Professional Documents
Culture Documents
ii
Contents
Page
Introduction
Chapter features
vii
Learning outcomes
viii
xviii
Objectives of Organisations
Financial Strategy
29
61
101
Equity Finance
143
Debt Finance
171
Lease Finance
195
221
Capital Structure
259
Dividend Policy
291
11
Market Efficiency
305
319
13
373
14
399
Business Valuation
435
16
485
17
535
Introduction
iii
iv
18
Introduction to Risk
583
19
619
20
685
Appendix
727
Index
731
Introduction
KC2 Corporate Finance and Risk Management
The corporate level course module KC2 includes aspects such as setting financial objectives, financing,
investments and dividends. Fundamentals of risk management is also covered to ensure future CAs
will be equipped to consult the right parties in an informed manner in complicated risk management
scenarios.
Syllabus structure
Main syllabus areas
Weightings
10%
30%
5%
20%
20%
15%
One of the key elements in examination success is practice. It is important that not only you fully
understand the topics by reading carefully the information contained in this Study Text, but it is also
vital that you practise the techniques and apply the principles that you have learned.
In order to do this, you should:
Work through all the examples provided within the chapters and review the solutions, ensuring
that you understand them;
Complete the progress test for each chapter.
In addition, you should use the Practice and Revision Kit. These questions will provide you with
excellent examination practice when you are in the revision phase of your studies.
Introduction
Pillar structure
The Curriculum 2015 is structured around three pillars, namely, Knowledge, Skills and Personal.
The Pillars are subdivided into specific subject areas or sub pillars and content is delivered to meet the
requirements of three progressively ascending levels of competency, namely, Executive, Business and
Corporate.
The Executive Level provides the fundamentals of accounting and harnesses the skills and professional
values needed to mould a Business Accountant.
The Knowledge Pillar focuses on imparting sound technical knowledge required of a competent CA,
and comprises five sub pillars that focus on the following subject areas:
Sub pillar 1: Financial Accounting and Reporting (FA&R)
Sub pillar 2: Management Accounting and Finance (MA&F)
Sub pillar 3: Taxation and Law (T&L)
Sub pillar 4: Assurance and Ethics (A&E)
Sub pillar 5: Management and Contemporary Issues (M&C)
vi
Chapter features
Each chapter contains a number of helpful features to guide you through each topic.
Topic list
This tells you what you will be studying in the chapter. The topic items form
the numbered headings within the chapter.
Chapter
introduction
The introduction puts the chapter topic into perspective and explains why it is
important, both within your studies and within your practical working life.
Learning
Outcomes
The learning outcomes issued for the module by CA Sri Lanka are listed at the
beginning of the chapter, with reference to the chapter section within which
coverage will be found.
Key terms
These are definitions of important concepts that you really need to know and
understand before the exam.
Examples
Case study
Often based on real world scenarios and contemporary issues, these examples
or illustrations are designed to enrich your understanding of a topic and add
practical emphasis.
Questions
These are questions that enable you to practise a technique or test your
understanding. You will find the answer underneath the question.
Formula to
learn
These are the formula that you are required to learn for the exam.
Section
introduction
Chapter
roundup
Progress
Test
Progress tests at the end of each chapter are designed to test your memory.
Bold text
Throughout the Study Text you will see that some of the text is in bold type.
This is to add emphasis and to help you to grasp the key elements within a
sentence or paragraph.
Introduction
vii
viii
Comprehension
Conceptual
Knowledge
Process
Knowledge
Dimension
Knowledge Component
Chapter
1.1.1 Discuss appropriate strategic objectives, both financial and nonfinancial, for different types of organisations (profit maximisation,
wealth maximisation, value for money, balanced scorecard) and how
these objectives can assist in meeting the corporate goals of such
organisations.
Learning Outcome
CA Sri Lankas Learning outcomes for the Module are set out on the following pages. They are cross-referenced to the chapter in the Study Text where they are
covered.
Learning outcomes
Knowledge
Process
Application/
Analysis
Application
Knowledge
Dimension
Procedural
Procedural
Knowledge Component
Learning outcomes
Chapter
1.2.2 Analyse financial results by using trends and ratios [including the
DuPont analysis in financial statements across time/different
companies/different accounting policies in appraising the short and
long-term viability of the organisation (working capital issues such as
overtrading and solutions to overtrading is expected to be discussed
here)].
