternative pricing models. Read
this section in the textbook before continuing with this section.
Multifactor models can be divided into three types: statistical,
macroeconomic and fundamental factor models. Statistical factor models
derive their pervasive factors from factor analysis of the panel data set of
security returns. Macroeconomic factor models use observable economic
time series, such as inflation and interest rates, as measures of the
pervasive shocks to security returns. Fundamental factor models use the
returns on portfolios associated with observed security attributes such as
dividends yield, the book-to-market ratio, and industry identifiers.
The basic model takes the following form:
One of the most cited literatures on macroeconomic variable model is Chen,
Roll and Ross (1986). They observe that asset prices are driven by exogenous
forces as daily experience seems to support the view that prices react to
unexpected news. If these forces are not diversifiable, the market will
compensate investors for bearing those risks. They find that, most notably,
the industrial production, changes in the risk premium, twists in the yield
curve, and somewhat more weakly, measures of unanticipated inflation and
changes in expected inflation during periods when these variables were
highly volatile are significant. Contrary to previous belief, they find that the
market return is not priced despite its high content of explanatory power.
Fama and Frenchs three factor model is a good example of a fundamental
factor model. BMA Chapter 8 (pp.22931) explains how this model can be
estimated.
Act ivit y 3.9
Pract ical considerat ion of CAPM
Despite the highly unrealistic assumption underpinning the CAPM and the
empirical evidence against the model, practitioners remain faithful to the
CAPM. Harvey and Graham (2002) examine what CFOs use in practice to
estimate the cost of capital for their companies. Over 70% of the respondents
rank the CAPM as the most popular tool to estimate the cost of capital.
Est imat ion met hod f or cost
of capit al
Popularit y, % always or
almost always
CAPM 73.49
Average hi st ori c ret urn 39.41
CAPM wi t h ext ra ri sk f act ors 34.29
Di scount ed di vi dend model 15.74
Invest ors expect at i on 13.93
Regul at ory deci si ons 7.04
Table 3.1: Popularit y of met hods of calculat ing t he cost of equit y capit al.
52
describe the meaning of risk and return
calculate the risk and return of a single security
discuss the concept of risk reduction/diversification and how it relates
to portfolio management
calculate the risk and return of a portfolio of securities
discuss the implications of the capital market line (CML)
discuss the theoretical foundation and empirical evidence of the capital
asset pricing model (CAPM) and its application in practice.
1. Suppose we have the following inflation rates, stock markets and US
Treasury Bill returns between 2006 and 2010:
Year Inf l at i on (% ) S&P 500 Ret urn (% ) T-bi l l Ret urn (% )
2006 3.3 23.1 5.2
2007 1.7 33.4 5.3
2008 1.6 28.6 4.9
2009 2.7 21.0 4.7
2010 3.4 -9.1 5.9
a. What was the real return on the S&P 500 in each year?
b. What was the average real return?
c. What was the risk premium in each year?
d. What was the average risk premium?
e. What was the standard deviation of the risk premium?
2. Is standard deviation an appropriate measure of risk for financial
investments or projects? Discuss.
3. A game of chance offers the following odds and payoffs. Each play of
the game costs 100, so the net profit per play is the payoff less 100:
Probabilit y Payoff Net Profit
0.1 500 400
0.5 100 0
0.4 0 100
What are the expected cash payoff and expected rate of return?
Calculate the variance and standard deviation of this rate of return.
4. What do you understand by the term risk and return in the context of
financial management?
53
1. Suppose that you are considering investing in only two companies,
Rose Plc and Thorn Plc. Their returns for the last five years are as
follows:
Year Ret urn on Rose Pl c (% ) Ret urn on Thorn Pl c (% )
5 8 6
4 20 7
3 16 8
2 4 1
1 12 10
Required:
a. Calculate the expected return and standard deviation to the nearest
percentage of both Rose and Thorn.
b. Calculate the coefficient of correlation between the return of Rose
and Thorn.
c. Suppose you combine 50% of Rose and 50% of Thorn in a portfolio.
Calculate the portfolios expected return and standard deviation.
d. Suppose that the risk-free rate is 6%. Explain, with the aid of a
graph, the composition of an optimal portfolio.
2. James, who is a risk averse investor, is deciding how to divide his
money between two assets, peppers and corn, which have the following
characteristics:
Peppers Corn
Expect ed ret urn 10 10
St andard devi at i on 5 5
If the returns on Peppers are independent of those on Corn, what will
be the composition of his optimal portfolio? Would the composition of
the portfolio be different if a risk-free investment is available to James?
3. What are the necessary conditions for an efficient diversification of
risk?
a. What is the relationship between the number of available securities
and the gains from diversification?
b. Does this relationship have any implication for the small investor?
c. In theory, an investor in risky securities is presumed to select
an investment portfolio which is on the efficient frontier and
touches one of his indifference curves at a tangent. But in
practice, neither the efficient frontier nor the indifference can be
estimated with high degree accuracy. Therefore, the portfolio
theory is redundant.
Explain the terms in bold in the above statement. Critically assess their
validity.
4. Suppose that you have estimated the expected returns and betas of the
following five stocks using annual data available for the last 10 years:
54
St ock Market Si ze (m) Bet a Expect ed Ret urn (% )
A 360 0.6 8
B 23 0.8 10
C 250 1.2 11
D 10 1.3 12
E 500 1.4 12
The risk-free rate of interest and the expected return on the market are
5% and 10% respectively. You are also told that the market size of the
companies in this market is normally distributed with a mean of 400m
and a standard deviation of 150m.
Required:
a. Explain carefully the extent to which these data are consistent with
the capital asset pricing model and whether there is any optimal
investment strategy.
b. What would you advise an investor who would like to hold a portfolio
with a beta equal to 1?
c. The risk of a company depends upon much more than how well
the stock market is doing. Beta only captures the co-movement of a
companys share price with the market; and hence fails to capture
various sources of risk.
Critically assess the validity of the capital asset pricing model and its
use as a benchmark for project appraisals.
Chapt er 4: Capi t al market ef f i ci ency
55
Chapt er 4: Capit al market ef f iciency
Essent ial reading
McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapter 13.
Furt her reading
Hall, 2008) fourth edition [ISBN 9780273719069] Chapter 14.
Aims
The first part of this chapter introduces you to the theory and practice
of capital markets. It considers the concept of an efficient capital market
with its implications for the raising of capital and the assurances for a fair
game situation for the transfer of funds between investors. The types and
the degrees of efficiency have been tested in many various ways with more
recent research findings highlighting certain anomalies which give support
to those who have questioned the concept. Discrepancies in types and
degrees of efficiency between different international markets have also
been identified. The efficient market hypothesis has important implications
for all market operators and their agents.
Learning out comes
describe the nature and types of capital markets
explain the efficient market hypothesis, its different levels, the
anomalies and deviations between theory and practice as well as
summarise the evidence that has been produced both in support for
and against the hypothesis
explain the implications of market efficiency for the various operators
who use the markets or provide information regarding them (e.g.
investors, companies raising funds and financial analysts)
discuss how the financial markets operate particularly with respect to
the provision of funds for companies
list/outline the range of securities used to generate funds for
companies including a more in-depth insight of the main forms of debt
and equity.
Capit al market s
The primary function of the capital markets is to enable investors
and companies to raise funds. The secondary function is to provide
opportunities for providers of funds to liquidate their investments. Note
that this latter function is vitally important because, without the facility to
exit from an investment, few people or institutions would be prepared to
make investment funds available. Thus the marketplace is providing the
needed interface for investors to interact with companies, through their
management, that wish to raise funds as well as other investors who may
wish to buy or sell existing financial assets.
56
You should learn the assumptions underpinning the definition of a perfect
capital market and how the economists perfect market becomes the
financial managers efficient capital market and the necessary conditions
for that. Note you should also use and understand how the notion of being
involved in a fair game proves the basis for discussion here.
Types of ef f iciency
An efficient market needs operational, allocational and informational
efficiency. A perfect market requires that trading is costless, that
information is costless and freely available, and that no single investor is
dominant.
Operational efficiency means that transaction costs should be as low as
possible and that sales are quickly effected.
Allocational efficiency means that capital markets allocate funds to
their most productive use.
Informational efficiency means that security prices fully and fairly
reflect all relevant information so that they are fair prices.
When discussing efficiency, the majority of the research findings in the
literature relate to pricing efficiency. It is to this that the efficient market
hypothesis (EMH) relates.
Ef f icient market hypot hesis (EMH)
There are three forms or levels of informational efficiency:
1. Weak form prices reflect all past information.
This means that one cannot consistently earn better-than-expected
(abnormal) investment returns as a result of studying past patterns of
prices for particular securities. This implies that people who draw charts
of past share price movements, and try to detect patterns of share price
movements, would not gain as a result.
Share prices in a market which are consistent with the weak form
should behave like a random walk (i.e. share prices do not follow any
particular pattern). Prices are moved only when relevant information
about the securities arrive in the market. Since the arrival of new
information does not normally follow any particular pattern, this has the
effect that share prices follow an apparently random walk.
BMA shows the random pattern (random walk) of Microsofts share
prices in Figure 13.2 on p.344.
The random walk hypothesis suggests that there is no connection
between successive share price movements. Early empirical work
supports this view, meaning that capital markets are weak form efficient.
2. Semi-strong form prices reflect all publicly available information.
This means that no one can earn abnormal returns based on the study
of publicly available information about the enterprise. For example, the
publication of a companys accounting reports would not be expected to
be advantageous.
3. Strong form prices reflect all public and private information.
This means that no one can obtain abnormal return by trading private
information. Security prices would have already incorporated the
information content of any valuable private information about a
company.
57
It is important to understand that, if a market is efficient in the strong
form, it must also be efficient in the semi-strong form and the weak
form. Similarly, if a market is efficient in the semi-strong form, it must
also be efficient in the weak form.
These distinctions are useful. This is because evidence, which consists
of the results of a large number of research studies, tends to suggest
that the worlds capital markets are efficient in the weak and semi-
strong form, but not in the strong form. In other words, those who have
relevant information that is not generally known can expect to earn
better than average investment returns.
Note carefully what is meant by efficient market hypothesis (EMH).
EMH does not require that the markets are perfect in the sense that they
are referred to by economists, nor does EMH require that any investors
have perfect knowledge of the future. EMH is concerned with the extent
to which the knowledge which does exist about a particular security
is fully taken account of in its market price. Thus the price at which a
security is traded today may, with the advantage of information which
may subsequently come to light, be above or below the true worth of the
security. EMH requires that the price at which that security is traded today
rationally reflects all of the information which is available today.
Act ivit y 4.1
Look at a l ocal paper whi ch quot es dai l y share pri ces. Sel ect a company and pl ot t he
cl osi ng share pri ces f or t he f i ve days i n one week wi t h t i me on t he x axi s. Draw a l i ne of
best f i t t hrough t hose f i ve poi nt s. Then pl ot t he next Mondays cl osi ng pri ce. By readi ng
t he paper about Mondays market act i vi t i es t ry t o expl ai n why t he pl ot f or Mondays
pri ce i s where i t i s, on, above or bel ow t he t rend l i ne you have drawn. Is your expl anat i on
drawn f rom t he weak, semi -st rong or st rong f orm?
Foundat ion of market ef f iciency
To ensure that information can be reflected in security prices, the
following assumptions must be upheld:
Rat ionalit y
Investors are rational. They seek returns to compensate for their
investment risk and would avoid unnecessary risk wherever possible.
The stock market is rational in the sense that stock prices reflect their
fundamental values. If such rationality is in place, it is argued that
investors and the market will value securities based on their fundamentals.
Independent deviat ions f rom rat ionalit y
Efficient markets allow individuals to deviate from the principle of
rationality from time to time. As long as their irrational trading behaviour
is random, it is argued that the effects of their irrational actions will cancel
each other out without affecting the efficient price level.
Arbit rage
Arbitrage is possible to ensure securities that are out of price would be
aligned to their fundamental values. Even if most investors are irrational
in the same way, as long as some rational investors can arbitrage and
eliminate the influence of the irrational traders actions, then prices can be
restored to their efficient level. However, if arbitrage is not possible, any
mispricing in securities would not be adjusted.
58
Act ivit y 4.2
Ident i f y and expl ai n whi ch f orms of ef f i ci ency are adhered t o and/ or vi ol at ed i n each of
t he f ol l owi ng si t uat i ons:
i . St ock ret urns t end t o be l ower i n December t han i n January.
i i . Smal l capi t al i sed st ocks perf orm subst ant i al l y bet t er t han t he market whi l e l arge
capi t al i sed st ocks perf orm si gni f i cant l y worse t han t he market i n 2006.
i i i . The London St ock Exchange has recent l y publ i shed a report on i nsi der t radi ng. It has
been f ound t hat t here i s no evi dence f or any i nsi der t radi ng.
i v. BAC pl c has j ust announced a record prof i t but i t s share pri ce f al l s by 10% .
v. Mrs Smi t h announced on nat i onal TV t hat she can predi ct st ock ret urns bet t er t han
t he capi t al asset pri ci ng model .
Test s of t he ef f icient market hypot hesis
Chapter 13 of BMA, pp.34654 and Chapter 14 of Arnold, pp.57096
cover a good deal of the testing of EMH. You should read the relevant
sections in the textbooks and familiarise yourself with the evidence for and
against market efficiency.
In general, we can summarise the testing on market efficiency in 3 areas:
i. Weak form testing
Researchers have conducted the greatest number of tests on the
weak form efficiency. Tests have looked for data patterns that might
have particular properties similar to different frequency distributions
random-walk, sub-martingale,
1
simple sequences of increases or
declines all with the aim of being able to derive a trading rule which
would enable the investor to out-perform the market using a simple
buy and hold strategy. The tests have been performed on numerous
different markets, over different time periods, etc. The results have not
been uniform in outcome. The differences in results can be explained
by many features developed country markets versus developing
country markets, monthly versus daily versus weekly prices, upward
versus downward price trends etc.
ii. Semi-strong form testing
The tests on the semi-strong form have also been numerous and again
produced results lacking in consistency. The tests using data from
developed country markets have tended to support the conclusion
that the market adjusts quickly (i.e. efficiently) to publicly available
information. Results from developing market studies have been much
fewer and have tended to suggest a lower degree of efficiency.
iii. Strong form testing
The strong form tests have been least successful in their proof of
the strong form of efficiency in the markets. Clearly there are still
circumstances that exist where investors under the strong form could,
and do, earn above average profits. This is in spite of legislation in
some countries in the markets outlawing particular operations (e.g.
insider trading).
1
A sub-mart ingale
is a process in which
t he expect ed next
periods value, based
on t he current periods
informat ion, is great er
t han or equal t o t he
current periods value.
59
Anomalies, f ads, insider t rading and doubt s concerning ef f iciency
There are now many published articles on the anomalies of EMH (e.g.
day-of-the-week effect, trading-hours-of-the-day effect, even month of the
year effect, size anomalies and small company effect). These anomalies
may help to explain why certain investors can obtain abnormal profits.
However, there is no evidence of consistent abnormal gains accruing to
investors who have based their trading upon these anomalies.
There is also sufficient anecdotal evidence of investors following fads and
engaging in insider trading. This casts doubts on market efficiency.
Implicat ions of EMH
Invest ors
If markets are adhering to the strong form efficiency, then no one can
obtain abnormal returns by using any private or public information.
Equity research is pointless and no bargains exist on the capital markets.
Investors are best advised to buy a portfolio of shares and to hold those
shares rather than look for opportunities to buy cheap shares. This is
because securities reliably reflect all known information about a business,
so if shares look cheap it is illusory all that will happen is that the
investor will waste time and money seeking out the cheap shares, then
spend money on agents fees etc. to sell part of the existing portfolio and
replace it with the cheap shares.
However, if the market is not adhering to the strong form efficiency, then
for the vast majority of people, public information cannot be used to earn
abnormal returns. Arguably only those investors who have superior private
information would gain. The perception of a fair game market could be
improved by more constraints and deterrents placed on insider dealers.
Similarly, if the markets are adhering to the semi-strong form efficiency,
fundamental analysis (which looks for the fundamental value of a share)
would not add value. Instead, investors need to press for a greater
volume of timely information to ensure that stock prices reflect full public
information about companies.
If the markets are adhering to the weak form efficiency, then technical
analysis (which seeks to predict share prices from studying their historic
movements) would be redundant as past stock price patterns would have
already been incorporated in the current stock prices.
Companies
Accounting misinformation will not fool investors generally. There is a
body of evidence which suggests that attempts by corporate managers to
make alterations to the accounting bases, to figures published in annual
accounts which have the effect of giving a changed view of the profit for
a period or the assets on the balance sheet, will not affect the market
price of the businesss shares; this is provided that the facts concerning
the alterations to the accounting bases are made public. However not
everything may be made public and in any case some manipulation
may be possible within the guidelines and thus not published. There
are numerous reasons why management wants financial information
presented in a particular way (e.g. income smoothing because of the link
with a management remuneration scheme).
The timing of issues of new shares by businesses is not an important
question. It seems that corporate managers are frequently concerned not
to issue shares at a point where share prices are historically low, since in
60
order for the issue to be successful the new issue would have to be at a
low price; this is irrational if current share prices reflect all that is known
about the business. Only where the businesses managers have economic
information about the business that they have yet to release into the public
domain would delay be justified. Again, anecdotal evidence can show in
specific instances where businesses did lose out by having to issue at the
wrong time.
Possibly the shift in research findings reflects a genuine lessening of CME
over recent times, perhaps caused by an effective decline in the number of
individual investors active in the market.
Possibly it reflects the use of more sophisticated research techniques in
recent studies, which are leading to a truer view of things.
Act ivit y 4.3
Summari se t he si x l essons of market ef f i ci ency on pp.358 61 of BMA, Chapt er 13. In your
opi ni on, how f ar do you agree t hat t he capi t al market s are i nf ormat i onal l y ef f i ci ent ?
describe the nature and types of capital markets
explain the efficient market hypothesis, its different levels, the
anomalies and deviations between theory and practice as well as
summarise the evidence that has been produced both in support for
and against the hypothesis
explain the implications of market efficiency for the various operators
who use the markets or provide information regarding them (e.g.
investors, companies raising funds and financial analysts)
discuss how the financial markets operate particularly with respect to
list/outline the range of securities used to generate funds for
companies including a more in-depth insight of the main forms of debt
and equity.
Critically comment on each of the following statements:
1. The stock market is depressed at the moment. This is a very bad time
for our business to make an issue of new shares to the public.
2. If stock market prices are efficient, it means that all investors have
complete information about all of the shares quoted in that market.
3. The stock market cannot be semi-strong efficient, otherwise you
wouldnt have all those well paid analysts spending most of their
working day poring over business reports and other published
information.
61
1. a. Explain clearly the following terms:
i. weak form efficiency
ii. semi-strong form efficiency
iii. strong form efficiency.
b. Discuss and identify which form of efficiency the following markets
are adhered to and/or violated:
i. Stock returns tend to be higher in January than in other months.
ii. Some stocks perform substantially better than the market while
some stocks perform significantly worse than the market in any
given month.
iii. Roughly half of a group of professional portfolio managers beat
the market during 2000.
iv. Consistently superior returns are earned by buying a companys
stock the day after an announcement of good news, for example,
after an increase in earnings.
v. Mr Solaree announced on national TV that he has discovered
a trading strategy that can outperform the market by 3% on
average.
c. Why is it important to ensure that the market is informationally
efficient?
2. a. What are the main implications of market efficiency to:
i. investors
ii. companies/financial managers.
b. What empirical evidence do we have for and against the following
forms of market efficiency?
i. weak form
ii. semi-strong form
iii. strong form.
Not es
62
Chapt er 5: Sources of f i nance
63
Chapt er 5: Sources of f inance
Essent ial reading
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New
York: McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters
14 and 15.
Furt her reading
Aims
In this chapter we focus on the main reasons why firms raise funds from
capital markets and discuss the main methods of raising equity and debt.
We will also discuss the pros and cons of each method of fund-raising.
Learning out comes
discuss how the financial markets operate, particularly with respect to
outline the range of securities used to generate funds for companies,
including a more in-depth insight of the main forms of debt and equity.
Int roduct ion
In Chapter 2 we discussed why firms engage in financial investments.
In order to maximise the value of a firm, managers must come up with
sufficient cash flows to undertake all positive NPV projects. A firm may
rely on two sources of funds: internal and external.
1
Int ernal f unds
The main source of internal funds comes from retained earnings. Firms
set aside resources by retaining part of their yearly earnings for future
investment purposes. It is often argued that internal funds are much more
preferred to external funds because:
retained earnings are seen as a ready source of cash or cash equivalent
there is no issue or transaction cost involved with retained earnings
(as opposed to equity or debt issues see below)
there is no dilution of control with retained earnings
no public scrutiny of why the funds are needed and how they are to be
used.
1
We will discuss more
t horoughly t he t heory
of capit al st ruct ure in
Chapt er 6. In part icular
t he pecking order t heory
will be covered.
64
Ext ernal f unds
External funds can be roughly divided into equity finance and debt finance.
1. Equity finance
Equity finance can be raised by selling ordinary shares to existing
shareholders or new investors. These shares can be sold or bought
in stock exchanges around the world. Ordinary shareholders are
the ultimate bearers of risk in a company, as they are at the base of
the creditor hierarchy and stand to lose everything in the event of
liquidation. They therefore demand a higher return to compensate for
the risk they bear.
Ordinary shares have a nominal (or par) value which gives every
shareholder an equal voting right. An ordinary share is normally issued
at a price higher than the par value. The difference is called the share
premium. However, the issued price is not normally the same as the
market price of a share and the share price fluctuates on the basis of
how stock markets value the company.
2. Debt finance
Debt finance refers to the borrowings of a company to finance its
operations. We will cover this on page 68.
Act ivit y 5.1
On 4 May 2010, Essar Energy, an Indi an oi l and gas producer, i ssued ordi nary shares at
4.20 f or a t ot al of 5,470m on t he mai n London St ock Exchange. It s share pri ce as on
1 November was 2.97.
(Sources: www.essarenergy.com/ and www.newi ssuecent re.co.uk/ 2010i ssues.ht m)
Why woul d a company such as Essar Energy i ssue ordi nary shares on a st ock exchange?
Why di d t he share pri ce of Essar f al l af t er t he i ssue on 4 May 2010?
Flot at ion
Many companies, such as Essar, would like to issue shares on stock
exchanges. The main reasons for companies to do so are to:
raise funds for current and future investments, ease out liquidity
shortages and reduce debts
gain easier access to equity and other sources of finance in the future
use quoted shares in various ways, such as in a take-over bid.
However, flotation of shares in stock exchanges is not without
consequences. Some of the concerns are listed below:
Meeting investors expectations it is evident that once a company is
floated on a stock exchange, it will be more heavily scrutinised by the
public and especially existing investors. As share prices are supposed
to reflect the investors expectations about the companys future
dividends, managers must try hard to ensure that this expectation is
met.
Costs of flotation the process of flotation is a very expensive exercise
for a company. It is often thought that most companies would at
some point in their life cycle have to consider flotation in the stock
markets. The attraction or benefits from a flotation must outweigh the
limitations.
65
Increased financial transparency and stock exchanges requirements
the costs of flotation are not confined to the payments made to
sponsors, stockbrokers, underwriters and other professionals. Once
a company is listed on a stock exchange, the requirement for a high
degree of transparency and reporting requirements might threaten its
continued listing.
2