Learning Outcome
ix
Evaluate
Procedural
Conceptual/
Procedural
Comprehension
Procedural
Remember/
Comprehension/
Application/
Analysis/
Evaluation
Knowledge
Process
Knowledge
Dimension
Knowledge Component
5
8
Chapter
Learning Outcome
Knowledge
Dimension
Conceptual/
Procedural
Procedural
Knowledge Component
Comprehension/
Application
Comprehension/
Application
Knowledge
Process
Learning outcomes
Chapter
Learning Outcome
xi
xii
Procedural
Knowledge
Dimension
Knowledge Component
Comprehension/
Application
Knowledge
Process
9
8
9
Chapter
Learning Outcome
Knowledge
Dimension
Procedural
Conceptual/
Procedural
Knowledge Component
Comprehension/
Evaluate
Comprehension/
Evaluate
Knowledge
Process
3.2.3
11
11
11
10
10
10
Chapter
Learning outcomes
3.2.2
3.1.3
Discuss dividend theories such as dividend irrelevancy theory, birdin-hand theory, tax preference theory, residual theory and pecking
order theory.
3.1.2
3.2.1
3.1.1
Learning Outcome
xiii
xiv
Procedural
Knowledge
Dimension
Knowledge Component
Analysis/
Evaluate
Knowledge
Process
4.1.2
4.1.3
4.1.4
4.1.5
Asset replacement
Tax
4.1.1
Learning Outcome
12, 14
14
12
12, 13, 14
12
Chapter
Knowledge
Process
Comprehension
Evaluate/
Analysis
Knowledge
Dimension
Conceptual
Procedural/
Metacognitive
Knowledge Component
15
15
16
16
Learning outcomes
15
16
Chapter
Learning Outcome
xv
xvi
Knowledge
Dimension
Knowledge Component
Knowledge
Process
16
17
17
Chapter
Learning Outcome
Knowledge
Dimension
Conceptual/
Procedural
Procedural/
Metacognitive
Knowledge Component
6.2.3
6.2.4
19, 20
19, 20
19, 20
18, 19, 20
18
18
18
18
Chapter
Learning outcomes
6.1.4
6.2.2
Discuss value at risk as a risk measurement tool and control tool and
its limitations.
6.1.3
6.1.2
6.2.1
Discuss various types of risks such as credit risk, interest rate risk,
liquidity risk, foreign exchange risk, price risk, operational risk and
reputational risk.
6.1.1
Comprehension
Application/
Evaluate
Learning Outcome
Knowledge
Process
xvii
Verb List
Verb Definitions
Tier 1 Remember
Define
Draw
Identify
List
Relate
State
Calculate/
Compute
Discuss
Explain
Interpret
Recognise
Record
Summarise
Tier 2 Comprehension
Explain important
information
xviii
Knowledge Process
Verb List
Verb Definitions
Tier 3 Application
Apply
Assess
Demonstrate
Graph
Prepare
Prioritise
Reconcile
Solve
Analyse
Compare
Contrast
Differentiate
Outline
Tier 4 Analysis
Draw relations among ideas
and to compare and
contrast/solve open-ended
problems
xix
Knowledge Process
Verb List
Verb Definitions
Tier 5 Evaluate
Advise
Convince
Criticise
Evaluate
Recommend
Resolve
Validate
Compile
Design
Develop
Propose
Tier 6 Synthesis
Solve unfamiliar problems by
combining different aspects
to form a unique or novel
solution
xx
CA Sri Lanka
CHAPTER
INTRODUCTION
Organisations have many objectives, both financial and non-financial. In this
chapter the key question is what are we trying to achieve?
You need to understand what the most important objectives are and how
you recognise that they have been achieved. However, don't assume that you
will always be asked about the financial objectives of businesses. Questions
may ask you to consider the objectives of non-commercial bodies or public
sector bodies such as hospitals.
In addition, this chapter explores the three key decisions of a commercial
financial strategy investment, finance and dividends.
Knowledge Component
1
Corporate Financial Objectives and their Measurement
1.1
Corporate financial
management and strategic
financial objectives
1.1.1
Discuss appropriate strategic objectives, both financial and nonfinancial for different types of organisations (profit maximisation/
wealth maximisation/value for money/balanced scorecard) and how
these objectives can assist in meeting corporate goals of such
organisations.
1.1.2
CHAPTER CONTENTS
LEARNING
OUTCOME
1 Objectives of companies
1.1.1
1.1.1
1.1.1
1.1.2
1 Objectives of companies
1.1 Introduction
In this section we identify the main objectives of companies. Profit maximisation
is often assumed to be the main objective of a business but shareholders may still
be disappointed even when profits are rising. Are other objectives therefore also
important?