Act ivit y 5.2
Read t he f ol l owi ng art i cl e f rom The Daily Telegraph, 4 November 2007:
www.t el egraph.co.uk/ f i nance/ market s/ 2818853/ Vi rgi n-i n-t rai ni ng-f or-1bn-f l ot at i on-of -
gyms-di vi si on.ht ml
Di scuss t he pros and cons of f l ot at i on on t he st ock market .
Why do companies seek list ing on more t han one st ock exchange?
Some companies may seek flotation on more than one stock exchange.
Some of the main reasons are listed below:
Broaden the investor base it allows companies to tap into a wider
base of investors with the hope that more funds can be raised in the
future.
Domestic stock exchange is too small it is argued that when
the domestic markets are too small, companies might seek listing
elsewhere.
Reward to employees employees of foreign-owned companies may
receive shares in their parent company as part of their remuneration.
If shares are quoted in the domestic market, it is argued that these
employees could be able to manage their share value better, appealing
more to them as a result.
Better understanding in the foreign market (price stabilisation).
Raising awareness of the company (Chinese and Russian companies
quoted on stock exchanges such as the Hong Kong Stock Exchange and
the London Stock Exchange).
Act ivit y 5.3
Read t he f ol l owi ng art i cl e:
www.f undi nguni verse.com/ company-hi st ori es/ Dai ml erChrysl er-AG-Company-Hi st ory.ht ml
In your opi ni on, why di d Dai ml er-Benz (t he l uxuri ous car maker) seek l i st i ng on t he New
York St ock Exchange?
Share issues
We have discussed at great length the pros and cons of issuing shares in
stock markets. In the following section, we will look at the mechanism of
issuing shares to the public.
Init ial public of f er (IPO)
This is when a firm issues shares to the public for the first time. It is a
major step for a firm to go public.
2
Olympus was
t hreat ened wit h delist ing
from t he Tokyo St ock
Exchange if it failed t o
le a quart erly report by
14 December 2011. See
www.bbc.co.uk/ news/
busi ness-15669164
66
Issuing process
Given the complexity of raising funds in the stock markets, it is often
considered to be essential that advisers should be appointed. These
advisers fall into the following categories:
Sponsor
This is normally an investment banker, stockbroker or another
professional who possesses all the necessary expertise and is approved
by the local listing agents to act as an adviser to issuing firms. The
sponsor (commonly known as the issuing house) will first examine and
assess if going public is the appropriate corporate objective by taking
into consideration the composition of the board. The sponsor will also
advise on the issue price and the number of shares to be issued given
the market conditions and the method and timing of the equity issue.
Underwriters
Since it is difficult to estimate the precise demand of the new shares, an
issuing company will normally appoint an underwriter (or a syndicate
of underwriters) to underwrite any unsubscribed shares. If the price
set by the sponsor is too high, the demand will be less than supply and
the issuing firm will be left with unwanted shares. This implies that the
firm will not be able to raise sufficient funds for its use. To ensure that
this is not going to happen, a firm will pay the underwriters a sum of
money (acting like an insurance premium). In return, the underwriters
will guarantee to buy back any unwanted shares. The price of the
unwanted shares that the underwriters will buy back from the issuing
firm will be lower than the original issue price to the public.
Other professionals
Accountants and lawyers provide reports about the issuing firms
financial position and advise on legal matters relating to the equity
issue.
In considering issuing shares to the public, a company might need to take
the following factors into account:
Price stability a newly floated firm should ensure that its share
price is stable to give investors additional confidence. Therefore it
is important that after listing, the issuing firm has the continuing
obligation to release any price-sensitive information to the market as
soon as possible.
Timing market timing for new share issues is crucial to determine if
the issue is going to be fully subscribed. The Industrial and Commercial
Bank of China (ICBC) simultaneously floated its shares on both the
Hong Kong Stock Exchange and the Shanghai Stock Exchange. It was
the worlds largest IPO at that time. Due to the favourable market
timing, the shares were heavily over-subscribed and the share price
ended up some 15% over the initial offer price by the end of the first
trading day.
Initial returns investors are drawn to the prospect of receiving good
returns from their IPO shares. Companies which seek to float their
shares for the first time might need to consider underpricing their
shares to attract investors.
3
Long-term performance even though there are investors who
often look for bargain or short-term profit from their investment,
the majority of them are looking for sustainable long-term returns
3
See BMA pp.400401
and Figure 15.3.
67
on their investment. A new IPO firm would need to prove itself to
be a worthwhile investment by showing solid and good long-term
performance.
Right s issues
Apart from issuing shares to the public, a company can also raise funds
directly from its existing investors. This is known as a rights issue. In a
rights issue, new shares are issued pro-rata to existing shareholders which
preserves the existing patterns of ownership and control. It is cheaper
than an offer for sale, but is limited by funds at the disposal of existing
shareholders. Shares in a rights issue are usually offered at a discount
(around 15% to 20%) on the current market price, making them more
attractive to shareholders and allowing for any adverse share price
movements.
After a rights issue, shares would be traded at the theoretical ex-rights
price. The theoretical ex-rights price is given by:
P
e
=
P
0
N
0
+ P
N
N
N
N
Where:
P
0
is the share price before the rights issue
N
0
is the number of old shares
N is the total number of shares after the rights issue
P
N
is the issued price of the rights issue
N
N
is the number of new shares created from the rights issue
Example 5.1
TLC plcs current share price is 10 each. There are 1m ordinary shares in issue.
The company considers a one for four rights issue at an issuing price of 8 per
new share. What is the theoretical share price after the rights issue?
P
e
=
P
0
N
0
+ P
N
N
N
N
= 10
1,000,000
1,250,000
+ 8
250,000
1,250,000
= 9.60.
Rights can be sold to investors: the value of rights is the difference between
the theoretical ex-rights price and the rights issue price. If shareholders either
buy the offered shares or sell their rights, there is no effect on their wealth.
In the case when a shareholder accepts the rights and buys the share, her net
worth is 9.60 5 8 = 40 which is the same value before she subscribes
to the new share (i.e. 10 for each of the 4 shares she owns). If she sells the
rights, she should have (under the no arbitrage assumption) the same wealth.
Consequently, the value of the rights must be calculated as 10 4 9.60 4
= 1.60.
However, the actual ex-rights price will be different from the theoretical ex-
rights price due to market expectations about the economy, the company and
dividends.
68
Privat e issues
Sometimes it is more advantageous for a company to issue shares privately
to potential shareholders. Some of the possible ways of offering shares to
private investors are listed below:
Placement or placing this involves issuing blocks of new shares at
a fixed price to institutional investors. It is a low-cost issuing method
involving little risk. There is no limit on the amount to be placed. It is a
popular choice for small to medium-sized share issues.
Offer for sale this is when the issuing firms sponsor offers the shares
by inviting institutional and individual investors. Normally the offer
is at a fixed price usually for large issues of new equity and involves
offering shares to the public through an issuing house or a sponsoring
investment bank. A variation to this is the offer for sale by tender. Here
investors are invited to state at what price they are willing to buy the
shares. The sponsor will gather all information and determine a price
(the strike price) that will guarantee all shares are sold. This strike
price will be the selling price for all the shares. Those investors who
submit a bid price higher than the strike price will be allocated shares,
while those who submit a price lower than the strike price will not be
allocated any shares. This method is popular when the actual issued
price is difficult to determine.
The role of st ock market s
Allow firms to raise funds and grow stock markets enable companies
to find investors to raise funds to finance their investments.
Allow investors to buy and sell stocks well-organised stock markets
enable investors to buy and sell stocks whenever they want. A stock
market is said to be liquid if investors can easily buy or sell their shares
at the prevailing market prices.
Status and publicity due to the heavy scrutiny by regulators and
stock exchanges, companies which are floated on well-organised stock
exchanges are often regarded as more valuable.
Mergers one of the requirements for companies to be floated on
stock exchanges is that they would need to file quarterly financial
information. This more regular reporting process helps companies to
disseminate financial information more readily to investors. It is argued
that this makes companies financial status more transparent and hence
under-valued companies are easier to identify. This might encourage
under-valued companies to be take-over targets.
Improve corporate behaviour the heavy regulations and scrutiny by
the markets are often seen as the invisible hand which helps steer
financial managers action to maximise shareholders wealth.
Debt f inance
Advant ages of debt f inancing
The issue of loan capital (debt) can bring certain advantages to a business
and its shareholders. These advantages include:
By employing loan capital to help finance the business, the returns to
equity shareholders will increase, providing the returns from the funds
invested exceed the cost of servicing the loan.
69
Loan capital is normally perceived as being less risky by investors than
equity shares as loan interest is payable before share dividends and
security is normally provided by the business for the loan this lower
level of risk results in lower expected returns by lender than equity
shareholders.
In most countries, interest on loan capital is viewed as an allowable
business expense which can be offset against profits for taxation
purposes this is not the case for dividend payments.
The degree of sophistication and variety now available in bond or
quasi-bond securities has grown enormously in recent years through
the increasing competitiveness within financial markets. Examples of
these new types are junk bonds, deep discounted bonds, mezzanine
finance, interest-rate swaps and debt-equity swaps.
Disadvant ages of debt f inancing
The use of loan capital to finance a business, however, also brings certain
disadvantages:
The higher the level of borrowing, the higher the level of financial risk
associated with the business. The level of borrowing is also known as
the amount of gearing. Interest must be paid irrespective of the profit
level and capital must be repaid on maturity of the debt. Also in a
winding up, administration or receivership, an unsecured lender is
repaid before a shareholder. This higher level of risk is likely to mean
that equity shareholders will seek higher returns in compensation.
The business may also be required to accept loan covenants as part
of the loan agreement (e.g. maintaining a certain level of liquidity,
seeking permission from existing lenders before raising new loan
capital, etc.) which will restrict managements freedom of action.
Although interest rates are generally lower than equity returns, there
can be occasions when the returns on loan capital are higher than those
on equity capital.
The issue of loan capit al
Long-term debt is likely to be issued by a business when some of the
following conditions prevail:
earnings are relatively stable over time or on an increasing trend
adequate security for the debt exists
the existing level of gearing is fairly low for the particular business
sector
there is a risk of a change in the pattern of control from the issue of
new equity shares.
However, the level of borrowing (gearing) will also be influenced by the
companys profitability and the present and future underlying economic
conditions. If the economic conditions are poor, then the risk attached to
paying the interest due increases and interest rates may be higher. The
higher the gearing, the greater the gains in earnings for shareholders in
times of increasing profits. Conversely, in times of declining profits the
higher the gearing, the faster the decline in earnings per share. Thus,
simplistically, it is better to be low geared in low profit or declining profit
periods; in growth and high profit periods it is better for the company to
be highly geared.
70
discuss how the financial markets operate, particularly with respect to
outline the range of securities used to generate funds for companies,
including a more in-depth insight of the main forms of debt and equity.
BMA, Chapter 15, Questions 10, 14, 15 and 16.
1. a. Why are the costs of debt financing less than those of share issues?
Why do companies still seek flotation on a stock exchange?
b. Outline the reasons why companies seek flotation on more than one
stock exchange.
c. Why does shareholders wealth remain unchanged regardless of
whether they take up the shares in a rights issue? What factors are
there to motivate shareholders to take up the rights shares?
Chapt er 6: Capi t al st ruct ure
71
Chapt er 6: Capit al st ruct ure
Essent ial reading
McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters 17
and 18.
Furt her reading
Works cit ed
Altman, Edward I. A further empirical investigation of the bankruptcy cost
question, J ournal of Finance39, 1984, pp.106789.
DeAngelo, H. and R.W. Masulis Optimal capital structure under corporate and
personal taxation, J ournal of Financial Economics 8, 1980, pp.329.
Graham, J.R. and C.R. Harvey The theory and practice of corporate finance:
evidence from the field, J ournal of Financial Economics 60, 2001, pp.187
243.
Jensen, M.C. and W.H. Meckling Theory of the firm: managerial behavior,
agency costs and ownership structure theory of the firm, J ournal of
Financial Economics 3, 1976, pp.30560.
Miller, M. Debt and taxes, J ournal of Finance 32, 1977, pp.26175.
Modigliani, F. and M.H. Miller The cost of capital, corporate finance and the
theory of investment, American Economic Review 48, 1958, pp.26196.
Modigliani, F. and M.H. Miller Taxes and the cost of capital: a correction,
American Economic Review 53, 1963, pp.43343.
Warner, J.B. Bankruptcy costs: some evidence, J ournal of Finance32, 1977,
pp.33747.
Aims
We have discussed the reasons for companies to raise funds from external
sources in Chapter 5. In this chapter we will look more formally at how
different sources of funds raised by companies may affect their values.
In particular we will examine the various contrasting theories on capital
structure.
Learning out comes
describe and assess how Modigliani and Millers arguments on capital
structure with and without taxes might affect the way we look at
optimal capital structure
examine thoroughly concepts of risky debt, signalling effect and agency
costs of both equity and debt in the capital structure theory
discuss the implications of the pecking order theory.
72
Int roduct ion
We discussed in Chapter 5 how firms raise funds from equity and debt.
In this chapter we examine the capital structure theory and attempt to
provide an answer to the following question: Can a firm create additional
value through the use of a financing policy which does not change the
nature of the assets held by the firm?
If the answer to the above question is no, then corporate managers should
only be focusing on maximising the firms value by undertaking all positive
Net Present Value (NPV) projects. This is the conclusion we arrived at in
Chapters 1 and 2. However, if the answer is yes, then the financing policy
becomes important and an optimal way of funding projects must be found.
Modigliani and Millers t heory
BMA, Chapter 17, pp.44652 begins with an explanation of the irrelevance
of capital structure. The key points of Modigliani and Millers arguments
are summarised below:
Assumptions:
Capital markets are frictionless with no transaction costs.
Individuals and corporations can borrow and lend at the risk-free rate.
All firms are in the same risk class and all cash flow streams are
perpetuities (i.e. no growth).
There is no taxation in the world (no corporate tax nor personal taxes).
There is no cost on bankruptcy (i.e. debt is risk free).
Corporate insiders and outsiders share the same set of information (i.e.
no signalling opportunities).
Managers always maximise shareholders wealth (i.e. no agency costs).
This is a highly unrealistic and restrictive set of assumptions. But to
understand Modigliani and Millers (1958) argument, we will, for the time
being, be content with this setting. Under this setting where there are no
taxes and capital markets are functioning properly, Modigliani and Miller
(MM) argue that it makes no difference whether a firm or an individual
shareholder borrows. The market value of a company does not depend on
its capital structure.
To see why this is the case, lets consider the following example.
Example 6.1
A B
$ 000 $ 000
Earni ngs 1,000 1,000
Int erest (100)
Earni ngs avai l abl e f or di vi dends 1,000 900
Suppose Company A and B are identical in every respect except in their
capital structure. Company A is an all-equity financed firm whereas Company
B is partly financed with debt. Given that they are identical, both companies
generate the same cash flows. Suppose they pay out all earnings, after
interest and tax, to shareholders as dividend. Shareholders in Company A will
receive $1,000,000 as dividends at the end of the period while stakeholders
of Company B who have claims on both the debt and equity would have a
73
combined cash return of $1,000,000 as well. Since the cash returns to both
stakeholders are the same, the value of their investments must be identical (to
avoid arbitrage in an efficient market); and hence we have MMs proposition I
(without tax):
The value of an unlevered firm is equal to the value of a levered firm:
V
u
= V
L
(6.1)
Proposition I tells us that regardless of how a firm is financed, its value will
always be independent of the level of debt. The average return on assets will be
identical across all firms in the same risk class.
However, as the percentage of debt (relative to equity) increases, a larger share
of earnings would be distributed to debt-holders as interest. Shareholders
potential return will thus be affected. This increases the shareholders financial
risk. The required rate of return by shareholders will need to increase to
compensate for the higher financial risk. However, the weighted average cost
of capital (WACC) remains constant as the value of the company remains
unchanged.
R
d
R
o
R
e
R
D/E
Figure 6.1: Cost of capit al and debt -equit y rat io
Since assets are financed by a mixture of debt and equity, the average return on
assets must be the same as the WACC.
R
a
=
D
D + E
R
d
+
E
D + E
R
e
where
R
a
is the average return on assets
R
d
and R
e
are the return on debt and equity respectively
D and E are the market value of debt and equity respectively

(6.2)
Rearranging this equation we have proposition 2 with tax
R
e
= R
a
+
D
E
R
a
R
d
( )
(6.3)
Figure 6.1 indicates the relationship of proposition 2. As the debt to equity ratio
increases, shareholders require a higher return to compensate for the increased
risk. This can be seen as the straight part of the line of R
e
. However, as the debt
to equity ratio becomes too high, debt-holders risk increases as well. At some
point, shareholders can walk away from their investments and they would not
see the increased debt ratio as an additional source to their risk. In this case,
shareholders would actually drop their required rate of return.
Rd: return on debt
Re: return on equity
WACC
74
Example 6.2
A firm has 2 million of debt and 100,000 of outstanding shares at 30 each. If
investors can borrow at 8% and the shareholders require 15% return, what is
the firms WACC?
Answer:
The value of debt, D = 2 million.
The value of Equity, E = 100,000 shares 30 per share = 3 million.
R
a
=
D
D+ E
R
d
+
E
D+ E
R
e
=
2
2 + 3
8%+
3
2 + 3
15%
=12.2%
Act ivit y 6.1
At t empt Quest i on 3 of BMA, Chapt er 17, p.463.
Modigliani and Millers argument wit h corporat e t axes
We now turn our attention to the world with taxes. Suppose that both
companies in Example 6.1 pay corporate taxes at 20% on their earnings
after interest.
Example 6.3
A B
$ 000 $ 000
Earni ngs 1,000 1,000
Int erest (100)
Earni ngs bef ore t ax 1,000 900
Tax (200) (180)
Di vi dend 800 720
The after-tax cash return to a 100% shareholder in Company A is $800,000.
The after-tax cash return to an investor who owns all the debt and equity of
Company B would be $820,000 ($100,000 of interest + $720,000 of dividend).
Given that the cash returns are not identical, the value of these two companies
must be different (in order to avoid arbitrage in an efficient market).
By how much would the value of B be different from A?
In most countries, interest on debt is deducted before corporate tax is
calculated. This tax deductibility of debt interest provides an additional after-
tax cash flow to the stakeholders in B. The difference of the after-tax cash
return between B and A is exactly the same as the tax saving arising from the
interest (i.e. interest tax rate = $100,000 20% = $20,000). So over the
lifetime of the debt, the amount of tax savings interest would be:
Interest T
c
1+ r
d
( )
i
i=1
= T
c
D
This tax saving represents the value of a levered firm over an unlevered firm.
Consequently, the MM proposition 1 in the world with tax will become:
D T V V
c u L
+ = (6.4)
75
Where T
c
is the corporate tax rate and D is the market value of debt.
Similar to the previous explanation, shareholders will demand a higher return
to compensate for the increased risk due to higher level of debt. However,
the tax deductibility of interest allows the company to save up taxes for
shareholders. The perceived risk, which increases as a result of higher levels of
debt, would to some extent be offset by the tax shield. Consequently the MM
Proposition 2 will become:
( )( )
E
D
T R R R R
c d a a e
+ = 1

(6.5)
What is the implication of the above argument?
According to the tax argument, a firm can maximise its value by using all debt
financing.
Act ivit y 6.2
Di scuss what t he f ol l owi ng compani es shoul d do wi t h t hei r debt pol i cy:
1. Company A has a subst ant i al l y hi gh corporat e t ax rat e.
2. Company B i s a l arge, est abl i shed company wi t h a hi gh t axabl e prof i t l evel .
3. Company C i s a newl y est abl i shed company.
Personal t axes
We have discussed the effect of corporate tax on debt policy. We now
turn our attention to personal taxes. Suppose investors pay taxes on their
investment income. The total after-tax cash return to stakeholders in a
levered firm can be represented as follows:
C = (EBIT R
d
D)(1T
c
) (1T
e
) + R
d
D(1T
d
)
= EBIT(1T
c
)(1T
e
) + R
d
D [(1T
d
) (1T
c
) (1T
e
)]

(6.6)
Where:
EBIT = earnings before interest and tax
D = market value of debt
R
d
= return on debt
T
c
, T
e
and T
d
are the tax rates on the corporations profit, equity and debt
respectively.
Miller (1977) argues that the first term represents the payments to equity-
holders in an all-equity financed firm and the second term represents the
tax shield effect from debts. If these cash flows are perpetual, the total
value of the levered firm can then be calculated by discounting the two
terms by the appropriate rates. Consequently, it can be represented by the
following mathematical expression:
V
L
=
EBIT 1T
c
( ) 1T
e
( )
R
e
U
+
R
d
D 1T
d
( ) 1T
c
( ) 1T
e
( ) | |
R
d
1T
d
( )
=V
U
+ 1
1T
c
( ) 1T
e
( )
1T
d
( )

(

(
(
D

(6.7)
It should be noted that the discount rate for the after-tax dividend income
to equity-holders is the required rate of return by the equity-holders
whereas the discount rate for the after-tax debt interest income should be
discounted by the effective required rate of return by debt-holders. We can
76
see from equation (6.7) that an incentive to issue debt is provided if:
1
1T
c
( ) 1T
e
( )
1T
d
( )

(

(
(
> 0 more advantageous to issue debt
1
1T
c
( ) 1T
e
( )
1T
d
( )

(

(
(
< 0 less advantageous to issue debt
Act ivit y 6.3
In many count ri es, t he t ax rat e f or bot h i ncome f rom di vi dends and capi t al gai n i s t he
same. How woul d t hat af f ect equat i on 6.7 and what advi ce woul d you gi ve t o compani es
about t hei r debt pol i cy?
Ot her t ax shield subst it ut es
DeAngelo and Masulis (1980) argue that a companys depreciation,
investment credits and oil depletion allowance may serve as another form
of tax shield substitute. The more of these other tax shield substitutes a
company has, the less it will be inclined to issue debt. Consequently, firms
will choose the level of debt which is negatively related to the level of
other tax shield substitutes. They also argue that there will be an optimum
trade-off between the marginal expected benefits of interest tax shield and
the marginal expected cost of bankruptcy.
Act ivit y 6.4
What l evel of debt woul d you expect t o f i nd i n t he f ol l owi ng compani es (based on
DeAngel o and Masul i s, 1980)?
1. A nat i onal ut i l i t y company (such as a wat er company) whi ch has a l ong-t erm pl an f or
subst ant i al capi t al i nvest ment .
2. An oi l expl orat i on company whi ch hi res most of t he equi pment .
3. A pharmaceut i cal company whi ch has commi t t ed i t sel f t o a hi gh l evel of research and
devel opment act i vi t i es.
Financial dist ress
So far we have assumed that corporate debt is relatively risk free. In
reality, only a small percentage of corporations receive the AAA rating
from credit agencies. If corporate debt is not risk free, then how significant
is the potential cost of bankruptcy?
Warner (1977) looks at data from 11 railroad bankruptcies between 1933
and 1955 in the USA. He measures only direct costs of bankruptcy (i.e.
legal and professional fees and managerial time spent in administering the
bankruptcy). He finds out that the bankruptcy cost represents 1% of the
market value of the firm seven years prior to bankruptcy, and it rises to
5.3% immediately before the bankruptcy.
Altman (1984) examines the indirect costs of bankruptcy of 19 companies
which experienced financial distress between 1970 and 1978. He
measures mainly the loss of profit opportunities. He finds out that these
costs of financial distress represent about 8.1% of the average firms value
three years prior to bankruptcy and they rise to 10.5% in the year of
77
bankruptcy. He also identifies that the direct bankruptcy costs measured as
a percentage of a firms value seem to decrease relative to the size of the
bankruptcy firm.
Overall these two studies indicate that the costs of financial distress are
not trivial.
Act ivit y 6.5
Trade-of f t heory
In the previous sections, we discuss the benefits of debt issues and how
the interest on debt can provide a tax shield effect. However, debt also
increases the probability of financial distress and the cost of administering
bankruptcy. An optimal capital structure may exist when the marginal tax
shield benefit equals the marginal cost of financial distress.
D/E rao
Opmal
debt rao
Value of levered rm
(with tax shields and
nancial distress)
Value of
unlevered
rm
Value of levered rm
(with tax shields only)
Maximum value of
rm
Cost of nancial distress
PV of tax
shields
Market Value
Figure 6.2: Trade-of f t heory
Figure 6.2 shows the trade-off theory. As the debt increases, the value
of a firm increases as the tax shield of debt interest kicks in. However,
as the level of debt increases, the potential cost of financial distress also
increases. Part of the tax shield benefit is cancelled out by the cost of
financial distress. The net increase in the firms value will be smaller
than the tax shield effect alone. The optimal capital structure is reached
when the marginal cost of financial distress equals the marginal tax shield
benefit, the firm should stop issuing more debt.
Act ivit y 6.6
78
Signalling ef f ect
The trade-off theory appears to have provided a solution for corporate
managers to form the optimal capital structure. However, in reality,
suppose there are two types of firms in the market: good quality firms
characterised by high future cash flows, and poor quality firms with
low future cash flows. The true quality is not observable by the market.
Investors would not be able to distinguish the true quality between these
two types of firms. Consequently, they will all be valued at the same price.
The question is: How do managers of good quality firms signal their firms
true quality to the market?
It is argued that a carefully selected debt policy might be able to signal the
true quality of a good firm. Lets consider the following scenario:
A firm with a high level of debt implies that there is a higher probability of
bankruptcy. If this is a poor quality firm, it would not have sufficient profit
to absorb the potential tax shield from debt interest and it would have
insufficient funds to pay the debt interest and would thus be insolvent.
Therefore, only managers who are in charge of good quality firms would
be willing to adhere to a high level of debt. The market sees this as a
signal sent by the financial managers about the true quality of their firm.
Its share price would rise accordingly. However, in order to ensure that the
debt can be signalled effectively, the following conditions must be met:
1. The market must adhere to the semi-strong but not strong form;
otherwise the firms value can be observed.
2. There is an incentive for the managers in a good quality firm to signal
the firms true value.
3. The penalty of using a misleading signal by managers in a poor firm is
more costly than the short-term gain.
So what incentive do we have for good and bad managers telling the truth?
If the signal is linked with a managers compensation scheme, M, such that:
M =(1 +r)
0
V
0
+
1
V
1
B
or
M =(1 +r)
0
V
0
+
1
(V
1
C) if V
1
< B
where
0,
1
=positive weights
r =the one-period interest rate
V
0
, V
1
=the current and future value of the firm
B =the face value of debt
C =a penalty paid if bankruptcy occurs, i.e. V< B.
A managers compensation is based on the realised value of the firm at
time 0 and 1. Suppose that B
*
is the maximum amount of debt that a poor
quality firm (type B) can carry. Managers from a good quality firm (type
A) will set a debt level higher than B
*
at time 0. The value of the firm at
time 1 will be V
1a
, and the value of the firm at time 0, V
0a
is the discounted
value of V
1a
. Managers will receive the following positive compensation:
( )
1
0 1 1
1
1
a
a
V
M r V
r
= + +
+
If managers of a poor quality firm try to raise the debt level above B
*
, the
value of the firm at time 0 will be the same as that of the good quality
79
firm, V
0a
. However, the value of the firm at time 1 when the market
realises that this is a poor quality firm will be V
1b
. If this value is less
than B
*
, managers of the poor quality firm will receive the following
compensation:
M = 1+ r ( )
0
V
0b
+
1
V
1b
C ( )
This compensation is negative if:
1+ r ( )
0
V
0b
+
1
V
1b
C ( )< 0
1+ r ( )
0
V
1a
1+ r
+
1
V
1b
C ( )< 0
0
V
1a
+
1
V
1b
<
1
C
In other words, the penalty exceeds the total incentive payments over the
period.
Agency cost s on debt and equit y
Equit y
Suppose we have a 100% equity-financed firm and all the shares are held
by the owners who also work in the firm (owner-managers). In the event
that the firm expands and the owner-managers have run out of additional
capital to invest in the firm, additional shares would have to be offered
to the outsiders. Suppose now that a proportion of equity, o, is held by
outsiders (not the management).
Jensen and Meckling (1976) argue that the owner-managers are less likely
to make a full effort to increase the value of the firm as this will be shared
by the outside equity-holders as well. This implies that owner-managers
will supply lower levels of effort for higher values of o. Outsiders will
incur monitoring costs to ensure that owner-managers act in their interest.
Owner-managers may also make sub-optimal decisions which might not
benefit the company as a whole. This direct monitoring cost and the
sub-optimal effect together represent the agency costs of external equity.
They rise as the percentage of financing supplied by external equity goes
up. To reduce these agency costs of external equity, it is argued that more
debt financing should be used. Consequently, the higher the debt-to-equity
ratio, the lower the agency costs of (external) equity. But one needs to
take into account the proportion of an agents personal wealth held in the
equity of his company of employment when considering his actions.
Agency cost s on debt
On the other hand, an increase in debt may also increase the agency costs
of debt. Debt-holders may insist on various types of protective covenants
and monitoring devices to ensure that their wealth is being protected.
Debt-holders may demand a higher return. These costs may increase as
a function of the level of debt. More importantly, managers may make
investment decisions which might be biased towards the equity-holders
interest. When a firm is in financial trouble, both equity-holders and
debt-holders would like to recover their investments. Lets consider the
following two scenarios:
1
1. Risk shifting
Suppose a firm, C, has $50m debt and $50m equity. Lets assume that,
due to some financial problems, the value of assets falls to $20m. If
debt-holders force the firm into liquidity, the best they can get is $20m.
1
Refer t o BMA Chapt er
18 (pp.48283) for
t he ot her possible
sub-opt imal managerial
act ions in t he event of
nancial dist ress.
80
Suppose the firm has an investment opportunity which requires $10m
as the initial investment outlay and generates $90m of PV with a 10%
chance and $0m with a 90% chance. Should financial managers of this
firm go for this investment?
First we should consider whether this is a positive NPV project or not.
The NPV of this project can be calculated as:
E(NPV) =$90m 10% +$0m 90% $10m =($1m)
It is clear to see that this is a sub-optimal project and under normal
circumstances, the firm should reject it. However, given that the firm
is in serious financial distress, financial managers who are supposed
to work for the best interest of their shareholders may attempt to
undertake this project using the existing cash resources from the firm.
There are two possible outcomes from this investment decision:
Worst case the project does not pay off and the value of the firm
falls to $10m (being the original value less the investment outlay
which is not recovered from the investment). Shareholders will get
nothing in the event of liquidation.
Best case the project pays off with $90m PV, the value of the firm
rises to $100m (being the original value, $20m less the investment
outlay, $10m plus the pay-off from the project, $90m). Shareholders
will get $50m in the event of liquidation after paying off the
outstanding debt.
The expected pay-off to each stakeholder is as follows:
Worst Best Expect ed Do not hing Dif f erence
$m $m $m $m $m
Debt -hol ders 10 50 14 20 (6)
Sharehol ders 0 50 5 0 5
Fi rms val ue 10 100 19 20 (1)
The expected pay-off is the probability weighted average of the
outcomes of the two cases. From the above table we can see that
shareholders gain at the expense of the debt-holders.
2. Underinvestment
Suppose Firm C in the above example is faced with a safe investment
which requires an initial investment outlay of $10m and generates a
fixed PV of $15m instead. Would managers undertake this project?
Lets look at the expected pay-offs to the stakeholders in this case.
Do not hing I nvest Dif f erence
$m $m $m
Debt -hol ders 20 25 5
Sharehol ders 0 0 0
Fi rms val ue 20 25 5
Debt-holders, in this case, would hope that managers will undertake
this investment and their debt value will go up by $5m. However,
shareholders are not going to receive anything in any case. If managers
work for the best interest of their shareholders only, then it is likely that
debt-holders will lose out once again.
81
How do agency costs of debt arise?
In the above two scenarios, we can see that a firm with high level of
debt is likely to undertake sub-optimal investment decisions. These
actions will reduce the value of a firm. In order to avoid risk shifting
from equity-holders to debt-holders, debt-holders would need to impose
more restrictions on their loan agreements (covenants) and introduce
monitoring systems to ensure that their interests are protected. These
agency costs will reduce the tax shield benefits of higher debt levels.
Putting both agency cost of equity and debt together
As we increase the level of debt, the agency cost of equity will decrease
while the agency cost of debt rises. To minimise these costs, one should set
a debt level such that the aggregate agency costs are at their lowest.
Act ivit y 6.7
Agency cost s rel at e t o bot h t he di rect and i ndi rect moni t ori ng cost s on t he agent s
behavi our and t he i ndi rect cost s of sub-opt i mal agent s act i on. How can we measure
t hese cost s i n pract i ce?
Pecking order t heory
BMA Chapter 18, Section 18.4 (pp.48892) discusses the pecking order of
financing. In short, the pecking order theory is:
Firms prefer internal finance.
Firms can build up an internal cash reserve to avoid external financing.
External financing involves issuing costs and indirect effects on share
values such as the agency costs on debts and equity discussed on p.79.
It is the preferred source of finance.
Debt finance is better than equity finance.
The signalling effect on debt discussed on p.78 indicates that managers
in a good quality firm prefer to issue debt. Therefore it is often argued
that managers who issue equity must know that their companys shares
are over-valued. If the market is efficient and investors are rational,
the equity issue must be viewed as a pessimistic signal about the firms
long-term value.
Conclusion
The search for an optimal capital structure continues. This chapter outlined
several theories on capital structure. MM argued that a firms value is not
affected by its capital structure. However, tax and financial distress lead us
to the trade-off theory. When information is not shared equally between
managers and investors (asymmetric information), the signalling effect on
debt and equity may lead us to the pecking order theory.
82
Debt policy f act ors Percent age of CFOs ident if ying f act or
as import ant or very import ant
Fi nanci al f l exi bi l i t y 59.38
Credi t rat i ng 57.10
Earni ngs and cash f l ow vol at i l i t y 48.08
Tax advant age of i nt erest deduct i bi l i t y 44.85
Transact i ons cost s and f ees 33.52
Comparabl e f i rm debt l evel s 23.40
Bankrupt cy/ di st ress cost s 21.35
Cust omer/ suppl i er comf ort 18.72
Debt rest ri ct ed so proj ect prof i t s can be capt ured
f ul l y by sharehol ders and not pai d t o debt hol ders
12.57
Invest ors personal t ax cost s when t hey recei ve
i nt erest i ncome
4.79
Enough debt not t o be a t akeover t arget 4.75
Table 6.1: Fact ors af f ect ing t he decision t o issue debt
In practice, however, managers seem to value financial flexibility more in
consideration of debt or equity issue. Graham and Harvey (2001) found
that in a survey of 392 CFOs asked about whether they had any target
debt-to-equity ratio, 37% of them indicated that they had a flexible target
and 17% had no target at all.
When these CFOs were asked about the factors which influenced them
in deciding the debt issue, financial flexibility appears to be the most
important factor. This seems to suggest that agency costs on debt might be
one of the main considerations for capital structure.
describe and assess how Modigliani and Millers arguments on capital
structure with and without taxes might affect the way we look at
optimal capital structure
examine thoroughly concepts of risky debt, signalling effect and agency
costs of both equity and debt in the capital structure theory
discuss the implications of the pecking order theory.
BMA Chapter 18, Questions 18, 19 and 27.
1. Explain clearly how the value of a levered firm, V
L
can be linked with
the value of an unlevered firm, V
U
in a world with corporate tax, T
C
and
personal taxes on income from equity and income from debt, T
E
and T
D
,
as discussed in Miller (1977).
2. Outline briefly the effects of the following situations:
a. a cut in corporate tax rate for all companies
b. unifying personal taxes such that T
E
= T
D
.
Chapt er 7: Di vi dend pol i cy
83
Chapt er 7: Dividend policy
Essent ial reading
Furt her reading
Works cit ed
Black, F. and M. Scholes The effects of dividend yield and dividend policy on
common stock prices and returns, J ournal of Financial Economics, 1(1), 1974,
pp.122.
Brav, A., J.R. Graham, C.R. Harvey and R. Michaely Payout policy in the 21st
century, J ournal of Financial Economics 77, 2005, pp.483527.
Elton, E. and M. Gruber Marginal stockholders tax rates and the clientele effect,
Review of Economics and Statistics 52(2), 1970, pp.6874.
Fama, E.F. The empirical relationships between the dividend and investment
decisions of firms, American Economic Review 64(3), 1974, pp.30418.
Fama, E.F. and H. Babiak Dividend policy: an empirical analysis, J ournal of the
American Statistical Association 63(324), 1968, p.1132.
Gordon, M.J. Dividends, earnings and stock prices, Review of Economics and
Statistics 41(2), 1959, pp.99105.
Lintner, J. Distribution of incomes of corporations among dividends, retained
earnings and taxes, American Economic Review 46, 1956, pp.97113.
Litzenberger, R. and K. Ramaswamy The effects of personal taxes and dividends
on capital asset prices: theory and empirical evidence, J ournal of Financial
Economics 7(2), 1979, pp.16395.
Modigliani, F. and M.H. Miller The cost of capital, corporate finance and the
theory of investment, American Economic Review 48, 1958, pp.26196.
Aims
Corporate dividend policy, or how companies can provide a return to
shareholders by way of a cash distribution or other means, is one of the more
important financial decisions management has to make. So this chapter will
cover how a firms value can or cannot be affected by the chosen dividend
policy. It starts by mentioning the different types of dividend and follows
on with the irrelevancy argument before discussing and describing other
theories such as the clientele effect, the information content of dividends
and the agency costs on dividends. Some practical aspects concerning the
determination of the policy in practice such as what are non-cash dividends
and whether they should be paid are covered.
Learning out comes
explain how companies decide on dividend payments
describe and critique the theory and practice of corporate dividend policy
dividend clientele theory, agency cost theory, and signalling theory
84
describe and discuss alternative views on the effect of dividend policy
explain the informational aspects of dividend payments
explain the impact of tax on the dividend decision.
Int roduct ion
In Chapter 16 of BMA you will be exposed to the theory and practices
associated with corporate dividend policy. We will present opposing views
of the effects of dividend policy on the valuation of shares and discuss
the significance of the traditional view of dividends. This chapter also
addresses informational aspects of dividend payments and potential
clientele effects and how dividend payments are set in practice. The
general intention of this chapter is to provide an in-depth discussion on
the controversial question of how dividend policy affects firm value.
Dividend policy has been the source of some controversy over the years.
In this chapter we consider the nature of that controversy and the factors
that influence dividend policy in practice. We also consider alternatives to
dividend payments which a business might consider.
Types of dividend
Corporations can pay out cash to their shareholders roughly in three ways:
1. Cash dividend
Investors look for a return from their investment holding in
corporations. It is therefore natural for corporations to pay dividends
on a regular basis (yearly, half-yearly or quarterly) as a return to
their shareholders. Some corporations pay a high percentage of their
corporate earnings as dividend whereas some choose to keep the
dividend payout ratio low.
1
However in some cases, a corporation may choose to pay a one-off
special dividend.
2. Stock
2
repurchase
Another way for a corporation to pay out to shareholders would be
through a stock repurchase. Figure 16.1 of BMA shows the history
of dividend and stock repurchases in the USA between 1980 and
2008. One emerging fact is that the absolute amount of stock being
repurchased by corporations from their shareholders has increased
significantly over that period. What is the main reason for that?
There are four ways to repurchase shares from shareholders:
3
i. open market
ii. tender offer
iii. auction
iv. private negotiation.
3. Scrip dividend
Scrip dividend (or bonus shares) is an issue of shares (not for cash) to
existing shareholders.
Act ivit y 7.1
Read BMA p.422. Ident i f y t he mai n advant ages and di sadvant ages of t he f our met hods of
st ock repurchase descri bed above.
1
See Securit ies Invest ors
Associat ion (Singapore)
for a list of t op paying
companies: ht t p://
www.sias.org.sg/index.
php?opt ion= com_co
nt ent &view= art icle
&id= 248%3Adivide
nd-payout -rat io-t op-50-
companies&cat id= 20%3
Apress-releases&It emid= 43
&lang= en
2
The t erm St ock is
oft en used in t he Unit ed
St at es t o refer t o shares
issued by companies.
3
See BMA p.422.
[Forms of Dividend Payments]
85
Dividend cont roversy
The key question is what effect would a change in the cash dividend
paid have on the value of a firm, given its capital budgeting plan and
borrowing decision. To examine the controversy surrounding dividend
policy, we must isolate dividend policy from other issues in financial
management. If we fix the investment outlays and the level of borrowings,
the only possible source of cash to increase dividend would be the issue
of new shares. So here we consider dividend policy as a trade-off between
retained earnings vs. paying out cash dividends and issuing new shares.
Modigliani and Millers argument
The argument put forward by Modigliani and Miller (MM) (1958)
concerning the irrelevance of dividends is particularly important and you
should study it carefully. The most important aspect of their argument
concerns the notion that share values are not influenced by the particular
dividend policy of the firm. They argue that the value of a firm depends
on the level of corporate earnings (net operating income or cash flows)
and the firms investment policy. Rational shareholders are indifferent
to whether they receive a capital gain (the price at which the share is
disposed of is higher than the price originally paid for it) or dividend
on their shares. A firm will optimise its value by investing in all positive
NPV opportunities regardless. Dividends will be paid out if there are
any internal funds left over. Dividends are thus a residual payment. If
no dividend is paid out due to cash flows being used for the optimal
investment plan, the market value of the firm will increase to reflect the
expected future dividend payments or increasing share prices resulting
from its investment returns. If shareholders want cash, they can generate a
home-made dividend by selling part of their shareholding.
To illustrate this argument, lets focus on the following example.
Example 7.1
4
Bear Inc. is currently traded at $10 each with 1,000,000 shares in issue. It
has $1,000,000 of cash and $9,000,000 of other assets (measured at their
market value). Suppose the firm has an investment opportunity which requires
$1,000,000 of initial investment outlay and can produce a net present value of
$2,000,000. If Bear Inc. is to undertake this investment, its value (in an efficient
market) will go up to $12,000,000.
$ 000
Ori gi nal val ue ($10 1,000,000 shares) 10,000
Invest ment opport uni t y (NPV) 2,000
New val ue 12,000
New share pri ce ($12,000,000/ 1,000,000) $12
Suppose Bear Inc. has now earmarked the $1,000,000 in the cash account for
investment. If existing shareholders would like to receive a dividend of $1 per
share, what should Bear Inc. do? To raise the amount necessary for the cash
dividend, Bear Inc. would need to issue $1,000,000 of shares. It should be noted
that the cash raised from the share issues is distributed out immediately as a
cash dividend to shareholders. The value of the firm would therefore remain at
$12,000,000.
4
Adapt ed from BMA,
Chapt er 16.
[alternative views on the effect of dividend policy]
86
But what would happen to the share price after the share issue and cash dividend
payment?
Let x be the number of new shares issued and p be the new share price after the
new share issue and dividend payment. We have the following two conditions:
(1) xp = 1,000,000
(2) (x + 1,000,000) = 12,000,000
(1) represents the $1,000,000 raised from the share issue
(2) indicates the value of the firm after the share issue.
Solving (1) and (2) simultaneously, we can easily see that the new price, p is
equal to $11 and the number of new shares issued is 90,909 ($1,000,000/$11).
What this example illustrates is that the shareholders value remains unchanged.
If the firm invests and pays out no dividend, each share entitles the existing
shareholder to a value of $12 (equal to the share value). However, if the firm
invests but pays out dividend from a new share issue, the same shareholder
will have a value of $12 (equal to the new share value of $11 + $1 of dividend
received). Therefore dividend policy does not alter a shareholders value. If the
existing shareholder would like to receive a dividend (but the firm does not pay
out), he or she can sell their shares to generate a home-made dividend.
But MMs argument is based on some restrictive assumptions!
First they assume that there is no transaction cost for shareholders to sell their
shares should they wish to generate a home-made dividend. Second, MM
assume that shareholders do not pay any tax on investment income. If these two
assumptions are not valid, the irrelevancy argument of dividend might not hold.
So lets see how these might change our understanding of dividend policy.
Client ele ef f ect
In reality, investors are often facing the following scenarios:
1. Buying and selling shares incur transaction costs (such as stamp duty,
brokerage fees etc).
2. Income from either the cash dividend or selling the shares is treated as
taxable income.
3. Investors have different income requirements and consumption
patterns.
Given these constraints, investors must consider their liquidity requirement
(subject to the consumption pattern) and their tax position before deciding
in which company they would like to invest.
Tax considerat ion
It is often argued that different investors are attracted to shares of
different businesses on the basis of their particular dividend policy.
Investors should consider their tax position before deciding which
company to invest in. We can easily hypothesise that those investors who
have a higher marginal tax rate on dividend income (than capital gain)
would prefer to invest in a firm which has a low dividend payout policy,
and those who have a lower tax rate on dividend income would prefer
to invest in a firm with a high dividend payout policy. Those who do not
have to pay any taxes or have the same marginal tax rate on both dividend
income and capital gain would naturally be indifferent to the different
dividend payout options.
Factors affecting how companies
decide on dividend payments
Clientele effect
1. Tax consideration
2. Liquidity requirement
Signalling effect
poor VS good quality firms
Agency costs and dividend
1. shareholders and bondholders' interest
2. managers and shareholders
87
So, given these three groups of investors, each type of firm (classified by
the level of dividend payout) caters to its own clientele of investors. It can
be seen that any change in the dividend payout level by a firm may upset
its investors as they may be subject to higher tax. If they are, they will sell
their shares and re-invest in firms which cater for their tax consideration.
The firm which alters its dividend policy may therefore witness price
changes in its shares. What it means is that dividend policy might be
relevant in this tax clientele context.
5
Act ivit y 7.2
In most count ri es t he t ax rat e on di vi dend i ncome and capi t al gai n i s i dent i cal . Does i t
i mpl y t hat t he t ax cl i ent el e ef f ect i s i rrel evant ?
Liquidit y requirement
Some investors such as pensioners, institutional investors and insurance
companies require regular dividends as a source of income to meet their
consumption and liquidity requirement. They would prefer companies to
pay dividends. If selling shares to generate cash flows incurs unnecessary
transaction cost, these tax-paying investors may prefer to hold dividend
paying shares. As a result, similar to the tax clientele effect, firms will
attract different clientele of investors. If a firm changes its dividend policy,
it might upset its investors and its share price will fall as a result when
investors rebalance their portfolios.
Act ivit y 7.3
On 18 November 2003 Vodaf one announced a 2.5bn share repurchase and an i ncrease
of di vi dends by 20% t o 1.5bn. It s share pri ce went up by 6.4% on t he day.
In Chapt er 4 we di scussed t he market ef f i ci ency hypot hesi s. Share pri ces react t o new
i nf ormat i on i n a semi -st rong f orm ef f i ci ent market . So what i nf ormat i on arri ved on 18
November 2003 t hat caused t he share pri ce of Vodaf one t o move up by 6.4% ? What
does t he share repurchase have t o do wi t h t he share pri ce? What i nf ormat i on does t he
i ncrease i n di vi dend convey t o t he market ?
Inf ormat ion cont ent of dividend and signalling ef f ect
Lintner (1956) interviewed a sample of managers from US corporations
and his research findings can be summarised into the following four
stylised facts:
1. Managers seem to have a long-term target dividend payout ratio.
2. This ratio is measured as a proportion of long-term earnings.
3. Managers focus more on dividend changes than on the absolute level of
dividend.
4. Managers are reluctant to make dividend changes that might have to
be reversed. Dividend changes follow shifts in long-term, sustainable
levels of earnings rather than short-run changes in earnings.
If Lintners stylised facts about how managers might formulate their
dividend payout are true, it means that an increase in dividend signals
managers confidence about their firms future. Share price will rise
accordingly like in the case of Vodafone.
5
Also client ele effect
relat es t o invest ors
preference for specic
payout pat t erns such
as xed percent age
payout of prot s, xed
percent age growt h in
annual dividend et c.
88
Is dividend an effective signal? Suppose we have a market with two types
of firms good quality firms are characterised with high future cash flows,
while poor quality firms are characterised with low future cash flows. For
dividends to act as an effective signal, we need to meet the following three
conditions:
1. Good quality firms are undervalued and their true values are not
unobservable. What this means is that good firms are not valued
correctly relative to the poor firms. The market fails to recognise the
mispricing. So how could we provide an incentive to managers to
signal the true value of their firms?
In this case, managers of a good quality firm would want to signal
the firms true value to the market provided that they will be suitably
rewarded by telling the truth about the firms value. Normally this is
done if their remuneration is linked to the value of the firm.
2. The market is consistent with the semi-strong form efficiency but
does not adhere to the strong form efficiency. Under this condition,
an increase in dividend sends good news about future cash flows and
earnings. Share prices will rise. On the other hand, a dividend cut
sends bad news as it indicates that managers are less confident about
the firms future than the market and a high dividend payout policy will
be costly to firms that do not have the cash flow to support it. Share
prices will fall accordingly.
3. A penalty will be imposed on managers of poor quality firms who
mishandle their firms.
This condition is necessary to stop managers of poor quality firms from
using high dividend payouts as a signal. Given that the market cannot
observe the true value of firms or distinguish the quality, an increase in
dividend by a manager of a poor firm might be mistaken as a positive
signal of the firms value. But we know that poor quality firms do not
have sufficient cash flow to sustain this high dividend policy. Eventually
the firm will collapse if it continues to pay out high dividends. So in
order to stop managers of poor firms lying about their firms value,
there must be a penalty system which discourages them from lying to
the market in the first place. This can be done as long as the reward
they get by temporarily increasing the firms value (as a result of the
increase in dividend) is outweighed by the penalty they will have to
pay when the true value of the poor firm is reviewed.
Act ivit y 7.4
What are t he mai n reasons why a f i rms t rue qual i t y cannot be observed? Does i t i mpl y
t hat a hi gher degree of t ransparency of i nf ormat i on i s needed?
Agency cost s and dividend
When the ownership and control of a firm are separated, managers
who run the firm might behave opportunistically. This problem is
further intensified when there are conflicts between shareholders and
bondholders interest. For example, if a firm is facing financial difficulty,
managers might choose to pay out a large cash dividend to shareholders
instead of investing in positive NPV projects. This action will increase
shareholders value at the expense of debt-holders. In this case, paying out
a large dividend will actually suppress the share price.
1. shareholders and bondholders' interest
2. managers and shareholders
89
To mitigate this problem, as one may recall in the section above, managers
in a poor quality firm would not increase dividend payouts as the penalty
of managing a bankrupt firm would be severe. Secondly, bondholders
would foresee that every firm has a chance of running into financial
difficulty. So before they lend, they would impose all kind of restrictions to
stop managers from paying out large dividends when the firm is suffering
financial distress.
Another possible conflict would be between managers and shareholders.
So far we assume that managers work for the best interest of their
shareholders. So what if they dont? Managers might engage in sub-
optimal investment decision-making and use any spare cash (which is
not invested) to pay for private uses (new office, company cars, etc.). As
the control over such a firm is lost as shareholders dont participate in
day-to-day operations, the only thing shareholders can do, would be to
vote against the re-appointment of the managers or sell their shares as a
protest. However, these actions might come too late to recover the loss
that shareholders might have already suffered.
To mitigate this problem, one might opt to drain the company of cash
by requesting a high dividend payout. When management need cash
for future investments, they have to approach shareholders for capital
funding. Shareholders can exercise some control over their savings
by refusing to buy the firms new securities if they are suspicious of
managerial behaviour, but then there are the transaction costs to be paid
for raising the cash this way.
Empirical evidence
The import ance of dividend decisions
Lintner (1956), Fama and Babiak (1968) and Fama (1974) concluded that
managers prefer a stable dividend policy and are reluctant to increase
dividends to a level which cannot be sustained.
Gordon (1959) finds positive correlation between a high payout ratio
(dividend per share/earnings per share) and high price to earnings
(market price/earnings per share) ratio among firms. He argues that
investors value companies more with high payout ratios. However, the two
ratios in his analysis contain the earnings per share as the denominator, so
when earnings move, both variables move.
If a companys earnings are volatile (high risk), it tends to have lower PE.
This company is likely to have a low payout ratio to reduce exposure to
volatile earnings shifts.
Dividends and t ax implicat ions
Black and Scholes (1974) do not find any positive relationship between high
dividend yields and before-tax return. But Litzenberger and Ramaswamy
(1979) find a statistical relationship between dividend yields and before-
tax return. Elton and Grubers (1970) work shows evidence that there is a
relationship between high payout ratio and low marginal rates of tax.
Det ermining dividend policy in pract ice
The early empirical evidence and casual observation seem to suggest
that managers consider the dividend decision to be very important and
that the maintenance of a stable dividend policy is preferred over time.
There seems to be a high degree of reluctance in firms to raise dividend
levels unless the directors of the firm are confident that the higher payout
90
ratio can be sustained over a long time period. Similarly, there is usually
reluctance for firms to cut dividends because of the (adverse) signals
which such an action may send out.
There is also evidence to suggest that managers of a firm consider the
firms level of earnings to be the most important influence on the dividend
decision. However, a more recent survey conducted by Brav, Graham,
Harvey and Michaely (2005) indicated that:
...maintaining the dividend level is on par with investment
decisions, while repurchases are made out of the residual cash
flow after investment spending. Perceived stability of future
earnings still affects dividend policy as in Lintner (1956).
However, 50 years later, we find that the link between dividends
and earnings has weakened. Many managers now favour
repurchases because they are viewed as being more flexible
than dividends and can be used in an attempt to time the equity
market or to increase earnings per share. Executives believe that
institutions are indifferent between dividends and repurchases
and that payout policies have little impact on their investor
clientele. In general, management views provide little support
for agency, signalling and clientele hypotheses of payout policy.
Tax considerations play a secondary role.
Conclusion
BMA, Chapter 16 has a good summary of the theories we discussed in
this chapter of the subject guide. In short, what we know about dividend
policy is that it seems to link with the life cycle of a firm. A young and
fast growing firm is likely to pay no dividend or repurchase no shares.
It is possibly that it will prefer to rely on internal funding for future
investments. As it matures and profitable investment opportunities become
less available, it will be forced to pay out dividend or repurchase shares
to avoid the agency cost of dividends and improve the signalling effect on
dividend.
explain how companies decide on dividend payments
describe and critique the theory and practice of corporate dividend
policy
describe and discuss alternative views on the effect of dividend policy
explain the informational aspects of dividend payments
explain the impact of tax on the dividend decision.
91
BMA, Chapter 16, Questions 9, 10, 12, 23, 24, 26 and 29.
1. Despite enjoying the success of iMac and iPhone, Apple Inc. has not
been paying out dividends for several years. The latest figures show
that Apple Inc.s net income to common shares is increasing:
2007 2008 2009
Net i ncome appl i cabl e
t o common shares
$3,496,000,000 $4,834,000,000 $5,704,000,000
Required:
a. What are the pros and cons of paying dividends?
b. Explain clearly, using appropriate financial theories when
applicable, how companies determine their dividend policy.
Explain why companies such as Apple Inc. might decide not to pay
dividends.
2. Critically discuss how a change of dividend policy may affect a
companys equity price.
3. Explain, with the aid of a diagram, how a firms dividend policy is
independent from its investment policy in a perfect and complete
world. You should include discussion of both Modigliani and Millers
argument on dividend and Fishers separation theorem in your answer.
4. Using arguments based on the signalling theory and tax clientele effect
of dividends, to what extent would you conclude that dividend policy is
irrelevant to corporate value?
Not es
92
Chapt er 8: Cost of capi t al and capi t al i nvest ment s
93
Chapt er 8: Cost of capit al and capit al
invest ment s
Essent ial reading
Furt her reading
Aims
This chapter focuses on how leveraged firms measure their cost of capital.
Learning out comes
calculate and explain the cost of debt, both before and after tax
calculate the weighted average cost of capital (WACC) for a firm and
explain the meaning of the number produced
explain the difficulty of using WACC to appraise investment projects in
practice.
Int roduct ion
In Chapter 2 of this subject guide we discussed how managers select
projects based on projects NPVs. In this chapter we discuss how corporate
managers choose the discount rate for projects when they are financed
with debt and equity. BMAs Chapter 19 begins with a good summary of
how projects should be evaluated. You should read that before proceeding
with the rest of this chapter.
Cost of capit al and equit y f inance
If a firm is financed 100% with equity, its investments will also be financed
with equity. Corporate managers will choose projects which maximise
equity-holders wealth. These projects may have different levels of risk but
equity-holders will ultimately bear the combined risk from these projects.
So how do we measure the risk of these projects and the firm itself?
If the CAPM is valid, then each project must have its market risk. Let |
j
be
the market risk of project j and |
e
be the market risk of equity. We have:
e
=
j
j
j =1
N
(8.1)
where e
j
is the weight of project j in the company. Consequently, the
return on equity must be the weighted average of the returns on all
projects:
E R
e
( )=
j
E R
j ( )
j =1
N
= E R
a
( )
(8.2)
94
Example 8.1
Suppose ABC Ltd., a 100% equity financed company, has three projects, A, B
and C. Their betas and values are as follows:
Proj ect s Bet as Val ues ( 000) Wei ght s
A 0.6 60 60/ 200 = 0.3
B 0.8 80 80/ 200 = 0.4
C 1.2 60 60/ 200 = 0.3
Suppose the risk-free rate is 5% per annum and the expected market return is
10% per annum.
The weighted average beta of the three projects is (which is also the equity
beta):
|
=0.3 0.6 +0.4 0.8 +0.3 1.2 =0.86 =|