Strategic financial management is 'the identification of the possible strategies
capable of maximising an organisation's net present value, the allocation of scarce
capital resources among the competing opportunities and the implementation and
monitoring of the chosen strategy so as to achieve stated objectives'.
It is a long-term plan and that considers the long-term objectives of an
organisation's stakeholders. In essence, it ensures that the organisation's finances
are congruent with business strategy and should ultimately meet stakeholder
goals.
Strategy depends on stated objectives or targets. Therefore, an obvious starting
point is the identification and formulation of these objectives.
Strategy is a course of action, including the specification of resources required, to
achieve a specific objective.
CA Sri Lanka
Break-up basis
Market values
When shares are in a non-quoted company, it can be hard to measure their value
as there is no market price readily available. However, the priorities of nonquoted shareholders will be the same, and therefore a company should be looking
to maximise their wealth, when a peer comparison of a listed related entity would
be used for valuation.
CA Sri Lanka
Management should set financial targets for factors which they can influence
directly, such as cash flows, profits and dividend growth.
Examples of financial targets
Increasing earnings per share
(EPS)
Borrowing levels
Profit retention
Cash generation
These financial targets are not primary targets, but they can act as subsidiary
targets or constraints that should help a company to achieve its main financial
objective without incurring excessive risks.
CA Sri Lanka
QUESTION
Financial analysis
Revenue in the current year reached Rs. 10,000,000, and forecasts for the
next five years are Rs. 10,600,000, Rs. 11,400,000, Rs. 12,400,000,
Rs. 13,600,000 and Rs. 15,000,000.
(b)
The ratio of profit for the year to revenues is 10%, and this is expected to
continue throughout the planning period.
(c)
Total assets less current liabilities will remain at around 125% of sales. The
summary statement of financial position for AB Ltd is as follows.
Rs
Rs
8,500,000
Non-current assets
4,000,000
Net working capital
12,500,000
Funded by
Equity
1,000,000
Share capital
7,750,000
Retained earnings
8,750,000
Total equity
10% irredeemable debentures
3,750,000
12,500,000
(e)
(f)
Required
Prepare a financial analysis of the draft long-range plan and suggested policies for
dividends, retained earnings and gearing.
CA Sri Lanka
ANSWER
The draft financial plan, for profits, dividends, assets required and funding, can be
drawn up in a table, as follows.
Revenues
Profit for the year
Dividends (50% of profit
after tax)
Retained earnings
Total assets less current
liabilities (125% of sales)
Equity (increased by
retained earnings)
Maximum debt (30% of
long-term funds)
Maximum funds available
/(shortfall
in funds)*
Current
year
Rs Mn
10.00
1.00
0.50
Year
1
Rs Mn
10.60
1.06
0.53
Year
2
Rs Mn
11.40
1.14
0.57
Year
3
Rs Mn
12.40
1.24
0.62
Year
4
Rs Mn
13.60
1.36
0.68
Year
5
Rs Mn
15.00
1.50
0.75
0.50
0.53
0.57
0.62
0.68
0.75
12.50
8.75
13.25
9.28
14.25
9.85
15.50
10.47
17.00
11.15
18.75
11.90
3.75
3.98
4.22
4.49
4.78
5.10
12.50
0.00
13.26
0.01
14.07
(0.18)
14.96
(0.54)
15.93
(1.07)
17.00
(1.75)
*Given maximum gearing of 30% and no new issue of shares = funds available
minus (Total assets less current liabilities).
These figures show that the financial objectives of the company are not
compatible with each other, and adjustments will have to be made.
(a)
Given the assumptions about sales, profits, dividends and assets required,
there will be an increasing shortfall of funds from year 2 onwards, unless
new shares are issued or the gearing level rises above 30%.
(b)
(c)
The net asset turnover appears to be low. The situation would be eased if
investments were able to generate higher revenues, so that fewer noncurrent assets and less working capital would be required to support the
projected level of revenues.
(d)
(e)
would have to be increased in order to pay dividends on the new shares. The
company seems unable to offer prospects of suitable dividend payments, and
so raising new equity might be difficult.
(f)
It is conceivable that extra funds could be raised by issuing new debt, so that
the level of gearing would be over 30%. It is uncertain whether investors
would be prepared to lend money so as to increase gearing. If more funds
were borrowed, profits would fall so that the share price might also be
reduced.
Welfare of employees
Welfare of management
Welfare of society
Responsibilities to suppliers
A company may use the balanced scorecard to help identify their non-financial
objectives and to consider how to measure their performance.
CA Sri Lanka
Profitability
Customer satisfaction
Internal efficiency
Innovation
Question
Explanation
Customer
Internal
Innovation and
learning
Can we continue to
Considers the business's capacity
improve and create future to maintain its competitive
value?
position through the acquisition of
new skills and the development of
new products.