e
The expected return on the average project is:
E(R
a
) = R
f
+ |
a
[E(R
m
) R
f
] =5 +0.86 [10 5] =9.3 =E(R
e
)
You should note that the expected return of the three projects can also be
calculated using the CAPM equation.
Proj ect s Bet as E(R)
A 0.6 5 + 0.6 (10 5) = 8
B 0.8 5 + 0.8 (10 5) = 9
C 1.2 5 + 1.2 (10 5) = 11
Using the weighted average cost of capital to appraise these three projects
simply ignores the respective project risk. The estimated NPV of each project
will be grossly inaccurate.
Cost of capit al and capit al st ruct ure
We now turn our attention to companies which finance themselves with a
mixture of debt and equity. Given that projects are financed with debt and
equity, the average return of projects must be the same as the weighted
average return on debt and equity. Since debt interest in most countries is
tax deductible, we have the following equation:
E R
a
( )=
E
E + D
E R
e
( )+
D
E + D
(1 t
c
)E R
d
( )
where
E and D are the market value of equity and debt and t
c
is the corporate tax rate

If the linear relationship depicted in the CAPM holds, the average beta of a
firm must be the weighted average of the equity and debt:
a
=
E
E + D
e
+
D
E + D
(1 t
c
)
d
(8.4)
Equation (8.3) is known as the weighted average cost of capital (WACC).
The no-tax equivalent to equations (8.3) and (8.4) are:
E R
a
( )=
E
E + D
E R
e
( )+
E
E + D
E R
d
( )
(8.5)
and
e
=
a
+
a

d
( )(1 t
c
)
D
E
(8.6)
(8.3)
D
relationship between a firms equity beta and its debt level
WACC
PROBLEM!!
Formula error?
95
Example 8.2
Make-it-easy plc has 100,000 shares at the current market price of 10 each.
It also has 500,000 worth of debt. The expected return on equity is 12%. The
debt is estimated to be relatively risk free and has a return of 5%. Corporate tax
rate is 40% per annum.
Calculate the WACC.
Answer:
WACC =
1,000
1,000 +500
12 +
500
1,000 +500
5 10.4 ( )
= 9
This WACC can be used as a discount rate for appraising average projects in
the company. So under what circumstances can we use WACC as an effective
discount rate?
Projects do not need to be financed at exactly the same ratio of debt and
equity each time when funds are raised. WACC can still be used as long as the
company adheres to a fixed debt and equity ratio over time (i.e. the weights on
debt and equity remain unchanged).
The risk of each project is not fundamentally different from each other. New
projects to be undertaken are not going to change much of the risk profile
of the company. If a company is undertaking a significant project with very
different risk level to the existing investment portfolio, the WACC might not be
effective.
Example 8.3
Using the information from Example 8.2, suppose Make-it-easy plc decides to
venture into a risky operation. It requires 1,500,000 as an initial investment
outlay. It is expected to generate 200,000 per annum of perpetual net cash
flows. This risky operation has an estimated beta of 2. The company intends to
raise the funds from existing equity-holders. Assume that the market return is
10% per annum.
If Make-it-easy uses the WACC (9% as in Example 8.2) to evaluate this risky
operation, the net present value of the risky operation will be calculated as:
NPV =
200,000
0.09
1,500,000 = 722,222
Make-it-easy will accept this venture as the NPC is higher than zero. However,
the risk of this venture is significantly higher than the companys average
project risk. Consequently, a higher discount rate should be used to compensate
for the increased risk. Using the CAPM, the expected return on a project with a
beta equal to 2 should be
E R
risky ( )
= 5 +2 10 5 ( ) =15
Using this risk-adjusted rate, the risky operations NPV should be:
NPV =
200,000
0.15
1,500,000 = 1,666,667
If WACC is inappropriately used to evaluate risky projects as in Example
8.3, a company risks making incorrect decisions about investment plans. In
general the problem with WACC in project appraisals can be highlighted in
the following diagram.
CF
WACC
96
Under investment
Risk
Return (%)
R
f
WACC
SML
Over investment
Figure 8.1: The problem of using WACC in project appraisals.
When WACC is used to appraise a project with a lower risk than the
company, the projects NPV is likely to be understated. On the other hand,
the use of WACC on projects with higher risk than the company would
result in overstating the projects NPV (such as the example of Make-it-
easy above).
Act ivit y 8.1
Consi der t he t hree proj ect s i n Exampl e 8.1. Ident i f y whet her t hei r NPVs are over- or
under-est i mat ed i f t he WACC i s used as t he di scount rat e.
The ef f ect of debt f inancing a project
BMA (Section 19.4) introduces the concept of adjusted present value
(APV). It is defined as:
APV = Base case NPV + sum of PVs of financial side effect
See the example in BMA, pp.51418 for an illustration of the use of APV.
Capit al st ruct ure and bet a
We have seen that equation (8.6) captures the relationship between a
firms equity beta and its debt level. In practice, when market data is
limited, a firms equity can be estimated by using equity beta from other
companies. The following example illustrates this technique.
Example 8.4
The managers of Grand plc would like to estimate their firms equity beta.
Grand has only had a stock market quotation for two months. Managers fear
that the lack of market data for their firm may make it difficult to estimate the
correct beta for Grand plc.
As a result they decide to use some existing firms data as it would be
inappropriate to attempt to estimate beta from Grands actual share price
behaviour over such a short period. Instead it is proposed to ascertain, and,
where necessary, adjust the observed equity betas of other companies operating
in the same industry, and with the same operating characteristics as Grand,
as these should be based on similar levels of systematic risk and be capable of
providing an accurate estimate of Grands beta.
97
Two companies have been identified as firms having operations in the same
industry as Grand that utilise identical operating characteristics. However, only
one company, Big plc, operates exclusively in the same industry as Grand. The
other two companies have some dissimilar activities or opportunities in addition
to operating characteristics that are identical to those of Grand.
Details of the three companies are:
i. Big plc
It operates exclusively in the same industry as Grand plc. Its observed
equity beta is 1.12. It is financed with 60% equity and 40% debt.
ii. Large plc
It has an observed equity beta of 1.11. It has two divisions. Division A
represents 30% of Large plc and has an equity beta equal to 1.9. Division
B shares very similar operating characteristics with Grand plc. Large plc is
financed entirely by equity.
iii. Grand plc is financed entirely by equity. It has a tax rate of 40%.
Assume that all debts are virtually risk free; determine three possible estimates
of the likely equity beta of Grand plc, based on the information provided for Big
and Large.
Approach:
i. Using the data from Big plc and equation (8.6), we first de-gear Big plcs
beta:

e
=
a
+
a

d
( )(1 t
c
)
D
E
1.12 =
a
+(10.4)
40
60
a
assume that the debt is risk free
a
= 0.8
The de-geared beta of Big plc can be a proxy for Grands all equity beta.
ii. Both Grand and Large are all equity financed. However, only Division B
of Large shares the same operating characteristics of Grand. So one may
argue that the beta for Division B would be a good proxy for Grands asset
beta. Given that Larges equity beta would be a weighted average of the
divisional betas, we have:

e
= a
A
+ 1 a ( )
B
1.11 = 0.3 1.9 +0.7
B
B
= 0.77
Grands equity beta can be proxied as 0.77.
Act ivit y 8.2
Suppose t hat t he ri sk-f ree rat e and t he expect ed ret urn on t he market i n Exampl e 8.4 are
5% and 10% respect i vel y. Est i mat e t he expect ed ret urn of Grand pl c.
calculate and explain the cost of debt, both before and after tax
calculate the weighted average cost of capital (WACC) for a firm and
explain the meaning of the number produced
explain the difficulty of using WACC to appraise investment projects in
practice.
98
BMA, Chapter 19, Questions 6, 17, 18 and 28.
Sample examinat ion quest ion
BMA, Chapter 19, Question 27.
Chapt er 9: Val uat i on of busi ness
99
Chapt er 9: Valuat ion of business
Essent ial reading
McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters 3, 4
and 21.
Furt her reading
Hall, 2008) fourth edition [ISBN 9780273719069] Chapters 1518 and 20.
Works cit ed
Rappaport, A. Creating shareholder value. (New York: Free Press, 1998) Revised
and updated edition [ISBN 9780684844107].
Aims
In this chapter we focus on three main methods of valuing a business.
They are:
1. Asset based.
2. Earning based.
3. Cash flow based.
Learning out comes
apply the three methods of valuing a business
explain how the value of equity and bond can be measured and
calculated
discuss the key issues of measuring business in real life.
Int roduct ion
Business valuation is an important topic in finance management. We have
seen in previous chapters that managers need to focus on value creation
when taking on positive NPV projects, valuing businesses in mergers and
acquisition activities, developing capital structure and dividend policies. In
this chapter we will more formally address the issues of valuation.
There are three broad approaches to business valuation. They are:
1. Asset based valuation.
2. Earnings based valuation.
3. Cash flow based valuation.
Approaches t o business valuat ion
Asset based valuat ion
The statement of financial position (balance sheet) of any company
provides a useful starting point for us to estimate a firms value. The
100
statement consists of all recognisable and quantifiable assets and
liabilities that a business has. The net asset value (i.e. total assets total
liabilities) would then give an idea of the value of the firm and hence the
value to the owners (i.e. shareholders).
Act ivit y 9.1
Exami ne t he f i nanci al st at ement s of Coca Col a. Det ermi ne a val ue f or t he company usi ng
t he asset based val uat i on met hod. Why mi ght t he val ue you det ermi ne di f f er f rom t he
st ock market s val uat i on (i .e. share pri ce number of shares i n i ssue)?
The statement of financial position only reports what accountants can
deem to be recognisable and quantifiable. It is for this reason that
some of the valuable assets might not necessarily be accounted for in the
statement. For example, innovative knowledge may probably be one of
the most important assets for Apple Inc.; brand awareness is the most
important asset of Coca Cola; and British Airwayss world-wide established
contacts with airports, clients and authorities are their competitive
advantage. Knowledge, brand and customer relationships are valuable
to a company but might not be easily quantifiable. These resources are
often not reported on financial statements. As a result, the asset-based
method is unlikely to indicate the true value of a business. Nevertheless,
asset based valuations are often used in practice as a basis for adaptation.
For example, a bidder might be looking for a value to start within a set of
takeover bid negotiations using the asset based valuations.
Earnings based met hod
This method requires us to estimate the earning power of a company.
Typically we use the price-to-earning ratio (PER) as a surrogate. PER is
defined as:
Historic PER =
Current market price of share
Last year's earnings per share
=
p
t
E
t 1

(9.1)
The following table shows some UK retailers and their historic PER.
Ret ailers PER
Al l i ance Boot s 23.6
Debenhams 11.6
DSG Int ernat i onal 17.5
HMV 10.5
JJB Sport s 24.0
Ki ngf i sher 21.6
Marks and Spencer 21.0
Next 16.4
Table 9.1: UK ret ailers and t heir hist oric PER.
Source of informat ion: Financial Times, 5 May 2007 (also Arnold, 2008).
How do we use PER in business valuat ion?
PER tries to measure the earning potential of a company. For a company
with a high PER, the market is expecting it to show a faster growth in
earnings in the future. Investors can analyse the historic PER of a company
and determine the future price. With Next it could be argued that you are
buying 16.4 years of constant profits.
101
Example 9.1
The following data relates to Company A plc:
2007 2008 2009 2010

Pri ce per share 6 8.4 11 9.18
Earni ngs per share 0.6 0.8 1.0 0.9
PER 10 10.5 11 10.2
The average PER between 2007 and 2010 is 10.425. If the estimated earnings
per share for 2011 is 0.75, the estimated share price (based on the historic PER)
would be 0.75 10.425 = 7.82.
But this analysis is extremely crude and unsophisticated. It suffers from the
following problems:
i. We assume that the PER of a company stays constant over time. But history
tells us that PER fluctuates (See diagram on p.764, Arnold, 2008).
ii. We assume that the stock market knows how to value companies correctly in
the past and that the PER has been correctly computed (as in the table above).
This assumption that stock market analysts have a view of an appropriate
PER for each company seems to be unfounded. A good example of this is the
internet bubble between 1998 and 2000. Prices for some internet companies
were too high relative to their earnings.
We therefore need to explore a much more intellectually rigorous approach to
valuing a business.
Discount ed cash f low met hod
This method uses the technique of discounted cash flow we addressed
in Chapter 2 to evaluate a company. A company is typically engaged in a
number of investments or activities that are financed by, roughly speaking,
two types of funds. The following balance sheet depicts this relationship:
$ $
Invest ment 1 X Equi t y (shares) X
Invest ment 2 X Debt (borrowi ngs) X
Invest ment 3 X
.
Tot al val ue of i nvest ment s XX Tot al val ue of capi t al XX
If a company is made up of a number of investments, each investments
net present value can be computed using the discounted cash flow
technique we introduced in Chapter 2. The value of the company would
then be the sum of the NPV of all investments.
V = NPV
i
i=1
N
for all investments i

(9.2)
On the other hand, these investments are funded by the companys two
types of finance mainly equity (shares) and debt (borrowings). The value
of the business can therefore be evaluated by measuring the sum of the
value of these two types of finance.
102
Valuat ion of debt /bonds
A company which borrows would need to set out
i. how long the borrowing is for
ii. the amount it borrows
iii. the interest it promises to pay during the life time of the borrowing.
A lender will receive a certain sum of cash flows over the life of the
debt depending on the terms and structure of the above three aspects.
The value of such debt (borrowing) to the lender will therefore be the
discounted value of the cash flows that the lender can receive from the
borrowing firm. Consequently, the expected market value of redeemable
fixed interest debt will be found by discounting interest payments and
redemption value by the cost of debt:
D =
I
1+ R
d
( )
t
t =1
T
+
RV
1+ R
d
( )
T

(9.3)
Where:
D = market value of the debt
T = number of years to maturity
R
d
= rate of return (before tax) required by debt investors
RV = redemption value
I = interest paid.
Example 9.2
What is the value of a 5 year 10% bond if the yield to maturity is 15% per
annum? Assume that the face value is $100.
Answer:
The annual interest received by a bondholder is $100 10% (face value
coupon rate) = $10. The yield to maturity is the required rate of return by
the lender for a bond of this kind. It is also the discount rate for the valuation
purpose. Putting these together we have:
D =
10
1.15
+
10
1.15
2
+
10
1.15
3
+
10
1.15
4
+
10
1.15
5
+
100
1.15
5
=10 A
5,15%
+100 DF
5,15%
=10 3.352 +100 0.497
= 83.22
Act ivit y 9.2
What woul d be t he val ue of t he same debt i n Exampl e 9.2 i f t he yi el d t o mat uri t y were
now 5% per annum?
In the previous example, we considered a bond which needs to be repaid
by the issuing company within a fixed period of time. What if the bond is
irredeemable?
If a bond is irredeemable, the redemption value of the bond is equal to
zero. Consequently, the valuation formula will be reduced to:

D =
I
1+ R
d
( )
t
t =1
=
I
R
d

(9.4)
103
Where:
D = ex-interest market value
I = annual interest paid
R
d
= rate of return required by debt investors.
Example 9.3
Consider the case of a 5% irredeemable bond of 100 par value where bond
investors require a yield of 10% per annum. The expected market value of the
bond will be:
D =
I
R
d
=
5
0.1
= 50
A more complex debt structure which provides varying cash flows to
bondholders can be evaluated by the same discounted cash flow technique. But
of course the computation will be much more burdensome.
Valuat ion of equit y
We now turn our attention to the value of equity (shares). A shareholder
who owns a share in a company will receive cash flow in terms of the
resale value of the share and/or dividend paid by the company. Suppose
that at the end of the period, the price for a quoted share is P
t
. Assume
that shareholders receive dividends Div
t
at the end of each time period t.
Let the discount rate (or the required rate of return) by the shareholders
be r%. The value of a share can then be computed as:
P
0
=
E Div
1
( )
1+ r
+
E P
1
( )
1+ r
But the expected one period share price is the discounted value of the
expected dividend receivable and the resale value of the share in year 2:
P
0
=
E Div
1
( )
1+ r
+
E Div
2
( )
1+ r ( )
2
+
E P
2
( )
1+ r ( )
2
By forward substitution, the share price can be rewritten as:

P
0
=
E DIV
1
( )
1+ r ( )
+
E DIV
2
( )
1+ r ( )
2
+
E P
2
( )
1+ r ( )
2
=
E DIV
1
( )
1+ r ( )
+
E DIV
2
( )
1+ r ( )
2
+
E DIV
3
( )
1+ r ( )
3
+
E P
3
( )
1+ r ( )
3
=
E DIV
t
( )
1+ r ( )
t
t =1
...
...

(9.5)
This is the discounted dividend model for the valuation of shares. To use
this model to estimate share prices in reality, we will need to estimate a
companys future dividend and its cost of equity.
In Chapter 3 we discussed how one can use the capital asset pricing
model (CAPM) to estimate the required rate of return by equity-holders.
If this estimation process provides us with the correct discount rate, the
remainder of our work is to estimate the forecasted dividend.
104
Suppose we observe a company has been paying a constant dividend of
Div each year in the past. It is natural to assume that it is going to pay the
same constant dividend in the future. Given that the future dividend is
going to be constant, equation (9.5) will become:

P
0
=
Div
r
(9.6)
Now suppose a companys dividend has been growing by g% each year in
the past. If we believe that the same constant growth rate is going to be
persistent in the future, equation (9.5) will become:

P
0
=
1+ g ( ) Div
0
r g

(9.7)
Equations (9.6) and (9.7) are known as the constant dividend model and
Gordons growth model.
Act ivit y 9.3
Sunl i ght pl c pai d t he f ol l owi ng di vi dends f or t he l ast 5 years: 1.30, 1.40, 1.55, 1.70 and
1.90. The companys current cost of capi t al i s 14% per annum.
Suppose di vi dend i s expect ed t o grow at t he hi st ori c growt h rat e of t he l ast 5 years f or
t he f oreseeabl e f ut ure, what woul d be t he est i mat ed share pri ce of Sunl i ght ? If di vi dend
i s onl y expect ed t o grow at t he hi st ori c rat e f or t he next 3 years and t hereaf t er st ays
const ant , what wi l l be t he revi sed share pri ce?
Answer:
We f i rst cal cul at e t he hi st ori c growt h rat e of di vi dend. Gi ven t hat Di v
(0)
was 1.30 and
Di v
(4)
was 1.90. We can depi ct t hi s rel at i onshi p as f ol l ows:

Div
= 1+ g ( )
4
g =10%
(4)
Div
(0)
1

Case 1 when di vi dend i s growi ng at 10% i nf i ni t el y. Usi ng t he const ant growt h model ,
t he share pri ce i s:

P
0
=
1+ g ( )D
0
r g
=
1+0.1 ( ) 1.90
0.14 0.1
=
2.09
0.04
= 52.25
Case 2 when di vi dend onl y grows at 10% f or 3 years and t hereaf t er st ays const ant , t he
share pri ce i s:

P
0
=
Div
1
1+ r ( )
+
Div
2
1+ r ( )
2
+
Div
3
1+ r ( )
3
+
P
3
1+ r ( )
3
Not e t hat P
3
i s t he t ermi nal pri ce at t he end of year 3. Those who obt ai n a share at t hat
t i me woul d be ent i t l ed t o di vi dend f rom year 4 t o i nf i ni t y. Theref ore t he t ermi nal pri ce i s:
P
3
=
Div
4
1+ r ( )
+
Div
5
1+ r ( )
2
+
Div
6
1+ r ( )
3
+......
=
Div
3
r
since all future dividends are identical to dividend in year 3
Subst i t ut i ng P
3
i nt o t he di scount ed di vi dend equat i on and t aki ng t he growt h f or t he f i rst
t hree years di vi dend, we have:
P
0
=
1.11.90
1.14 ( )
+
1.1
2
1.90
1.14 ( )
2
+
1.1
3
1.90
1.14 ( )
3
+
1.1
3
1.90 0.14
1.14 ( )
3
=
2.09
1.14 ( )
+
2.299
1.14 ( )
2
+
2.5289
1.14 ( )
3
+
2.5289 0.14
1.14 ( )
3
=1.833+1.769 +1.707 +12.192
=17.501
1
For examinat ion
purposes, you can
assume t hat t he
growt h on dividend
is not compounded.
Consequent ly we have
Div
(4)
= Div
(0)
(1 + 4g)
g = 11.5%
105
Pract ical considerat ions
This section is based on Arnold (2008) Chapters 1518.
We often think that an increase in earnings over time must be a good
indicator of value creation. However, measurement of value creation based
on earnings can be misleading:
the accounting rules which define the earnings figures can be distorting
and subject to judgments and manipulation
the investment required to generate the earnings growth is often not
adequately represented
the time value of money is not included in the consideration
the risk of the company is not being considered thoroughly.
Value-based management
The recent talk about value-based management brings together three
important aspects of corporate management: finance function, strategy of
a firm and organisational capabilities. There are three steps to create value
to shareholders:
1. Mission statement with value for shareholders at its core.
2. Measuring shareholder value for the entire corporation.
3. Actively managing to create shareholder value.
How is value creat ed?
In simple terms, shareholder value is created when the return on
investment is higher than the return on capital provided. So how do we
ensure that the return on investment can be higher than the return on
capital provided in the long run? Arnold identifies a five-step approach:
i. increase the return on existing capital through efficiency
ii. raise capital and place in positive investment
iii. divest assets which are not effectively producing the required return
iv. extend the planning horizon
v. lower the required return on capital through careful capital structure
planning.
How do we measure t he value?
We can summarise how we measure value as follows:
1. In Chapter 2 we discussed how a firms value is based on the aggregate
of a firms projects NPVs.
2. The value of a firm can also be proxied as the sum of the value of the
financial instruments. We discuss this in Chapter 6 and this chapter.
3. A free cash flow approach which is discussed below.
Rappaport (1998) defines free cash flow (FCF) within the planning period as:
FCF = sales operating costs tax
incremental investment in fixed capital
incremental investment in working capital
The corporate value is then defined as:
Corporate value = PV of free cash flow within the planning period + PV of
free cash flow after the planning period + the current value of marketable
securities and other non-operating investment.
106
A forecasted free cash flow is estimated and then discounted accordingly
to take into consideration the time value of money.
Conclusion
It is not easy to estimate correctly how much a business is worth. In this
chapter we showed three different approaches to estimate a value of a
business. Each method, based on different assumptions, provided different
valuations of a business. We should try to understand the advantages and
disadvantages of each of those three methods.
apply the three methods of valuing a business
explain how the value of equity and bond can be measured and
calculated
discuss the key issues of measuring business in real life.
Falcon Ltd. is a private company in the UK. Its balance sheet on 31
December 2011 shows the following information:
000
Share capi t al @ 1 par val ue 10,000
Share premi um 5,000
Reval uat i on reserve 2,500
Ret ai ned prof i t s 12,500
Sharehol ders f unds 30,000
5% bonds, mat ured i n 2019 20,000
Capi t al empl oyed 50,000
Falcon paid the following dividends in the last 5 years:
2006 0.51
2007 0.60
2008 0.68
2009 0.77
2010 0.90
The risk-free rate is assumed to be 4% per annum and the expected
markets return is set to be 10% for the foreseeable future.
Required:
a. What is the balance sheet value of Falcon Ltd.?
b. What is the market value of the bond in Falcon, assuming that the
market risk, beta, of the bond is 0.5.
107
c. Suppose a similar quoted company to Falcon Ltd. has an observed beta
of 1.1. Estimate the equity value of Falcon.
d. What is the value of Falcon based on (b) and (c) above?
e. Why is your answer to (a) different from (d)?
f. What reservations do you have in terms of the value you calculate in
(d)?
Not es
108
Chapt er 10: Mergers
109
Essent ial reading
Furt her reading
Aims
Most companies are involved in either a merger or a takeover at some time
during their corporate existence, so understanding the motives and tactics
behind mergers is very important. There are waves of merger activity and
an explanation for this is given in this chapter. The motives and theories
behind mergers and takeovers are also described. To achieve success in
taking over a company requires knowledge of appropriate tactics, as well
as knowledge of defence tactics should a company not wish to be taken
over these are explained. We then move onto a section which looks at
corporate restructuring and divesting.
Learning out comes
describe the motives for a merger
explain the tactics employed in attempting to bring about a merger or
to defend against a merger
express the advantages and disadvantages of alternative methods of
financing mergers
describe the merger process and the main regulatory constraints
investigate the benefits derived from a merger
appreciate a merger as an investment decision, a financing decision
and a dividend decision.
Int roduct ion
This chapter focuses on trying to explain the motives and tactics involved
in merger and acquisition activity. During periods of intense merger
activity, financial managers spend a great deal of time searching for firms
to acquire or they spend time worrying about firms that are likely to take
their firm over. When one firm buys another, it is exactly the same as
undertaking any ordinary investment. Therefore, from our earlier studies
of financial management we will know that the investment should only
proceed if there is going to be a net contribution to shareholder wealth.
The only problem is that mergers are very difficult to evaluate because
the benefits and costs may not be easy to measure and due to tax they are
more complicated than, say, buying a machine, as legal and accounting
regulations need to be followed.
110
The terms merger and takeover are used interchangeably. This is because
in many instances it is not clear whether one or the other is occurring.
Strictly, a merger is when two companies of equal size come together and
continue to have an interest in the combined business. A merger supports
the idea of the combination while, in a takeover or acquisition, a larger
company makes a bid for a smaller company, and the directors of the
smaller company do not recommend that shareholders sell their shares to
the purchaser and neither the pre-bid shareholders nor the directors of the
company have any interest in the combined firm.
In a merger, the accounting rules emphasise the continuity of ownership,
while in a takeover, the emphasis is rather on a purchase and discontinuity
of ownership; the main differences between the accounting rules are
concerned with the treatment of goodwill, value of shares exchanged and
pre-acquisition profits.
Mot ives f or mergers
BMA Chapter 31, pp.82028, explains the main motives for mergers and
acquisitions. Some of these motives are explained here.
Economies of scale
You may have come across this term in your earlier studies. In short,
economies of scale can be found in the following areas:
In production a larger firm may be able to reduce its per unit cost by
using excess capacity or spreading fixed costs across more units.
In finance a large firm may be able to reduce its per unit
administrative cost when administrating finance issues.
Internalisation of transactions
This usually occurs when firms vertically integrate (vertical integration
backwards occurs by the acquisition of firms that supply raw materials and
vertical integration forwards occurs when firms are acquired nearer the
selling of the product). It is an important form of merger as it eliminates
transaction costs when firms have to deal with each other. One drawback
is that by merging two large firms, extra costs may result. For example,
suppliers may be less inclined to compete with one another, leading to
higher prices paid by the merged entity. Another problem is that firms may
be over-integrating. In this case, the benefits of reducing transaction costs
may be outweighed by the increase in costs of mergers.
Market power
During the boom of 197985, it was estimated that 3% of assets in the
UK changed hands as a result of vertical integration, while 57% were a
result of horizontal integration (horizontal integration occurs where firms
acquired are at the same stage of the production process, and the merger
leads to a greater share of a particular market). This is an attractive
feature for firms as it has been shown that a concentration in an industry
leads to a greater level of profit.
Entry into new markets/industries
A merger may allow the acquiring firm to enter into markets where the
acquired firm has the know-how. As the growth through a takeover is
quick, it can provide, almost instantly, the necessary size for a firm to
become an effective and formidable competitor.
111
Elimination of misguided management
There is a substantial separation between the ownership and management
of large firms. Shareholders do not appoint or supervise the firms
management; they only elect directors who are agents responsible for the
choosing and monitoring of the top management of the firm.
Mergers as a use for surplus funds
If a firm is in a mature industry with few, if any, positive NPV projects
available, acquisition may be the best use of its funds.
Complementary resources
Merging may result in each firm filling in the missing pieces of their firm
with pieces from the other firm. For example, an accounting firm merges
with a consultancy firm to provide an all-round one stop service to clients.
Similarly, a merger may take place when one firms loss can be used to
offset another firms profit for tax purposes within the group.
Dubious reasons f or mergers
Risk diversification
During the conglomerate merger boom of 197985, the rationale for
the mergers was said to be diversification, which would eventuate
in the stability of future cash flows. As firms in different industries
experience booms and slumps in their profits and cash flows at
different times, it was felt safer for firms to conglomerate to reduce
this volatility. From this point of view takeovers reduce risk for
companies.
However, it is costly to merge or acquire another firm. Apart from
the direct costs that a firm needs to pay to its advisors and other
professional teams, there might be other restructuring costs which
need to be considered. If the merger is simply reducing the overall
risk to investors, it is argued that this might not be a sensible
reason as shareholders can achieve the same level of diversification
by rebalancing their portfolios. Arguably it is much cheaper for
shareholders to do so via stock exchanges.
Bootstrapping
This was particularly important during the conglomerate merger booms
of the 1960s. If Firm A possesses a high stock market rating relative
to another Firm B, then the former company is able to purchase the
latter firm on advantageous terms, as banks and financial institutions
are more likely to support a takeover bid from a company with a better
stock market rating.
A B
EPS 1 1
P/ E 10 5
Share Pri ce 10 5
No. of shares 10m 1m
Market val ue 100m 5m
Earni ngs 10m 1m
Suppose Firm A acquires Firm B for 5m in cash and there is no
synergy created from the merger. Both companies have identical risk.
112
After the acquisition, the total market value of the combined firm:
= 100m (value of Firm A) 5m (cash paid out) + 5m (value of
Firm B)
= 100m
Total earnings of the combined firm:
= 10m + 1m = 11m
Total outstanding shares:
= 10m (only Firm As shares are counted as Firm Bs shares will be
cancelled on acquisition)
New share price of the combined firm:
= 100m/10m = 10
New earnings per share, EPS:
= new earnings/number of shares
= 11m/10m
= 1.10
It seems that the merger has created a higher EPS for the combined
firm. One might think that the combined firm has become more
profitable than before the merger. However, as we assume that there is
no synergy involved in this merger, the increase in EPS is only cosmetic.
It should not be regarded as a merger benefit. One should also note
that the P/E ratio of the combined firm will be reduced to:
100m/11m = 9.09
Act ivit y 10.1
At t empt Quest i on 1 and 2 of BMA, Chapt er 31, p.845.
Financing a merger
In the previous section, we discussed the main reasons for mergers and
acquisitions. In this section, we turn our attention to the ways that these
mergers and acquisitions should be financed.
A firm can finance a merger using a combination of the following
methods:
1. Cash purchase.
2. Equity exchange.
A firm can purchase another company in cash. Cash can be raised from an
internal cash reserve, by issuing new shares to existing shareholders, or by
issuing additional debt. Each of these methods presents different benefits
to, and is met with different reservations by, the shareholders in both the
acquired and acquiring firms.
We have discussed the relative advantages of financing with internal cash,
debt and equity in Chapter 6 on capital structure. You should revise that
chapter and familiarise yourself with the concept. In short, the relative
advantages can be summarised as follows:
113
Cash of f er
Acquired firms shareholders
In a cash offer, the shareholders of the acquired firm will receive a
certain sum of cash flow in selling their shares to the acquiring firm.
While they can calculate the actual return of the investment, the sale
of the shares will be deemed as a disposal which normally will attract
capital gain taxes. There is therefore a tax consideration that the
acquired firms shareholders would need to take into account when
accepting the offer price from the acquired firm.
Acquiring firm and its shareholders
If the firm is using idle cash, both free cash flow theory and pecking
order theory suggest that this will increase the value of the firm.
If the firm can afford to purchase another firm with cash despite the
cash flow implication, it might suggest that the acquiring firm might
still have sufficient cash flows for other future investment. Based
on our discussion of the signalling effect on debt and dividend, this
might suggest that it is a good quality firm. Once again its value
might further be enhanced.
Another advantage of using cash in acquiring another firm is that
there is no dilution effect to the existing shareholders holding in the
acquiring firm.
Share issues
Issuing new shares to raise additional cash for acquisitions has very
similar advantages as in the cash offer above.
However, according to the pecking order theory, issuing shares might
lead the market to believe that the existing shares are overpriced. This
might have an adverse effect on the share value if the acquiring firm
issues new shares to raise funds for the acquisition.
There can be difficulties for the market when trying to evaluate the
resultant combination if it perceives that the target company has part
or all of its operations in a different risk class or classes from that of the
acquiring company.
Debt issues
According to our discussion in the trade-off theory, as long as the firms
marginal tax shield benefit exceeds the marginal cost of financial distress,
the debt financing will increase the value of the firm. In a similar way, a
firm which issues debt to finance an acquisition might also increase its
value due to this financial effect.
Share exchange
In this mode of financing an acquisition, the acquiring firm issues new
shares to the shareholders of the acquired firm in exchange for the
control of the acquired firms net assets. In return, the shareholders of the
acquired firm will surrender their shares in the acquired firm. The relative
advantages and disadvantages of this method to the different stakeholders
can be summarised as below:
Acquiring firm and its shareholders
There is no immediate outflow of cash and therefore it reduces
the burden of raising additional finance. This is especially valuable
when the acquiring firm is facing a capital rationing problem.
114
However, the shareholders of the acquired firm will now be holding
shares in the combined company. There is therefore a dilution
effect of the shareholding among the existing shareholders of the
acquiring firm.
Acquired firms shareholders
The surrender of the shares by the shareholders in the acquired firm
is not deemed as a sale or disposal of shares. Therefore there is no
capital gains tax to be paid by the acquired firms shareholders.
However, the value of the shares in the combined firm after the
acquisition is completed fluctuates and it will be dependent on how
well the firms are merged and whether the synergies can be created
as planned. Therefore the merger value to the shareholders of the
acquired firm is more uncertain in this case than in the cash offer.
In practice, an immediate premium is usually offered to the target
companys shareholders as an incentive to them to surrender
their shares. At the same time it provides the market and existing
shareholders a benchmark against which they can review efforts
of their management as well as realising the potential of their
investment operating on its own.
Act ivit y 10.2
Exami ne several recent mergers and i dent i f y t he pri nci pal f i nanci ng opt i ons i n each case.
Impact of mergers
1
There is a significant volume of academic and practitioner research on
mergers and their impact. In Arnold, the impact on different types of
stakeholder is discussed. Here is a brief summary:
Societ y
Society will benefit from mergers provided that the combined firms will
produce cheaper products as a result of economies of scale and improved
managerial efficiency. Empirical findings seem to suggest that at best
mergers are neutral to society.
Shareholders of acquired f irms
In practice, a significant premium is often paid over the pre-bid price
of the acquired firm. The empirical evidence seems to overwhelmingly
suggest that shareholders of the acquired firm gain from mergers.
Shareholders of t he acquiring f irms
Empirical evidence seems to suggest that the majority of mergers result in
a poorer than expected return to the acquiring firms.
Why do mergers fail to generate value for acquiring shareholders?
Different mergers have their different reasons for possible failure.
However, there seems to be some common explanatory factors:
1. Misguided strategies
Companies engage in mergers in the hope of gaining larger market
shares. However, some of these mergers might be carried out at the
wrong time. For example, Daimler-Benz merged with Chrysler to create
a global car producer and found itself in a high-tech recession in 2001,
and lost over 90% of its share value.
1
See Arnold (2008),
pp.88793.
115
2. Over-optimism
Acquiring managers often over-estimate the benefits of a merger and its
cost. This explains why acquiring firms seem to lose value in mergers.
3. Failure of integration management
Coopers & Lybrand (1993) surveyed the UKs top 100 companies and
interviewed senior executives and found that the most commonly cited
reasons for merger failures are:
Target management attitudes and cultural differences (85%).
Little or no post-acquisition planning (80%).
Lack of knowledge of industry or target (45%).
Poor management and poor management practices in the acquired
company (45%).
Little or no experience of acquisitions (30%).
Employees
In most merger cases, operating units of the merged firms are fused and
redundancy is inevitable. However, in some cases, mergers actually create
competitive strength in the combined firm and allow jobs to be saved or
created.
Direct ors
The directors of the acquiring firm will normally enjoy an increase in
status and power in the combined firm. Their salary and remuneration are
increased as a result.
On the other hand, the directors of the acquired firm will often be sacked
as they are regarded as the failed managers. However, these directors are
often given a good redundancy package and are often able to find jobs in
other companies.
Financial inst it ut ions
Financial institutions benefit from mergers greatly as they are usually paid
handsome fees for providing advice to both the acquired and acquiring
firms during merger talks.
Est imat ing economic gain
The economic gain of a merger is defined as the value of the combined
firm less the aggregate value of the individual firms.
Gain =PV
Combined
PV
i
i=1
N
The net gain of a merger is defined as the gain over the cost of acquisition.
The cost of acquisition is the sum of the cash paid and value of securities
issued for the acquisition. Net cost is the cost of acquisition less the
original value of the acquired firm.
The gain generally comes from the synergies created from the merger.
Examples of synergies are:
Revenue enhancement
marketing gains
strategic benefits
market or monopoly power.
116
Cost reduction
elimination of inefficient management
economies of scale
complementary resources.
A bidder is typically estimating the value of a target company using some
of the valuation methods we outlined in Chapter 9. The following example
illustrates how the cost and gain of a merger can be estimated.
Example 10.1
Wardour plc is a 100% equity financed company. It is considering acquiring
the net assets and full control of Frith plc. Currently Frith is expected to have a
dividend growth of 6% per annum. Under the management of Wardour plc, this
growth rate is expected to increase to 8% per annum without any additional
investment.
Wardour Fri t h
Earni ngs per share 50p 15p
Di vi dend per share 30p 8p
Share pri ce 9 2
Wardour plc has the following three financing options:
i. Cash offer pays 2.50 for every share in Frith.
ii. Share exchange Wardour offers one of its own shares in exchange for
3 shares in Frith.
iii. Debt issue raise 60m via a 5% irredeemable debt.
The corporate tax rate is 30% for both companies.
Calculations:
The gain of the acquisition can be calculated using Gordons Growth Model:
Old share price of Frith before the merger:
P = Div(1)/(r g)
200p = 8p (1.06)/(r 0.06)
r = 0.1024
The new share price of Frith, P*, under the new management is:
P*= 8p 1.08/(0.1024 0.08)
= 386p
The gain of acquisition:
= New value of Frith Old value of Frith
= (3.86 2) 24m
= 44.64m
Cash offer
The cost of the acquisition if Wardour plc pays 2.50 for each of Friths shares:
= Cash offer per share number of shares in Frith
= 2.50 24m = 60m
Net cost of acquisition to Wardour:
= Cost of acquisition Old value of Frith
= 60m 2 24m = 12m
117
Net gain of acquisition to Wardour:
= gain net cost
= 44.64m 12m
= 34.64m
Share exchange
One of Wardours shares is exchanged for every three of Friths shares:
The market value (MV) of the combined firm:
= MV of Wardour + MV of Frith after acquisition
= 9 40m + 3.86 24m
= 452.64m
Number of shares after the acquisition in the combined firm:
= Old shares + New shares
= 40m + 24/3m
= 48m
New share price for the combined firm:
= New MV/number of shares
= 452.64m/48m = 9.43
Cost of acquisition to Wardour:
= 9.43 8m
= 75.44m
Net cost of acquisition to Wardour:
= 75.44m 2 24m
= 27.44m
Gain of acquisition to Wardour:
= as before
= 44.6m
Net gain of acquisition to Wardour:
= 44.6m 27.44m
= 17.16m
Debt issue
The debt issue has a very similar effect on the merger as the cash offer.
However, according to Modigliani and Millers argument, the debt interest
attracts tax shield benefits. Assuming that the debt is risk free and the
acquisition does not change the risk profile of the combined firm, the gain of
acquisition will be the same as the cash offer; i.e. 44.64m.
However, the value of the combined firm will be:
= Value of Wardour + Value of Frith + Gain of acquisition + Financing effect
= 9 40m + 2 24m + 44.64m + TcD (where Tc = tax rate and D =
market value of the debt)
= 360m + 48m + 44.64m + 60m 0.3
= 470.64m
Act ivit y 10.3
118
Conclusion
In this chapter we discussed the main reasons for companies merging with
each other. We also looked at how the gains of a merger can be estimated.
In short this is an area in which corporate managers need to make three
key decisions:
Investment decision does the target company provide benefits to the
merged firm? We can view it as an investment project which should be
appraised in line with Chapter 2.
Financing decision how should the acquisition be financed? Does it
add value to the merged firm with the different methods of financing?
This links with what we discussed in Chapter 6.
Strategic decision the success of a merger depends on how well the
merger plan can be executed. Coopers & Lybrand (1993) provide a list
of common factors for merger success:
Detailed post-acquisition plans and speed of implementation.
A clear purpose for making the acquisition.
Good cultural fit.
High degree of management cooperation.
In-depth knowledge of the acquired firm and its history.
describe the motives for a merger
explain the tactics employed in attempting to bring about a merger or
to defend against a merger
express the advantages and disadvantages of alternative methods of
financing mergers
describe the merger process and the main regulatory constraints
investigate the benefits derived from a merger
appreciate a merger as an investment decision, a financing decision,
and a dividend decision.
119
Bei plc is an all-equity financed conglomerate in the UK. It is considering
taking over the operation of Jing Ltd. The following information is
available:
Bei pl c Ji ng Lt d.
Number of shares i ssued at 1 each 20,000,000 2,000,000
Market pri ce per share 10 12.5
Earni ngs af t er t ax per share 0.875 1.5
Bet a 0.9 1.8
The Board of Directors have identified the following options to finance the
proposed acquisition of Jing Ltd.
1. Raise 28 million of new shares to acquire the total control of Jing Ltd.
from its existing shareholders.
2. Raise 28 million of 10% perpetual debentures with 20 million
face value to acquire the total control of Jing Ltd. from its existing
shareholders.
The Board expect that, after the acquisition, the combined company could
reduce operational costs by 4,000,000 while maintaining the same level
of operations as before. Currently both companies are paying corporation
tax at the rate of 30%. The risk-free rate is expected to be 5% per annum
for the foreseeable future. The current market return is 10% per annum.
Required:
a. What are the main motives for mergers and acquisitions?
b. What are the effects on Bei plcs stock price, capital structure, return
on equity and return on debt under each of the two funding options?
Advise whether the acquisition should go ahead and which funding
option would maximise the companys value. Explain your answer
carefully and state any assumptions that you make.
Not es
120
Chapt er 11: Fi nanci al pl anni ng and worki ng capi t al management
121
Chapt er 11: Financial planning and
working capit al management
Essent ial reading
McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapter 25 and
Chapters 2830.
Aims
This chapter examines the importance of financial planning and how
carefully chosen techniques may improve the value of a firm.
Learning out comes
describe the core concepts of financial planning
evaluate the approaches to, and methods of, financial planning
explain the importance of working capital management
discuss techniques used to assist planning and management.
Int roduct ion
This chapter covers three key areas in financial planning:
1. Financial analysis.
2. Financial planning.
3. Working capital management.
Financial analysis
A companys financial statements provide shareholders, bondholders,
bankers, suppliers, employees and management with information about
how well their interests are protected. Naturally, it is important for each of
these stakeholders to understand the performance of their company. In 25
Principles of accounting, you would have already come across how
we can use financial ratios to assess a firms performance. BMA Chapter 28
provides a very detailed explanation of how these common financial ratios
can be calculated and used in interpreting a firms profitability, efficiency,
liquidity, financial risk and leverage. We are not going to repeat this
material here. You should revise Chapter 28 thoroughly before proceeding
with the rest of this section. In particular, you should refer to the summary
of financial ratios on p.748.
A companys set of accounts, its profit and loss account, cash flow
statement and balance sheet are only of limited value when read in
isolation and without analysis and evaluation. Therefore it is important
to give meaning to results portrayed by accounts via analysis and
interpretation. The analysis of financial information can perhaps be best
broken down into two elements, each with their own parts. These are the
process and the context elements, and each influences the other.
122
The process of analysis will be heavily influenced by its mode and its
purpose. The structure, depth and detail of work undertaken will be
influenced similarly. A very detailed review will start by strategically
analysing the company and then use the ratios to address strategic elements
within each area of enquiry. Most books delineate four areas: profitability,
liquidity and solvency, activity and efficiency, and financial structure.
Each of these areas can be broken down further, for example in the case
of profitability it can cover trading profitability, the margin on sales, the
proportions of sales taken by the different types of costs, etc. Profitability
also includes the return on the investment made. As to what constitutes
investment depends on the reviewers perspective. Is it the return on
the long-term funds invested capital employed or is it the return on
the total assets used to generate the profit or the return to the ordinary
shareholders for their investment in the company? Each of the areas has its
own family of ratios, providing information for answers to the appropriate
strategic questions. Remember the process is generally to prepare a set of
ratios, analyse them, and use them for a review of the past performance
with the view of helping in the projections for the future. Also a comparison
with competitors or industry sector benchmarks can be useful. The
following table summarises the key ratios and their interpretation.
Rat i os Def i ni t i on Int erpret at i on
Prof it abilit y
Economi c
val ue added
(EVA)
Af t er-t ax i nt erest + net
i ncome cost of capi t al
capi t al
1
Measures t he ext ra val ue added t o
sharehol ders and bondhol ders af t er
account i ng f or t he cost of capi t al .
Ret urn on
capi t al (ROC)
i ncome
2
/ t ot al capi t al
Measures t he pot ent i al ret urn t o
sharehol ders and bondhol ders on
t hei r i nvest ment i n t he company.
Ret urn on
equi t y (ROE)
Net i ncome/ equi t y
Measures t he pot ent i al ret urn t o
sharehol ders on t hei r i nvest ment i n
t he company.
Ret urn on
asset s (ROA)
i ncome/ t ot al asset s
Thi s measure f ocuses on how
prof i t woul d be generat ed f rom t he
ut i l i sat i on of asset s empl oyed i n t he
company.
Market val ue
added (MVA)
Market val ue of equi t y
book val ue of equi t y
Measures t he di f f erence bet ween
t he market val ue of sharehol ders
i nvest ment and t hei r cumul at i ve
i nvest ment i n t he company.
Gross prof i t
margi n
Gross prof i t / sal es
Measures how much gross prof i t a
company can generat e f rom every
of sal es.
Operat i ng
prof i t margi n
Operat i ng prof i t / sal es
Measures how much operat i ng prof i t
a company can generat e f rom every
of sal es.
1
An al t ernat i ve
def i ni t i on of EVA i s
(prof i t af t er t ax + bef ore
t ax i nt erest ) cost of
capi t al capi t al . The
di f f erence depends on
whet her i nt erest i s t ax
deduct i bl e.
2
It shoul d be not ed t hat
BMA def i ne net i ncome
as t he prof i t af t er
t ax. Some UK aut hors
(such as Arnol d, 2008)
def i ne ROC as prof i t
bef ore i nt erest and t ax
/ capi t al . Bot h t he US
and UK def i ni t i ons are
accept abl e.
123
Ef f iciency
Asset
t urnover
Sal es/ t ot al asset s
3
Measures how wel l t he company
generat es revenues f rom i t s asset s
empl oyed i n t he year.
Invent ory
hol di ng
peri od
Average
4
i nvent ory/ cost of
sal es 365 days
Provi des an est i mat e of how l ong
on average goods purchased f rom
suppl i ers woul d be hel d i n t he
company bef ore t hey are sol d.
Debt ors
col l ect i on
peri od
Average debt ors/ credi t
sal es 365 days
Thi s measure i ndi cat es on average
how l ong i t t akes f or a company t o
col l ect i t s debt s f rom credi t cust omers.
Credi t ors
payment
peri od
Average credi t ors/ credi t
purchases
5
365 days
Measures on average how l ong i t
t akes f or a company t o pay i t s debt s
t o credi t suppl i ers.
Liquidit y
Current rat i o
Current asset s/ current
l i abi l i t i es
Indi cat es how much a company can
cover i t s obl i gat i ons i n t he next 12
mont hs usi ng i t s current asset s.
Qui ck rat i o
Current asset s (l ess
i nvent ory)/ current l i abi l i t i es
Thi s measure excl udes t he i nvent ory
f rom t he cal cul at i on. Ef f ect i vel y we
are measuri ng how wel l a company
can cover i t s l i abi l i t i es i n t he next 12
mont hs usi ng current asset s ot her
t han i nvent ory.
Financial
risk
Geari ng rat i o
Long-t erm debt / (l ong-t erm
debt + equi t y)
Measures t he rel i ance of a companys
f i nance on l ong-t erm debt .
Int erest cover
Earni ngs bef ore i nt erest and
t ax/ Int erest payment
Measures how much i nt erest a
company can cover f rom i t s operat i ng
prof i t bef ore i nt erest .
Table 11.1: Key rat ios and int erpret at ions.
Cash based rat ios
Apart from the ratios listed above, there are also cash ratios that focus on
a companys cash management.
Cash return on net assets (or cash return on capital employed) =
Net operating cash flow/total assets less current liabilities.
Cash interest cover = Net operating cash flow/interest payment.
Cash dividend cover = Net operating cash flow less tax and interest
payments/dividend payment.
Internally generated investment = Net free cash flow/investment.
The Du-Pont system (which is based on a pyramid of ratios, each level
interlocking with the next) is helpful in providing pointers for investigation
derived from the inter-relationships. For example return on net assets
is the product of operating profit margin (return on sales) and net asset
turnover. This causes the analyst to look at the profit margin change, say
3
We can al so def i ne
asset t urnover as sal es/
average l evel of t ot al
asset s f or t he year.
4
In most cases, t he
year-end f i gures are
used f or debt ors (t rade
recei vabl es), credi t ors
(t rade payabl es) and
cl osi ng st ock (i nvent ory)
i nst ead.
5
In t he case when
credi t purchases are
not avai l abl e f rom t he
f i nanci al st at ement s, t he
cost of sal es f i gure can
be used i nst ead.
124
in a price war between competitors, and see if it has helped improve the
net asset turnover enough to result in an overall improvement in return to
the net assets employed.
Example 11.1
(This example is adapt ed f rom t he 2008 subject guide)
The accounts for Chemistrand plc for the two financial years ended 31
December 2007 and 2008 are given below.
CHEM I STRAND PLC
Prof it and loss account f or years ended 31 December 2008 and 2007
2008 2007
000 000
Turnover 12,000 13,200
Vari abl e cost of sal es 5,700 6,660
Fi xed product i on cost s 1,320 1,200
Admi ni st rat i on cost s 1,020 1,080
Sel l i ng and di st ri but i on cost s 1,320 1,290
Research and devel opment cost s 300 270
Int erest 108
9,768 10,440
Net prof i t bef ore t ax 2,232 2,760
Taxat i on 642 960
Net prof i t af t er t ax 1,590 1,800
Di vi dend pai d (duri ng years) 900 900
Prof i t ret ai ned 690 900
Balance Sheet s as at 31 December 2008 and 2007
2008 2007
000 000
Fi xed asset s
Leasehol d propert y (not e 1) 6,750 6,900
Pl ant and equi pment (not e 2) 1,620 1,080
8, 370 7,980
Current asset s
St ock 1,140 1,020
Debt ors 1,320 1,140
Bank 60
2,460 2,220
125
Less
Credi t ors due wi t hi n one year
Tax credi t ors 600 540
Taxat i on 630 1,470
Bank 720
Net current asset s 510 210
Net asset s 8,880 8,190
Ordi nary share capi t al
(1 shares) cal l ed up 6,000 6,000
Prof i t and l oss account 2,880 2,190
8,880 8,190
Not e 1 Leasehol d propert y (cost ) 7,200 7,200
Accumul at ed depreci at i on 450 300
Bal ance 6,750 6,900
Not e 2 Pl ant and Equi pment (NBV) 1,080 1,140
Addi t i ons 720 60
Depreci at i on f or year (180) (120)
Cl osi ng bal ance (NBV) 1,620 1,080
Not e 3 No sal es of asset s t ook pl ace duri ng t he year (NBV Net Book Val ue)
Not e 4 Al l di vi dends were pai d duri ng t he f i nanci al year at t he rat e of 0.15 per share.
Cash f low st at ement f or t he year ended 31 December 2008
2008 2007
000 000
Cash f l ow f rom t he operat i ng act i vi t i es 2,430 2,460
Ret urns on i nvest ment s and servi ci ng of f i nance
Int erest pai d (108)
Taxat i on (1,482) (240)
Capi t al expendi t ure (720) (6,060)
120 (3,840)
Equi t y di vi dends pai d (900) (900)
(780) (4,740)
Management of l i qui d resources
Fi nanci ng
Share i ssue 3,000
Increase/ (Decrease) i n cash i n t he peri od (780) (1,740)
126
The following information from a credit rating agency for the industry is also
available for the two years 2008 and 2007.
2008 2007
LQ M UQ LQ M UQ
Ret urn on net asset s (% ) 15.0 20.0 25.0 15.0 20.0 25.0
Net asset s t urnover (t i mes) 1.0 1.5 1.7 1.1 1.5 1.7
Current rat i o (t i mes) 1.0 1.9 2.8 1.1 2.0 3.4
Aci d t est (t i mes) 0.8 1.2 2.1 0.7 1.2 2.0
Col l ect i on peri od (days) 30 45 65 35 50 70
Tot al owi ng t o t ot al asset s (% ) 20 50 65 25 49 67
Long-t erm debt t o capi t al empl oyed (% ) 5 15 40 5 15 35
Ret urn on sal es 11.5 13.3 14.7 11.0 13.3 14.7
LQ Lower Quart i l e (25% of group had rat i os same as or l ower t han f i gure gi ven)
M Medi an (50% of group had rat i os same as or l ower t han f i gure gi ven)
UQ Upper Quart i l e (75% of group had rat i os same as or l ower t han f i gure gi ven)
Required:
a. Compute a full set of basic financial ratios which will help give a rounded
assessment of Chemistrands performance in 2008.
b. Using a subset of the ratios calculated in (a) above, comment on the
performance of Chemistrand plc in comparison with the statistics provided
by the agency.
c. Write a short commentary on what additional information has been
obtained from the results of the computations in (a) which were not used in
(b) above.
Solut ion t o Example 11.1
a. Profitability
2008 2007
Ret urn on net asset s 2,232 100
8,880
= 25.2% 33.7%
Ret urn on sal es 2,232 100
12,000
= 18.6% 20.9%
Net asset t urnover 12,000
8,880
= 1.35 1.61
Ret urn on equi t y 1,590 100
8,880
= 17.9% 22.0%
Gross prof i t margi n (12,000 7,020) 100
12,000
= 41.5% 40.5%
Other ratios such as the various costs can be computed as percentages of
turnover, or annual growth rates of turnover, profit etc. Divisional and regional
breakdowns of profit, turnover and net assets can be evaluated similarly if it is
useful to the task.
127
Solvency and liquidit y
Current rat i o 2,460
1,950
= 1.26 1.10
Aci d t est (qui ck rat i o) 1,320
1,950
= 0.68 0.60
Act ivit y rat ios
Debt ors col l ect i on peri od 1,320 365
12,000
= 40.2 days 31.5 days
St ock hol di ng peri od 1,140 365
7,020
= 59.3 days 47.4 days
Credi t ors payment peri od 600 365
7,020
= 31.2 days 25.1 days
Financing rat ios
Long-t erm geari ng 0 100
8,880
= 0% 0%
Tot al owi ng t o Tot al Asset s 1,950 100
(8,370 + 2,460)
= 18% 19.7%
Int erest cover (2,232 + 108)
108
= 21.7 n/ a
Di vi dend cover 1,590
900
= 1.77 2.0
Earni ngs per share (EPS) 1,590
6,000
= 0.265 0.30
Di vi dend per share 900
6,000
= 0.15 0.15
Cash based rat ios
Cash ret urn on net asset s 2,430 100
8,880
= 24.7% 30.0%
Cash i nt erest cover 2,430
108
= 22.5 n/ a
Cash di vi dend cover 840
900
= 0.93 23.6
Int ernal l y f unded i nvest ment 0% 21.8%
N.B. The above ratios incorporate many more ratios and computations than
what you would be expected to compute in an examination answer. An
appropriate number could be the eight to be analysed in (b) below.
b. The decline in the return on capital employed appears to have been caused
by falling operating profit margins and the declining level of sales which is
also reflected in the falling asset turnover. Even so Chemistrand is still in the
upper quartile for its profitability both in its operations and on its capital
base. However compared to the rest of the industry it is below average in
turning its assets over (i.e. its marketing activities perhaps need reviewing).
Chemistrands solvency ratios are below average which could be due to
efficient management of current assets. It could also be due to increasing
current liabilities at a rate which could cause future problems. Since the
collection period is below average (i.e. the Sales ledger) its doing a better
than average job of getting in the money, and the overdraft has suddenly
emerged and grown, so the companys liquidity and solvency is perhaps to
be put under the spotlight. Note how over the past two years the cash flow
statement shows significant outflows of cash.
Turning to the financial structure, the two ratios, total owing to total assets
and the long-term debt to capital employed, reinforce what is obvious from
128
the balance sheet, namely that there is no long-term debt. The company is
distinctly under-geared compared with its competitors. Not knowing what
the future holds, or what the present lending situation is like, one can
probably still recommend that the company takes out a long-term loan. This
would improve the gearing, probably cost less than short-term borrowing
and reduce the risk of financial distress. Given the asset cover and the fact
that the assets are recent acquisitions bankers would, in the light of the
companys overall profitability, be more than willing to make a medium or
long-term loan to the company.
c. To complete the analysis and interpretation this section was added to
give the reader further insight into interpreting the accounts. Additional
operating profitability ratios indicating how different types of costs
have changed in proportion to turnover would have been useful. Note
that gross profit had actually improved so perhaps the company has
some internal strengths and some weaknesses, since return on sales had
declined (i.e. could it be that production had become more efficient, but
the administration and selling etc. had got less effective?). The increase in
collection and inventory periods reinforces this point though the financial
effects of this are lessened by the effects of increasing the creditor period.
The shareholders will not be pleased, as return on equity and earnings per
share declined, not something you wish to see when a company has just
doubled its called up share capital. So even though the cash dividend cover
hinted at insufficient funds to maintain the dividend level it was probably
felt necessary in order to steady the share price.
Notice how the introduction of the cash based ratios has provided much
more meaningful information on interested dividend cover. The cash
interest cover highlights the security lenders can feel over sufficient cash for
the payment of interest.
N. B. Not e w hen answeri ng t hese sor t s of quest i ons you may have
t o make some reasonabl e assumpt i ons i n order t o make your
i nt erpret at i ons. I f so, st at e t he assumpt i ons. Do remember w hen you
are asked t o i nt erpret , do not j ust descri be a change or an event , t r y t o
gi ve t he act ual , or a possi bl e, reason f or i t .
Act ivit y 11.1
At t empt Quest i ons 2 4 of BMA, Chapt er 28, p.753.
Financial planning
Managers need to ensure that their firm does not run out of cash.
Therefore it is important to understand how cash can be generated
from its operations and how it can be managed. In 25 Principles
of accounting, you would have already learned the concept of cash
budgeting and its use in internal management. The key points are
summarised here:
1. There are three main sources of cash. They are cash flows from
operating activities, investment activities and financing activities.
2. Operating activities involve the purchase of raw materials and other
goods for resale, the selling of finished goods and receipts from trade
receivables and payments to trade payables.
3. A cash cycle (operating effect) measures the period during which a
company receives cash from its customers to the point when it has to
pay its suppliers. The longer the cash cycle, the more working capital
would have to be raised to finance the company in the short run.
129
4. The cash cycle is defined as:
Cash cycle = Average inventory holding period + average collection
period average payment period.
5. Average inventory holding period is defined as:

days
It measures the average duration for a firm to hold its inventory
before selling.
6. Average collection period is defined as:

days
It measures the average duration for an average debtor to pay up.
7. Average payment period is defined as

days
It measures the average duration for a firm to pay its debt to its trade
creditors.
8. A cash budget provides a forecast of cash inflows and outflows
based on the companys estimates of the sales, collection of debts,
purchases (including inventory policy) and payments to suppliers. It
also incorporates other planned expenses such as capital expenditure,
administration and operating charges. Any forms of distribution
of profits, interest and taxes are also considered. A full example is
available in BMA, Chapter 29 (pp.76667).
9. The cash budget should provide an indication of how much cash
would be available to the business. Corporate managers should then
develop a short-term and long-term financing plan.
10. A short-term financing plan should identify how a company may
utilise surplus cash flows to reduce the burden of short-term working
capital and long-term finance. On the other hand, short-term cash
flow deficit should draw managers attention to the need for raising
short-term finance such as bank overdraft, short-term bank loans or
extended credit terms from suppliers.
11. A long-term financing plan focuses on three functions:
a. Contingency planning would the company have sufficient finance
to cover an unexpected shortfall of cash in the long run? Would the
company be able to cope with unexpected changes in governments
fiscal policies, tax rates and competitive environment?
b. Flexibility and options would the company have sufficient
cash flows for future investments should it decide to expand its
current operations or extend its existing investments beyond their
intended investment periods? Would the company be able to repay
the long-term loans when they fall due?
c. Alignment the long-term financing plan should be consistent
with the companys long-term objectives and link strategic goals
together.
130
Example 11.2
Plantree plc prepares long-term financial plans. In order to achieve its long-
term financial objectives the planning team will be faced with decisions on
investment policy, financing policy and dividend policy.
Required:
a. Comment on the nature of these three types of decisions.
b. Comment on the interrelationship of these three types and how they will be
affected by the choice of the long-term financial objective(s) of the business.
c. Describe briefly some of the main examples of forecast information needed
for each type of decision.
1. a. Investment policy decisions
This type of decision requires an understanding of the corporate strategy
as to how the funds should be apportioned between the strategic
groupings replacement needs, new product investments, expansion
investments, etc. The levels of required return from the investments
and their risk levels must be considered. The potentially different cash
flow patterns of returns from existing and new investments may need
assessment; similarly what effects will the withdrawal or sell off of a
major investment produce.
b. Financing decisions
The amount and type of funds required will be dependent not only
upon the selection of investments made, but also the financial market
place conditions and availability, combined with the present situation of
the business. Possible types of finance will include new equity, retained
earnings, loans, leasing and sale of assets. The different costs of funds and
their characteristics will also be of relevance here in the selection.
c. Dividend decisions
Whether or not to pay, if so how much, when and how are all very
important and relevant decisions here since they reflect the returns to the
shareholders, the owners of the business. They also provide the market
place with information on one of its major decision criteria.
2. Interrelations
The three types of decisions are interrelated. People making decisions
whether to invest require the opportunity cost of funds for final evaluation,
they also need to know the availability of funds. In reality, these are not
always available precisely when investors want them. The amount of
dividend paid per share, the size of the earnings per share and the annual
growth rate of these variables along with the size of profit and its return on
investment will influence the availability and cost of funds. Thus one can
see some of the interrelationships amongst the three decision types.
Likewise, theory would suggest businesses should be aiming to maximise
share price, while practice might add some other objectives like profit, profit
growth, sales, market share, earnings per share, dividend per share, etc.
Whatever a businesss objective(s), whether it be one or all of those listed,
it will influence the plan. For example, profit growth and thus dividend
payment may be targeted at the expense of cash flow in order to influence
equity market perceptions if the finance plan requires a share issue as the
next major source of long-term capital. Increasing dividend payout may,
in the shorter term, reduce availability of funds perhaps restraining or
deferring new investment.
131
3. a. Main forecast needs of investment decisions will include:
predictions of cash flows, their timings and the influence of inflation
the degree of variability in the cash flow estimates
the opportunity cost of capital to be used that is appropriate for the
business risk of the project
the impact on the accounting profit profile
the interactions (if any) with existing or new projects.
b. For financing decisions the main forecast needs are:
predictions of funds available and type of source equity, debt, etc.
the trend of costs of funds increasing costs of loans or equity
market perceptions of gearing, present corporate position vis--vis tar-
get gearing level, share price, risk classification for loans
cost of raising different forms of capital.
c. For dividend decisions the business needs predictions on:
the level of profits available for distribution over the planning period
the markets expectations of the business
the expectations of the payout behaviour of competing
businesses
internal sources should provide estimates of the needs for retained prof-
its along with the cash flow predictions of the business.
Act ivit y 11.2
Short -t erm versus long-t erm f inancing
The mix of finance used to acquire the total assets of a firm is a very
company-specific and time-specific selection. BMA go through the
rationale behind the matching of maturities of assets and liabilities. Since
a firms asset base grows irregularly over time, one would expect the mix
also to vary. Generally, though, firms will attempt to choose whether they
will be conservative and predominantly financed by long-term sources or
more aggressive and have a much higher proportion funded with short-
term sources. The level of financial distress will be greater the higher the
proportion of short-term funds, since, of necessity, they will be interest
bearing and not equity. However, they can be repaid more easily and
quickly. No period of notice or penalty would normally be attached to
repayment, which can be done to best advantage.
Bank borrowing
You should note the type of loans that the clearing banks and merchant
banks are prepared to make. When making a decision concerning a
business loan application, a bank will take a number of factors into
account. These include the:
quality and integrity of the management of the business
quality of the case made in support of the loan application
period of the loan and the security being offered
nature of the industry in which the business operates
financial position and performance of the business.
132
Specialist f inance
There are numerous short and medium-term sources available which are
only provided with a specific end in view. For example, there are a number
of ways of getting money to support exports, or finance for specific
projects, or the more general hire purchase. General knowledge of their
existence is all that is required.
Leasing
Read BMA, Chapter 25 (pp.65367). When reading these sections you
should note carefully the distinction between an operating and a finance
lease and the reasons put forward to explain the growth of this form
of financing in recent years. In addition, you should study carefully the
techniques of lease evaluation.
In brief, a company that arranges to hire an asset under a finance lease
agreement is effectively borrowing from the lessor the equivalent of the
lower of the fair value of the asset and the present value of the lease
payments. Therefore the decision whether to lease or buy rests upon the
cash planning of the company.
Sale and lease back arrangements offer an opportunity for a business
with valuable property to raise new finance. You should compare the
advantages and disadvantages of this form of financing with that of a
mortgage.
Act ivit y 11.3
Working capit al management
Invent ory management
A significant amount of a companys resources is often tied up in inventory.
Previously, we mentioned the inventory holding period. The shorter the
time we keep our inventory, the faster we would be able to turn it into
cash flow. Therefore it is important to set an inventory level that would
enable the company to meet the demands of its products and free up
spare capital at the same time. Economic modelling has been developed to
identify the minimum level of inventory to enable a company to balance
out the risk of stock-out and tied up working capital. BMA, Chapter
30 (pp.78688), describes how such minimum inventory level may be
modelled. We briefly explain the rationale behind this model.
Suppose we have a constant demand of D units for a product in a year. We
order from our suppliers Q units each time when we run out of inventory.
Each order incurs a handling/delivery charge, C, and there is no lead time
between the ordering and the delivery of the goods. The average of stock
level is Q/2. Suppose we incur an annual cost of storage per unit, H.
Given the above information, the total ordering cost and the total holding
cost per annum are D/Q C and Q/2 H respectively. To minimise the
total cost, we have:
133
Example 11.3
Suppose the annual demand of a product is 10,000 units. The cost per order,
C, is 300 and the annual unit storage cost is 5. The economic order quantity
(EOQ) is therefore:
Act ivit y 11.4
In BMA, Chapt er 30, p.788, t he aut hors ment i oned t he t erms j ust -i n-t i me and bui l d-
t o-order. Expl ai n what t hese t erms are and what pot ent i al probl ems a company may
encount er i f i t i nt roduces t hese concept s of i nvent ory management i n i t s operat i ons.
Trade receivables management
Allowing customers to pay for their purchases on credit requires some
serious management. Typically, there are five factors to consider:
1. Terms of sales how long do we allow customers to pay their invoices?
Are we prepared to offer a discount for quick settlement?
2. Promise to pay what sort of collateral do we require from the credit
customers?
3. Credit analysis how do we assess the creditworthiness of the
customers?
4. Credit decision how much credit are we prepared to offer? Are we
willing to take risks to extend risk terms even though there might be a
chance of bad debt?
5. Collection policy how do we ensure that all debts are collected? See
debt factoring below.
BMA, Chapter 30 (pp.78894) covers these five points in detail. You
should read through those pages and understand the key points.
Example 11.4
Pinewood Supplies Ltd. produces a pine bookcase which is sold to retailers
throughout Scotland. The accountant of Pinewood Supplies Ltd. has provided
the following information concerning the product:

Sel l i ng pri ce 70
Vari abl e cost s 42
Fi xed cost apport i oned 6 48
Net prof it 22
134
The annual turnover of the business is currently 1.4m and it is believed that
this can be increased in the forthcoming year by increasing the time given for
trade debtors to pay. All sales are on credit and the average collection period
for the business is 40 days. The business is considering an increase in the
average collection period by 15 days, 30 days or 45 days.
The effect on sales from adopting each option is as follows:
Opt ion
1 2 3
Increase i n average col l ect i on peri od (days) 15 30 45
Expect ed i ncrease i n sal es (,000) 120 150 325
The cost of capital to Pinewood Supplies is 12% per annum.
Required:
Explain, with supporting calculations, which credit policy option should be
offered to customers.
The profitability of each option can be determined by weighing the costs of the
additional investment in debtors against the benefits from the expected sales.
Cont ribut ion per unit
Sel l i ng pri ce 70
Less Vari abl e cost 42
Cont ri but i on per bookcase 28
Rat e of cont ri but i on 28/ 70 = 40%
Opt ion
1 2 3
Proj ect ed sal es (m) 1.52 1.55 1.725
Proj ect ed debt or peri od (days) (40 + 15) 55 70 85
Proj ect ed debt ors
1.52m 55/ 365 229,041
1.55m 70/ 365 297,260
1.725m 85/ 365 401,712
Less: Current debt ors
1.4m 40/ 365 153,425 153,425 153,425
Increase proj ect ed 75,616 143,835 248,287
Cost of addi t i onal i nvest ment i n debt ors
(12% i ncrease) (9,074) (17,260) (29,794)
Increase i n cont ri but i on
(40% sal es i ncrease) 48,000 60,000 130,000
Increase i n prof i t s 38,926 42,740 100,206
The calculations shown above indicate that extending the credit limit by 45
days provides the most profitable option. The expected profit of 100,206 is
considerably higher than the other two options. The choice of option based on
these figures is, therefore, unlikely to be very sensitive to any inaccuracies in
the underlying assumptions and estimates.
assumption: for both Short term and Long term financing charge
135
Debt f act oring
Read BMA, Chapter 30(p.793). When reading the relevant sections on
debt factoring note the services offered by a factor and the fee structure
employed. You must be clear about the distinction between debt factoring
and invoice discounting. Debt factoring is often a long-term arrangement
because of the administrative arrangements required to deal with the
transfer of the sales ledger accounting function. Invoice discounting, on
the other hand, may be a temporary arrangement.
Factoring can prove to be expensive and so it is important to identify the
relevant costs and benefits before entering into such an arrangement.
Study the worked example below.
Example 11.5
Aztec Electronics Ltd. has an annual turnover of 25 million of which 0.2
million prove to be bad debts. Credit controls within the business have been weak
in recent years and the average settlement period for its trade debtors is currently
70 days. All sales are on credit and turnover has been stable in recent years. The
business has been approached by a debt factoring business, which has offered
to provide an advance equivalent to 80% of its debtors (based on an average
settlement period of 30 days) at an annual interest charge of 14%. The factor will
take responsibility for the collection of credit sales and will charge a fee of 2.5%
of sales turnover for this service. The use of a factoring service is expected to lead
to cost savings in credit administration of 120,000 per annum and will reduce
bad debts by half. The settlement period for debtors will be reduced to an average
of 30 days which is in line with the industry norm. The business currently has an
overdraft of 6.2 million and pays interest at the annual rate of 15%.
Required:
Calculate the net annual cost or savings resulting from a decision to employ the
services of the factor.
000 000
Exi st i ng i nvest ment i n t rade debt ors
{(70/ 365)25m}
4,795
Expect ed f ut ure i nvest ment i n t rade debt ors
{(30/ 365)25m}
2,055
Reduct i on i n i nvest ment 2,740
Fact or cost s
2.5% of sal es t urnover 625
Int erest charge on advance {(2,055,000
80% )14% }
230
855
Fact or savings
Bad debt savi ngs (0.2m 0.5) 100
Credi t admi n savi ngs 120
Reduct i on i n t rade debt ors (2,740,000 15% ) 411
Reduct i on i n overdraf t i nt erest t hrough advance
{(2,055,000 80% )15% } 247 878
Net annual savi ngs 23
retrenchment of
existing staff's salary
do not affect calculation even if not given
cost benefit analysis
(+ve)
- customer owe less
- incurr lower financing charge
- save on admin fee
(-ve)
- need to pay factor interest + service fee
136
We can see that, in this case, the employment of a factor will lead to net savings
for the business.
Trade payables management
Trade credit from suppliers is an extremely important source of finance for
small businesses in particular. It can be described as a spontaneous source
of finance as it results from normal business operations (i.e. increases in
sales lead, in turn, to increases in purchases on credit from suppliers).
Trade credit from suppliers can be a free source of finance to a business
providing the goodwill of the trade supplier is maintained and providing
discounts for prompt payment are taken. Failure to maintain supplier
goodwill, however, can lead to a reduced level of service in the future and
failure to take advantage of discounts can have a high implicit annual
interest cost.
Suppose trade suppliers offer a 2% discount for invoices paid within seven
days and, if payment is not made within seven days, the payment period
for invoices is 28 days (with no discount being allowed). The implicit
annual interest cost of a business paying at the end of 28 days rather than
at the end of seven days is:
We can see that the cost of foregoing discounts can be very high and,
therefore, other forms of short-term finance may prove to be cheaper.
When reading the relevant sections on trade credit you should note in
particular, the five factors which determine the length of the credit period
given to customers.
Act ivit y 11.5
Cash management
Read BMA, Chapter 30 (pp.794810). Cash has been described as the
lifeblood of a business. In order to survive, a business must retain an
uninterrupted capacity to pay its maturing obligations. The efficient
management of cash is, therefore, of critical importance to a business.
When reading the relevant chapter you should note the importance
of controlling the cash collection and payments cycle and the cash
transmission techniques available.
Working capit al and t he problem of overt rading
Overtrading will arise where the level of working capital and fixed assets
employed by a business is insufficient for its level of operations. Overtrading
often occurs when a new business expands its trading operations quickly
but is unable to find the necessary finance to invest in fixed assets and
working capital. The consequences of overtrading are liquidity problems
and difficulties in supplying customers (through an inability to purchase the
necessary stock). At the extreme, a business may be forced to cease trading
because it lacks the cash to meet maturing obligations. Financial ratios
may help detect the symptoms of overtrading. The financial statements of
a business which is overtrading may reveal low liquidity ratios, high asset/
sales ratios and a poor average creditors payment period.
137
Overtrading is a reflection of weak financial management. It may arise
through such factors as poor forecasting of profits and cash flows, failure
to control costs or a failure to attract finance at the appropriate times. To
deal with the problem of overtrading it is necessary to bring the level of
operational activity into line with the level of finance available (even if this
does lead to the rejection of profitable opportunities in the short-term).
Careful monitoring and control of fixed asset utilisation and working
capital is essential.
Example 11.6
Danton Ltd. began trading recently on 1 April 2008 with a balance at the bank
of 300,000. The business is both a wholesaler and retailer of carpets and floor
coverings. During the first month of trading the business will make payments
for fixtures and fittings of 15,000 and 8,000 for motor vehicles. In addition,
the business will acquire an initial stock on credit costing 24,000. The business
has agreed with its bank an overdraft facility of 20,000 to cover the first year
of trading.
Danton Ltd has provided the following estimates:
1. The gross profit percentage on all goods sold will be 25%.
2. Sales during April are expected to be 10,000 and to increase at the rate
of 4,000 per month until the end of July. From August onwards, sales are
likely to remain at a stable level of 24,000 per month.
3. The business is concerned that supplies will be difficult to obtain later in the
year and so, during the first six months of the year, it intends to increase the
initial stock level of 24,000 by purchasing an additional 2,000 worth of
stock each month in addition to the monthly purchases required to satisfy
monthly sales. All stock purchases, including the initial stock, will be on one
months credit.
4. 60% of sales are expected to be on credit with the remainder being for cash.
Credit sales will be paid two months after the sale has been made.
5. Administration expenses are likely to be 1,000 per month and selling
and distribution expenses will be 700 per month. Included in the
administration expenses is a charge of 200 per month for depreciation and
included in selling and distribution expenses is a charge for 300 per month
depreciation. Administration expenses and selling and distribution expenses
are payable in the month incurred.
6. The business intends to buy more fixtures and fittings in June for 8,000 cash.
7. The initial bank balance arose from the issue of 60,000 ordinary shares
payable in instalments. The second instalment of 0.50 per share is payable
in September 2008.
Required:
a. Prepare a cash flow forecast for the six months ended 30 September 2008
showing the cash balance at the end of each month.
b. State what problems the business is likely to face in the forthcoming six
months and how might these be dealt with?
138
a. Cash flow forecast for the six months to 30 September 2008
Apr
000
M ay
000
June
000
July
000
Aug
000
Sept
000
Receipt s
Share i ssue 30.0
Credi t sal es 6.0 8.4 10.8 13.2
Cash sal es 4.0 5.6 7.2 8.8 9.6 9.6
4.0 5.6 13.2 17.2 20.4 52.8
Payment s
Fi xt ures 15.0 8.0
Mot or vehi cl es 8.0
Ini t i al st ock 24.0
Purchases 9.5 12.5 15.5 18.5 20.0
Admi n expenses 0.8 0.8 0.8 0.8 0.8 0.8
Sel l i ng expenses 0.4 0.4 0.4 0.4 0.4 0.4
24.2 34.7 21.7 16.7 19.7 21.2
Cash surpl us / (def i ci t ) (20.2) (29.1) (8.5) 0.5 0.7 31.6
Openi ng bal ance 30.0 9.8 (19.3) (27.8) (27.3) (26.6)
Cl osi ng bal ance 9.8 (19.3) (27.8) (27.3) (26.6) 5.0
Notes:
1. Purchases represent 75% of the sales for the relevant month plus an extra
2,000 for stockbuilding.
2. Depreciation is a non-cash item and therefore is excluded from the relevant
expense figures.
b. The cash flow forecast above reveals that the agreed overdraft limit of
20,000 will be exceeded in three consecutive months. However, the
proceeds of the second instalment of the share issue will bring the business
into cash surplus by the end of the six month period under review. It
may, therefore, be possible to negotiate an increase in the overdraft limit
to deal with this short-term problem. If this is not possible the business
must consider other options. For example, it may be possible to defer the
purchase of the fixtures and fittings in June until a later date. (It is this
purchase which pushes the business over its overdraft limit.)
However, if this is not possible, then the business might consider other
options such as the deferring of payments to trade suppliers, reducing the
credit period to customers, and reducing the level of credit sales. These
options, however, may involve some cost to the business.
describe the main focuses of financial planning
evaluate the approaches to, and methods of, financial planning
explain the importance of working capital management
discuss techniques used to assist planning and management.
139
BMA, Chapter 29, Question 24.
BMA, Chapter 30, Questions 14 and 23.
1. Consider the advantages and disadvantages of funding all of a
companys current assets from bank advances or other short-term
sources.
2. How might a firm go about determining its target cash balance?
Evaluate the model(s) you have recommended.
3. Consider the derivation and implementation of an optimal trade credit
policy. Discuss.
4. BMA, Chapter 28, Questions 2, 4, 22 and 28.
5. BMA, Chapter 29, Questions 2122.
6. BMA, Chapter 30, Questions 24 and 3841.
Not es
140
Chapt er 12: Ri sk management
141
Chapt er 12: Risk management
Essent ial reading
McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters 2022,
26 and 27.
Furt her reading
Hall, 2008) fourth edition [ISBN 9780273719069] Chapters 24 and 25.
Works cit ed
Haushalter, D, Financial policy, basis risk and corporate hedging, J ournal of
Finance55, 2000, pp.10752.
Aims
Companies undertake investments with various levels of risk. In Chapter
3 we discussed how risk could be diversified. In this chapter, we examine
other techniques in risk management.
Learning out comes
describe the reasons for companies managing risk
identify the different risks that companies are exposed to
evaluate the techniques to reduce risk exposure.
Int roduct ion
Managing financial risk of a company is essential. There are roughly three
types of financial risk which companies need to focus on:
1. Int erest rat e risk management
Companies with mainly floating (variable) rate debt face the risk of
increase in interest rates. If interest rates do rise, these companies will
be faced with higher interest payments (increased financial risk and
decreased cash flows). Those companies with mainly fixed interest
debt also face the risk that interest rates may fall. This decreases their
comparative advantage compared to companies with mainly floating rate
debt. It is therefore important for companies to manage interest rate risk.
2. Exchange rat e risk management
Exchange rate fluctuations may cause losses to multinational companies.
There are three types of exchange risk:
Transaction risk: Companies which expect foreign currency receipts
face the risk that the foreign currency may depreciate against the
domestic currency. On the other hand, companies which expect to
settle future payments in foreign currency face the risk that the foreign
currency appreciates against the domestic currency.
142
Translation risk: This is the risk that a company may face when
translating foreign currency based assets, liabilities and profits on
consolidation. Exchange rate movements may result in the company
experiencing a gain or loss. Even though the translation gain or loss
is only an accounting treatment on paper, it may affect investors
perception of the profitability of those companies.
Economic risk: This is the risk relating to the long-term exchange rate
movements affecting a multinational companys competitive advantage
or reducing the NPV of its operations. This is a risk that companies
would probably not be able to avoid.
Therefore it is important to manage exchange rate risk to stabilise
operating cash flows.
3. Delivery price risk management
Companies which buy or sell commodities such as crude oil, copper, cocoa,
cotton and metal might find it advantageous to manage their exposure to
the price changes of these commodities.
Reasons f or managing risk
The following reasons for managing risk are given as sensible by BMA:
Reducing the risk of cash shortfalls or financial distress.
Stable cash flows and reduced risk of financial distress are often seen
favourably by bondholders. The ability of a company to reduce or
hedge risk in order to stablise cash flows would provide bondholders
with additional confidence. This allows a company to tap into the bond
market. Haushalter (2000) finds that those firms which hedge risk have
higher debt ratios and low dividend payouts. It seems that hedging
programmes help these firms to access debt finance and to reduce the
possibility of financial distress.
Years Nomi nal Inf l at i on-adj ust ed
2000 $27.39 $35.76
2001 $23.00 $29.23
2002 $22.81 $28.50
2003 $27.69 $33.86
2004 $37.66 $44.81
2005 $50.04 $57.57
2006 $58.30 $65.03
2007 $64.20 $69.51
2008 $91.48 $95.25
2009 $53.48 $55.96
2010 $71.21 $73.44
Table 12.1: The annual average crude oil price f rom 2000 t o 2010.
Note: Prices are adjusted for inflation to April 2011 prices using the Consumer
Price Index (CPI-U) as presented by the US Bureau of Labor Statistics. Figures
are price per barrel.
Source: ht t p:/ / i nf l at i ondat a.com/ i nf l at i on/ i nf l at i on_ rat e/ hi st ori cal _ oi l _ pri ces_ t abl e.asp
2010 Ti mot hy McMahon.
143
Agency costs may be mitigated by risk management.
A companys profit may increase without the effort of internal
management. For example, oil prices have risen a lot in the first decade
of the twenty-first century (see Table 12.1). During the same period,
airline companies profits plummeted, whereas oil companies made
record-breaking profits. The question is how much of the increase (or
decrease) in profit is due to the effort (or lack of effort) by internal
management? It is argued that risk management will reduce the chance
of speculative profit and therefore the effect of managerial effort will
be revealed more readily.
Act ivit y 12.1
Inst rument s f or hedging risk
Opt ions
An option gives a right to buy or sell an asset or security at a
predetermined (exercise) price at or before a predetermined (expiry) date.
An option which gives the right to buy is known as a call option. An option
which gives the right to sell is a put option. A European option is an option
which can only be exercised on the expiry date whereas an American
option allows holders to exercise during the lifetime of the option.
Options can be written on different types of assets or securities. For
example, there are options on shares, stock indices, bonds, commodities,
foreign currency exchange rates and interest rates.
The following table gives the relationship between the buyer and seller of
options.
Buyer Sel l er
Cal l opt i on Ri ght t o buy Obl i ged t o sel l
Put opt i on Ri ght t o sel l Obl i ged t o buy
An option is said to be in-the-money if it would lead to a profit for its
holder when it is exercised.
An option is said to be out-of-the-money if it would be unprofitable for
its holder when it is exercised.
Example 12.1
A typical option written on a stock can be traded on the Chicago Board Options
Exchange. It might have different exercise prices such as the options below:
Opt i ons Expi ry
Exerci se
pri ce
Cal l pri ce Put pri ce
1 May 2011 45 10.50 1.97
2 May 2011 50 6.75 3.15
3 May 2011 55 3.85 5.25
Pay-of f of an opt ion
The pay-off of an option depends on the cash position at the time when
the option is exercised. Suppose the price of the underlying asset on
which the call option is written is S
T
at any time T. Upon exercising the
option, the buyer will get either 0 (if the asset price is lower than the
144
exercise price) or S
T
X if the asset price is higher than the exercise price.
Consequently the pay-off of a call option is Max [0, S
T
X]. The pay-off of
a put option, on the other hand, is Max [0, X S
T
].
The value of an option at the expiry date can be expressed as a function of
the stock price and its exercise price.
Example 12.2
Suppose today is 1 February 2011. Option 3 in Example 12.1 expires in three
months time. It has an exercise price of $55. The pay-offs of a call and a put
against the future share price in three months time are:
St ock pri ce $30 $40 $50 $60 $70 $80
Cal l 0 0 0 5 15 25
Put 25 15 5 0 0 0
When the share price is equal to or less than the exercise price, the call option
will not be exercised. The pay-off is therefore zero. However, when the share
price is higher than $55, the call option will be exercised. The pay-off of the call
option will be S
T
55. On the other hand, when the share price is below the
exercise price, the put option will be exercised and the pay-off will be $55 S
T
.
The pay-off diagram for the above scenario would be:
Pay-off ($)
Share price
55 75
Pay-off to a call holder
0
20
Figure 12.1: Pay-of f t o a call holder diagram
Act ivit y 12.2
Now t ry t o draw t he pay-of f di agrams f or Opt i ons 1 and 2 i n Exampl e 12.1.
Some simple uses of opt ions
Suppose an investor has a portfolio of shares in the FTSE100 index.
He or she could cap the downside risk of this portfolio by writing a
put option. This strategy is called a protective put, which has the
following pay-off. When the FTSE index falls below the exercise price,
the investor could exercise the put option. The pay-off from the put will
cancel out the loss in value of the portfolio.
Suppose the FTSE100 index is going to be very volatile in the next
three months. An investor can write a call and a put on the index with
the same exercise price. He or she will gain from the pay-off of the call
or the put whichever direction the FTSE100 index may go.
Similarly, an investor who is already holding the FTSE100 as an
investment portfolio could reduce the market volatility by writing a call
and a put.
145
Put -call parit y
Suppose we have a call and a put (both with the same exercise price = X)
and both are written on the same underlying stock, S. We can combine them
to form a riskless portfolio. Lets look at the pay-off of the following strategy:
T
0
T
1
Cash f l ows S
1
< X S
1
= X S
1
> X
Wri t e a cal l C 0 0 S
1
X
Sel l a put P (X S
1
) 0 0
Sel l t he st ock S S
1
S
1
S
1
Net cash f l ows S + P C X X
As long as the future share price moves away from the exercise price, this
strategy will ensure that an investment will earn a positive cash flow at T
0