Financial
By asking these questions, the organisation can establish its major goals for each
of the four perspectives, and can then set performance measures and
performance targets, based on these major goals, in relation to each of the
perspectives.
The scorecard is 'balanced' as managers are required to think in terms of all four
perspectives, to prevent improvements being made in one area at the expense of
another.
10
CA Sri Lanka
Financial perspective
Customer perspective
GOALS
MEASURES
GOALS
MEASURES
Survive
Succeed
Cash flow
Monthly sales growth
and operating income
by division
New products
Percentage of sales
from new products
On-time delivery
(defined by
customer)
Share of key
accounts' purchases
Number of co-operative
engineering efforts
Prosper
Internal
business perspective
GOALS
MEASURES
Technology
capability
Manufacturing
configuration vs
competition
Manufacturing Cycle time
excellence
Unit cost
Yield
Design
Silicon efficiency
productivity
Engineering efficiency
New product Actual introduction
introduction
schedule vs plan
Responsive
supply
Preferred
supplier
Customer
partnership
Innovation and
learning perspective
GOALS
MEASURES
Technology
leadership
Percentage of products
that equal 80% sales
Time to
market
New product
introduction vs
competition
CASE STUDY
Philips Electronics
(Based on a case study in Johnson, Scholes and Whittington, Exploring Corporate
Strategy)
Philips Electronics uses the balanced scorecard to manage its diverse products
lines and divisions around the world.
The company has identified four critical success factors (CSFs) for the
organisation as a whole:
Philips applies these four scorecard criteria at four levels: overall strategy review,
operations review, business unit level, and for individual employees.
CA Sri Lanka
11
In each case, criteria from one level are cascaded down to more detailed criteria at
the level below, so that employees can understand how their day-to-day activities
ultimately link back to overall corporate goals.
At the business unit level, for example, the management team determine the local
critical success factors and then agree indicators for each. Targets are then set for
each indicator.
Examples of the indicators at the business unit level include:
Financial perspective
Customer perspective
Economic profit
Income from operations
Working capital
Operational cash flow
Inventory turns
Leadership competence
Percentage of patent-protected turnover
Training days per employee
Quality improvement team participation
(b)
(c)
12
CA Sri Lanka
CASE STUDY
A study from Iran* shows how the balanced scorecard was adopted in Iranian
colleges and schools, and how it was used to formulate strategy by linking the
perspectives. This study is interesting, as it demonstrates how the perspectives
relate to each other.
The financial perspective includes increasing service prices and decreasing
costs. This was linked to developing services in the customer perspective.
The customer perspective included developing services and increasing customer
satisfaction. This was also linked to managing relationships and ensuring internal
systems could deliver services which both fall under the internal business
perspective.
The internal business perspective contains a number of goals which seek to
improve systems; for instance, developing IT, CRM (customer relationship
management) and marketing.
Finally, the learning and growth perspective covers cultural development,
developing IT skills and increasing employee knowledge. This links to the aims in
the previous perspective; for instance, developing IT skills links with developing
IT.
*Tohidi, H, Jafari, A and Afshar, A. Using balanced scorecard in educational
organizations. Procedia Social and Behavioural Sciences 2010; 2(2).
Kaplan and Norton (who developed the balanced scorecard) have found that
organisations are using it to:
Identify and align strategic initiatives
Link budgets with strategy
Align the organisation (structure and processes) with strategy
Conduct periodic strategic performance reviews with the aim of learning more
about, and improving, strategy
This is consistent with Kaplan and Norton's original intention of how the
scorecard should be used. They saw the scorecard as a means of translating
mission and strategy into objectives, and measures into four different
perspectives. They also say it is a means of communicating mission and strategy
and using the measures to inform employees about the key drivers of success.
It is interesting to note that Kaplan and Norton intended the scorecard to be a
communication and information system, not a control system.
CA Sri Lanka
13
Explanation
Conflicting
measures
Selecting
measures
Expertise
14
CA Sri Lanka
It may also be worth considering the following issues in relation to using the
balanced scorecard:
(a)
(b)
(c)
The scorecard should be used flexibly. Although there are four given perspectives,
these may need to be adapted to fit the particular characteristics of a business.
However, the process of deciding what to measure forces a business to clarify its
strategy. For example, a manufacturing company may find that 50-60% of costs
are represented by bought-in components, so measurements relating to suppliers
could usefully be added to the scorecard. These could include payment terms, lead
times, or quality considerations.
1.11 Linkages
If an organisation fails to look at all of the measures in their scorecard as a
whole, this might lead to disappointing results.
For example, increasing productivity means that fewer employees are needed for
a given level of output. Excess capacity can be created by quality improvements.
However, these improvements have to be exploited (eg by increasing sales). The
financial element of the balanced scorecard 'reminds executives that improved
quality, response time, productivity or new products, benefit the company only
when they are translated into improved financial results', or if they enable the
firm to obtain a sustainable competitive advantage.
CA Sri Lanka
15
EXTERNAL
STAKEHOLDERS
CONNECTED
STAKEHOLDERS
INTERNAL
STAKEHOLDERS
Employees
Managers
Shareholders
Bankers
Customers
Government
Pressure
groups
16
Suppliers
Professional
bodies
Local
communities
CA Sri Lanka
Suppliers
Long-term
lenders
Employees
Government
Management
QUESTION
Stakeholders
ANSWER
(a)
Customers
Customers are very significant to the bank because this group directly
provides income for the business. Some customers, for example large
corporate customers, are more significant than others.
(b)
Employees
This group looks to the bank to be a good employer, offering fair and
continuing employment. This group is very significant to the company, as
CA Sri Lanka
17
Suppliers
These may provide the company with key technologies that enable the
bank to have a competitive advantage.
(d)
Government agencies
There is a widespread feeling that banks abuse their position and exploit
customers, for example through cartel-type agreements. Government
agencies may have powers to control activities of the bank. The competition
authorities may recommend that a proposed takeover planned by the bank
be blocked.
(e)
Intermediaries
The bank sells some of its services (for example, insurance policies) through
intermediaries whose continued support is of significance.
CA Sri Lanka
One power that shareholders possess is the right to remove the directors from
office. However, shareholders have to take the initiative to do this, and in many
companies, the shareholders lack the energy and organisation to take such a step.
(b)
CA Sri Lanka
A not-for-profit organisation needs finance to pay for its operations, and the
major financial constraint is the amount of funds that it can obtain from its
donors (its 'customers').
19
(b)
Economically. Not spending Rs. 2 when the same thing can be bought
for Re. 1.
(ii)
Efficiently. Getting the best use out of what money is spent on.
(b)
(c)
(d)
The government gets its money for spending from taxes, other sources of
income and borrowing (such as issuing gilts) and the nature of its
fundraising differs substantially from fundraising by companies.
20
CA Sri Lanka
(b)
(c)
QUESTION
Voluntary sector
ANSWER
Strengths
There are no shareholders who would expect a short-term return on their
investment.
There is less chance of conflict between social goals and profit goals.
Voluntary organisations may be trusted more by users than a comparable
private sector organisation, for whom users may be suspicious of the
company's profit motives.
There may be greater dedication from staff who share the voluntary
organisation's vision.
CA Sri Lanka
21
Investment decision
Financing decision
Dividend decision
22
CA Sri Lanka
dividends and an increase in share price), balanced by the risk associated with the
investment.
Investment decisions may be on the undertaking of new projects within the
existing business, the takeover of, or the merger with, another company or the
selling off of a part of the business.
Managers have to take decisions in the light of strategic considerations such as
whether the business wants to expand internally (through investment in existing
operations) or externally (through expansion).
CA Sri Lanka
23
24
CA Sri Lanka
CHAPTER ROUNDUP
Many objectives and targets are set in terms of satisfying the requirements of
interested parties or stakeholders. In this chapter we considered in more depth
the importance of stakeholders and their role.
CA Sri Lanka
25
PROGRESS TEST
Identify three non-financial and three financial objectives that might be pursued
by a major international airline.
To obtain value for money, a not-for-profit organisation should aim for the 'three
Es', which are (fill in the blanks):
E __________________________________________________________________________________
E __________________________________________________________________________________
E __________________________________________________________________________________
26
Economy means doing things cheaply: not spending Rs. 2 when the same
thing can be bought for Re. 1.
Efficiency means doing things quickly: minimising the amount of time that is
spent on a given activity.
CA Sri Lanka
decisions
CA Sri Lanka
decisions
decisions
27
28
False
The answer is C. Efficiency means doing things well: getting the best use out of
what money is spent on.
Strategy
CA Sri Lanka
CHAPTER
INTRODUCTION
We now examine the range of factors which may constrain financial
strategy.
It is important to see how changes or differences in these factors may
influence strategy. For example, a change in government legislation
may limit (or maybe open up) opportunities. When seeking investment
opportunities in other countries, the particular external factors which
are important there will need to be considered.