and repay X at T
1
. The cash flow at T
0
is equivalent to a risk-free borrowing
of X/(1 + r
f
). Therefore we have the put-call parity:
Act ivit y 12.3
Corporat e uses of opt ions
Apart from having options written on corporate shares and stock market
indices, options can often be found implicitly in corporate financial
instruments:
Share option schemes Corporations give share options to their employees
to reward their services. Employees who receive such a share option have
the right to buy shares from their firms at a predetermined price. Unlike a
call option written on a share, this share option does require the issuing of
the new shares if it is exercised.
Warrants This is an instrument very similar to a share option. A firm
can issue warrants to both private and public investors for an issue price.
Holders of warrants can exercise the right to buy shares from the firm if
they wish, within a set period of time. Physical shares must be created,
issued and delivered to the investors.
Convertible bonds A convertible bond is an instrument which has two
financial components. It allows the holder to earn a fixed (or variable)
interest on the face value of the bond but also gives the right to the holder
to convert it into shares. Effectively, it is a straight bond with a warrant but
without any outlay.
Rights issues A rights issue is an issuance of shares to a firms existing
shareholders. It gives the right to the shareholders to buy shares from the firm
at a pre-set price based on the percentage of their shareholdings in the firm.
Share underwriting (put option) We have discussed underwriting in
Chapter 5. A firm who appoints an underwriter in a share issue has
effectively purchased a put option to sell shares (the unsubscribed shares in
a share issue) to the underwriters at the pre-determined price.
Real options In Chapter 2 we discussed project appraisals. Most of the
examples we looked at are fixed-term projects. However, in real life, most
Buy
146
projects or investments can be extended if the company wishes. Therefore,
effectively, a projects true NPV should be based on the NPV of the project
based on the fixed term estimates plus the value which can be derived
from extending its life. The value from the extension of life is effectively
the value of the option implicit in it.
Taking control of a company Shareholders who invest in a firm which
has both debt and equity are effectively holding a call option over the
firms assets. If the asset value is below the face value of the debt, they
would not exercise the option and allow it to expire.
Opt ion pricing
An option (call or put) gives the rights to the holders to buy or sell an
asset at a pre-determined price within a pre-determined period. It derives
its value from the underlying asset on which it is written.
Example 12.3 (based on BMA, pp.55457)
A call option with an exercise price of 100 is written on a share with a current
price at 100. The share price is expected to rise to either 105 or fall to 95 in
three months time. The effective risk-free rate for the next three months is 3%.
Suppose one writes a call option on this share (i.e. buy a call option which
gives us the rights to buy the share at 100 in 3 months time). The cash flow
implication is as follows:
T
1
T
0
S = 105 S = 95
Buy a cal l C S X = 105 100 = 5 Not exerci se, 0
Now consider an alternative investment borrow 45/1.03 now and buy half a
share at 50. The cash flow implication of this alternative would be:
T
1
T
0
S = 105 S = 95
Buy hal f a share 50 52.5 47.5
Borrow t hen repay + 47.5/ 1.03 47.5 47.5
50+ 47.5/ 1.03 5 0
Since the future cash flows of buying a call now and buying half a share and
borrow at the risk-free rate are identical, the initial cash positions must be
identical, too (in an efficient market where arbitrage opportunity is eliminated).
The cost of the call value must be:
C = 50 47.5/1.03 = 3.88
How do we know how many shares we need to buy and how much we need to
borrow to create a replicated portfolio for the call?
Assume that we can rewrite C as:
-
B = The PV of the difference between the pay-offs from the option and the pay-
offs from of the share.
(12.1)
147
A more formal derivation of an option based on the binomial distribution (share
prices go up and down in each period by exact percentages) can be found in
BMA pp.55862.
Suppose we can define the price changes of an asset over an infinitely small
interval. The equation (12.1) can be approximated by the Black-Scholes
formula.
The value of a call = S + Bank Loan
where

Act ivit y 12.4
Fut ures and f orward cont ract s
A forward contract is an agreement between two parties to conclude a
transaction at a fixed date at a fixed price. It is a custom-made contract
that is only traded over-the-counter.
A futures contract is similar to a forward contract but it is traded on an
exchange. It is therefore a standardised contract.
Both futures and forward contracts require parties to deliver the
underlying asset or commodity. However, a futures contract requires
investors to mark-to-market. The following table shows the main
differences of options, forward and futures contracts.
Opt i ons Forward Fut ures
St ruct ure St andardi sed: on st ock
and bond i ndi ces, st ock,
bonds, i nt erest rat e,
commodi t i es and currency
Cust om-made, can
be creat ed on any
i t ems
St andardi sed: on st ock
and bond i ndi ces,
st ock, bonds, i nt erest
rat e, commodi t i es and
currency
Market s Traded on exchanges wi t h
t ransparent pri ces
Over-t he-count er Traded on exchanges
wi t h t ransparent pri ces
Cash f l ows Requi re payment of an
i ni t i al premi um (i .e. t he
pri ce of a cal l or a put )
Not requi re an
i ni t i al premi um
Not requi re an i ni t i al
premi um
Physi cal
del i very
No del i very of t he
underl yi ng asset requi red
but t he pay-of f i s
t ransact ed
Del i very requi red Del i very requi red
Table 12.2: Dif f erences bet ween opt ions, f orward and f ut ures cont ract s.
Pricing
You should refer to BMA Chapter 26, pp.68488. It should be noted that
the pricing formulae are different for a commodity and financial futures
contract.

(12.2)
148
Act ivit y 12.5
Risk management
Int erest rat e risk
Internal management
Interest rate risk can be hedged internally by the following techniques:
Smoothing This involves a balanced financing with floating and fixed
rate debt. When the interest rate rises, the increased cost of floating rate
debt is cancelled by the lower cost of fixed rate debt. Likewise, when
the interest rate falls, the higher relative cost of fixed rate debt will be
balanced out by the decreased cost of floating rate debt.
Matching This involves matching assets and liabilities with similar
interest rates. When the interest rate changes, the change in values of
both assets and liabilities will be cancelled out by each other. Matching is
mainly used by financial institutions.
External management
Companies can purchase futures to hedge against a fall in interest rates
and sell futures to hedge against a rise in interest rates. Interest rate
futures often run in a three-month cycle (March, June, September and
December) and are priced by subtracting the interest rate from 100. A
futures contract with an interest rate of 5% is sold at 95. Profits and
losses are calculated from the changes in the futures prices.
Example 12.4
A firm is going to borrow 950,000 in three months time for three months. The
current interest rate is 5% and is expected to rise in the future.
Current position
The interest rate future is traded at 95 (100 5).
Number of contracts sold to hedge the total borrowing =
950,000/95 = 10,000 contracts.
A one tick price change = the value of the futures contract one tick
1

number of months covered by the contracts/12; i.e. 950,000
0.0001 3/12 = 23.75.
Future position
Suppose the interest rate has risen to 7% in three months time. The
futures price will be 93 (100 7).
Gain on futures = No. of ticks the price change per tick = 200
23.75 = 4,750
Increase in borrowing cost = Amount of borrowing increase in
interest rate number of months of the loan/12 = 950,000 0.02
3/12 = 4,750
Interest rate hedge has exactly offset the higher borrowing cost. This is a perfect
hedge.
1
One t i ck i s equi val ent
t o 1 basi s poi nt ; i .e.
0.01%
149
Exchange risk
Internal management
Matching Translation risk can be hedged if foreign currency based assets
and liabilities are matched. Transaction risk can be hedged if inflows and
outflows are in the same currency.
Netting Companies can net off foreign currency transactions that
occur at the same time and in the same currency, and hedge only the net
exposure.
Invoicing in the domestic currency One easy way to reduce exchange
rate risk is to avoid receipts and payments in foreign currency. An exporter
who purchases and pays for supplies in domestic currency may invoice
foreign customers in its own domestic currency.
External management
Forward/futures contracts.
Example 12.5
Suppose a UK exporter is expecting to receive a payment of $100,000 from a
US customer in three months time. The current (spot) exchange rate is 1 to
$1.60. A forward contract to sell $ in three months gives a rate of 1 to $1.65.
The exporter can engage in this forward contract and lock into an exchange
rate of 1 to $1.65. So in three months time, the exporter, upon receiving
$100,000, would then sell it at 1:$1.65. Effectively he will receive 60,606 in
three months time.
Alternatively the exporter can hedge the exchange risk via the money markets.
Knowing that he will receive $100,000 in three months time, the exporter can
borrow $X now at a borrowing rate of r% for three months. When the loan
is due, the exporter will repay the loan plus interest (i.e. $X(1+r)) out of the
proceeds from the US customer. If this payment can be covered entirely by the
$100,000 expected to be received from the US customer in three months time,
then we have a perfect hedge. The exporter can borrow $X now and convert
it into at the spot rate and the repayment of the loan and interest will be
covered by the future receipt.
Act ivit y 12.6
How much shoul d t he export er borrow now i n Exampl e 12.5?
In an efficient market when any arbitrage opportunity is eliminated, the
two hedging exercises should give identical outcomes.
Suppose the three month interest rate in $ is r % and the three month
interest rate in is R%. If we hedge via the money market, we must repay
$100,000 in three months. It means that we must borrow $100,000/
(1+r %) now. Convert this amount into at the spot exchange rate (i.e.
$100,000/(1+r %)/1.6) and deposit into a account for three months.
In three months we will get $100,000/(1+r %)/1.6 x (1+R%). This sum
must be identical to the cash flow the exporter will get in three months
from his forward contract position. Therefore we have:
100,000
1 r 1.6
1 R 60,606
100,000
1.65
1 r
1 R

1.65
1.6

150
What it implies is that the ratio of the interest rate in $ to must be
identical to the ratio of the future to spot exchange rates.
Advant ages and disadvant ages of using f ut ures t o hedge risk
Advantages:
Unlike options, futures contracts do not require payment of an initial
premium.
Unlike forwards, futures are tradable and have transparent prices.
Contracts are marked-to-market on a daily basis thereby reducing the
potential loss on default.
Disadvantages:
There is a cash flow implication from the mark-to-market requirement.
The significant variation margin might cause a company to run out of
cash. See the case of Barings and Nick Leeson.
2
It is difficult to construct a perfect hedge. In Example 12.4 we construct
a perfect interest rate hedge. However, if the borrowing amount was
1,000,000, we would have needed to have sold 1,000,000/95
= 10,626.3 contracts. Since futures contracts cannot be traded in
fractions, we would have to either sell 10,626 or 10,627 contracts. In
either case, it would not be a perfect hedge.
Apart from interest rates and currency, options and futures can be created
on stock market indices, commodity prices and precious metals.
Conclusion
Risk management is a very advanced topic in financial management. In
this chapter we have only briefly discussed the various methods that a firm
may engage in to hedge risk against price movements. We examined the
use of options, forwards and futures contracts in risk management and
discussed their advantages and disadvantages. You should work through
the practice questions and familiarise yourself with the risk management
concept.
describe the reasons for companies managing risk
identify the different risks that companies are exposed to
evaluate the techniques to reduce risk exposure.
BMA Chapter 26, Questions 3, 4 and 16.
2
www.ri skgl ossary.com/
l i nk/ bari ngs_debacl e.
ht m
151
1. Explain clearly the factors that affect the price of a European put
option.
2. Explain how you can use options in the following situations:
a. Suppose you dont own a share, how would you create a share
position without buying a share?
b. Suppose you now own a share, how do you insure it against any
fluctuation in the share price?
c. Suppose you do not own a share. You expect the share price might
go up and down in the next period. How would you use options to
bet on this shares volatility?
3. What is a financial futures contract? Explain the main use of it in risk
management. Give examples to illustrate your argument.
Not es
152
Appendi x 1: Sampl e exami nat i on paper
153
Appendix 1: Sample examinat ion paper
Important note: The format and structure of the examination may have
changed since the publication of this subject guide. You can find the most
recent examination papers on the VLE where all changes to the format of
the examination are posted.
Time allowed: three hours
Candidates should answer FOUR of the following EIGHT questions. All
questions carry equal marks.
Workings should be submitted for all questions requiring calculations.
Any necessary assumptions introduced in answering a question are to be
stated.
8-column accounting paper is provided at the end of this question paper. If
used, it must be detached and fastened securely inside the answer book.
A calculator may be used when answering questions on this paper and it
must comply in all respects with the specification given in the Regulations
The make and type of machine must be clearly stated on the front cover of
the answer book.
Quest ion 1 (Answer bot h part s)
a. Outline the main factors that a company should consider if it wants to
offer its shares to the public for the first time (Initial Public Offer)?
(10 marks)
b. Discuss the pros and cons of each of the following three methods in
valuing a companys share.
i. Asset-based method
ii. Earning-based method
iii. Discounted dividend method
(15 marks)
Total 25 marks
Quest ion 2
Yamamoto Ltd. has the following three bonds outstanding on 31 December
2009:
Mat uri t y (years) Coupon (% ) Face val ue, 000
Bond A 5 10 1,000
Bond B 20 12 3,000
Bond C 15 0 2,500
The companys financial director believes that Yamamoto is a financially
sound company and it would have at least an Aa rating for its bonds.
Currently a one-year UK gilt has an expected return of 5% per annum.
Required:
a. Based on the information given above, calculate the value of each of
154
the three bonds. What further information would you require in order
to refine your valuation of these bonds? (15 marks)
b. Explain clearly why companies such as Yamamoto Ltd. might issue
bonds with different maturities, coupon rates and face value?
(10 marks)
Total 25 marks
Quest ion 3
Lion plc is a newly set up IT company. It has very few capital assets.
However, the directors are committed to spend a significant amount on
research and development activities every year. Currently the company
is operating at a loss. The profit forecast indicates that it will become
profitable in three years time. Profit will rise rapidly at a rate of 20% per
annum thereafter for a period of no more than 5 years. It is then expected
to have a more moderate growth of 5% per annum. The company has a
cost of capital of 10% and it is 100% equity financed.
Required:
Advise the management of Lion plc what capital structure policy it
should adopt for the next 3, 8 and 20 years. Your advice must include an
explanation of the appropriate financial theory on capital structure.
(25 marks)
Total 25 marks
Quest ion 4 (Answer bot h part s)
a. Explain clearly the following terms:
i. Weak form efficiency.
ii. Semi-strong form efficiency.
iii. Strong form efficiency.
What are the implications for the market to be informationally efficient to
both the investors and companies?
(13 marks)
b. Identify and explain which forms of efficiency are adhered to and/or
violated in each of the following hypothetical situations:
i. Weekly returns appear to be weakly but positively correlated with
each other.
ii. The top 10 investment funds in the UK out-performed the UK
market by an average of 5% in 2009.
iii. A group of students from a famous Business School has created a
trading rule which appears to out-perform the UK market.
iv. Royal Petrol plc has just revealed that it has discovered a new
method to turn domestic waste into petrol. Its share price rises
by 5%.
(12 marks)
Total 25 marks
Quest ion 5
Apple Inc. is one of the most talked-about companies in recent years. From
155
its success in iPod to the latest iMac, the company has enjoyed a healthy
increase of earnings for the past years. However, the company has decided
to maintain its no dividend policy.
Required:
Critically discuss the various financial theories on dividend policy. In your
answer, you should also discuss the implications of a no dividend policy,
such as the one adopted by Apple Inc., on the company and its investors.
(25 marks)
Total 25 marks
Quest ion 6 (Answer all part s)
a. Explain clearly the factors that affect the price of a European call
option. (8 marks)
b. Suppose Shadow plc, a construction company financed by both debt
and equity, is considering a project. If the project succeeds, the value of
the company in one years time will be 25 million. If the project fails,
the companys value in one years time will only be worth 16 million.
The current value of Shadow plc is 20 million which takes into
consideration the prospect of the proposed new project. The company
has an outstanding zero-coupon bond which matures in one years time
with a face value of 19 million. The company pays no dividends and a
UK gilt that matures in a year has a yield of 7%.
Using the binomial (or two-state) option-pricing model, find the value
of the bond and equity of Shadow plc respectively.
(8 marks)
c. Explain how you can use options and futures to hedge risk. Give
examples to illustrate your argument.
(9 marks)
Total 25 marks
Quest ion 7
West Central plc has been quoted on the London Stock Exchange for 10
years. A regression analysis using the last 10 years of data reveals the
observed equity beta of 1.20 for the company. The company has 60% of
equity and 40% debt. The current market value of West Central plc is 100
million.
The company is going to undertake a risky project which has an estimated
beta of 2.5. The project is expected to be financed entirely by equity. As
a result of this financing option and the undertaking of the project, the
company will have 70% of equity and 30% of debt measured at market
values. The risk-free rate is expected to be 5% per annum and the
expected return on the market is approximated to be 10% per annum.
West Central plc pays corporate tax at 40%. The companys debt is thought
to be risk-free.
Required:
a. Calculate the companys beta before the proposed project. (4 marks)
b. Calculate the companys market value after the proposed project and
the funding option. (5 marks)
c. Calculate the net present value of the project. (2 marks)
d. Calculate the companys beta after the project. (4 marks)
e. Advise the management if the project should be funded entirely with
156
equity. What further information would you seek before you finalise
your advice? (10 marks)
Total 25 marks
Quest ion 8 (Answer all part s)
a. What are the main motives for mergers and acquisitions? (8 marks)
b. As a finance director of Tudor plc, you are examining a proposal to
acquire Windsor plc. The following current data is available:
Tudor Wi ndsor
Earni ngs per share 100p 30p
Di vi dend per share 60p 16p
Share pri ce 18 4
Assume that Windsor is expected to have a dividend growth rate of 6%
per annum, but that under the management of Tudor plc, the growth
rate would increase to 8% without any additional investment.
i. Calculate the gain from the acquisition. (6 marks)
ii. Calculate the net gain of the acquisition if Tudor plc pays 5 for
each of Windsors shares. (3 marks)
iii. What is the gain of the acquisition if one of Tudors shares is
exchanged for every three of Windsors shares? (6 marks)
iv. How would your answer to (ii) and (iii) alter if Tudor plc failed to
increase the growth rate of Windsor plc? (2 marks)
Total: 25 marks
157
Example of 8-column account ing paper
Not es
158
Not es
159
Not es
Not es
160

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F i n a n ci a l m a n a g e m e n t

is the discount rate which gives a negative NPV, NPV

When projects are not infinitely divisible

b. The probability for an investor not suffering from a loss is equal to

as the average variance and

as the average covariance,

=0.3 0.6 +0.4 0.8 +0.3 1.2 =0.86 =|

for all investments i

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