Interest rates are a key influence on investment decisions, and you
need to appreciate the main factors affecting interest rates, and why
rates differ across the economy.
The treasury function will tend to behave differently depending on
whether it is centralised/decentralised, and accounted for as a profit or a
cost centre.
Knowledge Component
1
Corporate Financial Objectives and their Measurement
1.1
Corporate financial
management and strategic
financial objectives
1.1.3
1.3
Treasurer's role in
financial management
1.3.1
29
CHAPTER CONTENTS
LEARNING
OUTCOME
1.1.3
2 Regulatory bodies
1.1.3
3 Economic constraints
1.1.3
4 International constraints
1.1.3
1.3.1
30
(a)
They fear that the company may be unable to service the debt, to make the
required capital and interest payments on time
(b)
The tax position is such that they will be unable to use the tax shield, to
obtain any tax benefit from interest payments
(c)
The company lacks the asset base to be able to generate additional cash if
needed or provide sufficient security
CA Sri Lanka
(d)
CA Sri Lanka
31
2 Regulatory bodies
Powerful external constraints on the ability of a company to create wealth for its
shareholders are local or overseas governments, or government regulators.
Companies Acts
Health and safety regulations
Consumer protection laws
Contract and agency laws
Employment law
Protection of the environment laws
32
CA Sri Lanka
The board's actions are subject to laws, regulations and the shareholders in
general meeting.
Corporate governance has emerged as a major issue in the last 10 to 15 years in
the light of several high-profile collapses. Guidance has been given because of the
lack of confidence both in financial reporting and in the ability of auditors to
provide the assurances required by the users of financial accounts.
2.3.1 Impact of corporate governance requirements on businesses
The consequences of failure to obey corporate governance regulations should
be considered along with failure to obey any other sort of legislation. In regimes
where corporate governance rules are guidelines rather than regulations,
businesses will consider what the consequences might be of non-compliance, in
particular the impact on share prices.
Obedience to requirements or guidelines can also have consequences for
businesses. For example, increased disclosure regulations have highlighted
director remuneration packages that investors have thought to be excessively
generous.
Price control
The regulator agreeing the output prices with the industry. Typically, the
price is progressively reduced in real terms each year by setting price
CA Sri Lanka
33
increases at a rate below that of inflation. This has been used with success by
regulators but can be confrontational.
CASE STUDY
34
CA Sri Lanka
'Since the implementation of this scheme in April 1989, Sri Lanka has gone through a
severe escalation of costs in the following areas regulatory; scientific and medical
education; professional information services; operational/infrastructure/personnel
and staff costs.
'It said under the present system, where demand and supply forces act on a free
and open market, prices are controlled by economic forces which not only allow a
choice to the patient, but are knitted into the fabric of the country's healthcare
system.
'This very reason, the chamber pointed out, may cause pharmaceutical prices to
further escalate under price regulation and for high quality innovator drugs to
become scarce in the market. It reiterated that the prices of essential
pharmaceuticals rather than moving upwards has come down, and in some cases
quite drastically through the years and this is mainly because of the healthy
competition that is currently prevailing in the market, especially with SPC pricing
creating a bench mark.'
Source: Sri Lanka Sunday Times (11 December 2011) Unrealistic price control of
drugs will send prices up: Pharma companies [Online]
(b)
Profit control
The regulator agreeing the maximum profit which the industry can make.
A typical method is to fix maximum profit at x% of capital employed, but this
does not provide any incentive to making more efficient use of assets: the
higher the capital employed, the higher the profit.
(b)
CA Sri Lanka
35
(b)
The interests of consumers, purchasers and users of the goods and services
of that industry in respect of quality, price and variety
(c)
3 Economic constraints
Economic constraints on strategy will be imposed by inflation, interest rates and
exchange rates. You will be expected to have a good understanding of how
economic factors can impact on an entity and be able to discuss the effect on
financial strategies.
36
(a)
The rate of inflation will affect the prices that a business must pay for all
the factors of production and the prices that it is able to charge to its
customers. It will therefore affect the level of reported profits.
(b)
(c)
(d)
Inflation places pressure on cash flow, particularly where the prices of raw
materials are rising ahead of prices charged to customers. Even where sales
prices do keep up, additional cash will still be required to cover the
increased payments to suppliers that will have to be made in advance of
monies being received in respect of credit sales.
(e)
(f)
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(g)
The relationship between inflation rates and interest rates means that
interest rates tend to rise during a period of inflation. This has implications
both for the capital structure decisions and investment appraisal criteria
used by companies.
(b)
(c)
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37
The relationship between nominal rates and real rates of interest was originally
explored by Fisher and can be expressed as follows:
FORMULA TO LEARN
(1 + nominal rate of interest) = (1 + real rate of interest) (1 + inflation rate)
If the nominal rate of interest is 12% and the rate of inflation is 8%, the real rate of
interest would be 1.12/1.08 1 = 0.037 = 3.7%.
3.2.2 The general level of interest rates
Interest rates on any one type of financial asset will vary over time. In other
words, the general level of interest rates might go up or down. The general level of
interest rates is affected by several factors.
(a)
(b)
Inflation
Nominal rates of interest should be sufficient to cover expected rates of
inflation over the term of the investment and to provide a real return.
(c)
(d)
38
CA Sri Lanka
(e)
Balance of payments
When a country has a continuing deficit on the current account of its balance
of payments, and the authorities are unwilling to allow the exchange rate to
depreciate by more than a certain amount, interest rates may have to be
raised to attract capital into the country. The country can then finance the
deficit by borrowing from abroad.
(f)
Monetary policy
The Central Bank of Sri Lanka makes decisions over Sri Lanka interest rate
policy. The Bank influences very short-term money market rates by means of
open market operations. Usually, longer-term money market rates, and
then banks' base rates, will respond to the authorities' wish for interest rate
changes.
(g)
Risk
Higher risk borrowers must pay higher rates on their borrowing, to
compensate lenders for the greater risk involved.
(b)
(c)
(d)
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39
(e)
Downward sloping
yield curve
The reasons why, in theory, the yield curve will normally be upward sloping, so
that long-term financial assets offer a higher yield than short-term assets, are as
follows.
40
(a)
(b)
There is a greater risk in lending long term than in lending short term.
To compensate investors for this risk, they might require a higher yield on
longer-dated investments.
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A yield curve might slope downwards, with short-term rates higher than longerterm rates for a number of reasons.
(a)
(b)
(c)
The market segmentation theory. The slope of the yield curve will reflect
conditions in different segments of the market. This theory holds that the
major investors are confined to a particular segment of the market and will
not switch segment even if the forecast of likely future interest rates
changes.
(ii)
(iii) To pay back loans which incur a high interest rate, if it is within the
company's power to do so, and take out new loans at a lower interest
rate
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41
(b)
(ii)
A company which has a large surplus of cash and liquid funds to invest
might switch some of its short-term investments out of equities and
into interest-bearing securities
Consumer spending falling because the higher interest rates raise the cost
of capital.
(b)
The value of investors' financial assets falling, and their maintaining their
total wealth by saving more and spending less.
(c)
However, the influx of foreign funds may also eventually mean that more capital
is available for domestic companies.
42
CA Sri Lanka
When the local currency, say the yen, goes up in value, goods sold abroad
by Japanese exporters, and invoiced in yen, will cost more to the foreign
buyers (who must purchase yens with their own currency in order to pay).
(b)
When the yen falls in value, goods sold abroad by Japanese exporters and
invoiced in yen will become cheaper to foreign buyers.
To the extent that demand is influenced by price, the demand for exports will
therefore vary with changes in the exchange rate.
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43
Similarly, if you are going on holiday or on a shopping trip abroad, you will be
interested in movements in the exchange rate. When you are buying currency, you
want your own currency to appreciate, as this means you will get more of the
foreign currency for every unit of your own currency. For example, if $1 is worth
Rs. 132 and you purchased Rs. 50,000 worth of dollars, you would receive
$378.78. However if the SL rupee appreciated to $1 = Rs. 125, you would receive
$400.
However, when you are exchanging foreign currency into your home currency,
you want your home currency to depreciate. For example, if you came back from
holiday with $50 and $1 = Rs. 128, you would receive Rs. 6,400 ($50 128). If the
SL rupee depreciated to $1 = Rs. 135, you would receive Rs. 6,750.
4 International constraints
An exam scenario may concern an entity which trades internationally. You need to
be able to discuss the particular factors that will impact on such an entity's
financial strategy.
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4.2 Multinationals
A multinational company or enterprise is one which owns or controls
production facilities or subsidiaries or service facilities outside the country in
which it is based. Thus, a company does not become 'multinational' simply by
virtue of exporting or importing products ownership and control of facilities
abroad is involved.
Examples of multinational companies include:
Food and
drink
Hospitality
and leisure
Car
manufacturers
Technology
Pharmaceuticals
Coca-Cola
Hilton
Ford
Microsoft
GlaxoSmithKline
McDonald's
Marriott
Toyota
Dell
Pfizer
CASE STUDY
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45
46
(a)
(b)
(c)
The transaction motive a company needs to hold enough cash to meet its
day-to-day obligations.
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Aims and
strategies
Policies
(b)
Systems
Liquidity management. Making sure the company has the liquid funds it
needs, and invests any surplus funds, even for very short terms.
Figure 2.3
LIQUIDITY MANAGEMENT
Working capital
management
Money transmission
management
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Banking
relationships
Money management
and investment
47
(c)
Funding management
Figure 2.4
Length of time/
funds available
Interest rate
Where funds
obtainable
Security
FUNDING MANAGEMENT
Funding policies
Types
Funding procedures
Sources
Currency management
Figure 2.5
CURRENCY MANAGEMENT
Exposure policies
and procedures
Exchange dealing
(futures and options)
Exchange
regulations
48
CA Sri Lanka
(e)
Corporate finance
Figure 2.6
CORPORATE FINANCE
Raising share
capital
Obtaining a stock
exchange listing
Dividend policies
Mergers, acquisitions
and business sales
The treasury department has a role in all levels of decision making within
the company. It is involved with strategic decisions such as dividend policy
or the raising of capital, tactical decisions such as risk management, and
operational decisions such as the investment of surplus funds.
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49
authorised
50
(a)
(b)
(c)
Any borrowing can be arranged in bulk, at lower interest rates than for
smaller borrowings, and perhaps on the eurocurrency or eurobond markets.
(d)
(e)
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(f)
(g)
(h)
Sources of finance can be diversified and can be matched with local assets.
(b)
(c)
However, since cash balances will not be aggregated at group level, there will be
more limited opportunities to invest such balances on a short-term basis.
5.4.3 Centralised cash management in the multinational firm
If cash management within a multinational firm is centralised, each subsidiary
holds only the minimum cash balance required for transaction purposes. All
excess funds will be remitted to the central treasury department.
Funds held in the central pool of funds can be returned quickly to the local
subsidiary by telegraphic transfer or by means of worldwide bank credit facilities.
The firm's bank can instruct its branch office in the country in which the
subsidiary is located to advance funds to the subsidiary.
QUESTION
Treasury centralisation
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51
Required
Prepare a memo, acting as a consultant to CD Co, that is suitable for distribution
from the group finance director to the senior management of each of the
subsidiaries explaining:
(a)
(b)
How the company proposes to minimise any potential problems for the
subsidiaries that might arise as a result of treasury centralisation
ANSWER
MEMORANDUM
To:
From:
Date:
52
CA Sri Lanka
(b)
(c)
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53
Please contact me with any further comments that you may have on our new
treasury policy.
(b)
QUESTION
Suppose that your company is considering plans to establish its treasury function
as a profit centre.
Required
Explain in what ways the following issues are of potential importance to these
plans.
54
(a)
(b)
(c)
(d)
Could there be a danger that attitudes to risk in the treasury team will differ
from those of the board? If so, how?
(e)
(f)
ANSWER
If a profit centre approach is being considered, the following issues should be
addressed.
(a)
Competence of staff
Local managers may not have sufficient expertise in the area of treasury
management to carry out speculative treasury operations competently.
Mistakes in this specialised field may be costly. It may only be appropriate to
operate a larger centralised treasury as a profit centre, and additional
specialist staff demanding high salaries may need to be recruited.
(b)
Controls
Adequate controls must be in place to prevent costly errors and
overexposure to risks such as foreign exchange risks. It is possible to enter
into a very large foreign exchange deal over the telephone.
(c)
Information
A treasury team which trades in futures and options or in currencies is
competing with other traders employed by major financial institutions who
may have better knowledge of the market because of the large number of
customers they deal with. In order to compete effectively, the team needs to
have detailed and up-to-date market information.
(d)
Attitudes to risk
The more aggressive approach to risk-taking which is characteristic of
treasury professionals may be difficult to reconcile with the more measured
approach to risk which may prevail within the board of directors. The
recognition of treasury operations as profit-making activities may not fit
well with the main business operations of the company.
(e)
Internal charges
If the department is to be a true profit centre, then market prices should be
charged for its services to other departments. It may be difficult to put
realistic prices on some services, such as arrangement of finance or general
financial advice.
(f)
Performance evaluation
Even with a profit centre approach, it may be difficult to measure the success
of a treasury team for the reason that successful treasury activities
sometimes involve avoiding the incurring of costs, for example when a
currency devalues. For example, a treasury team which hedges a future
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55
56
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CHAPTER ROUNDUP
Certain factors inside and outside an organisation may hold it back from
implementing its financial strategies. These factors include funding, investor
relations, regulatory bodies and economic factors.
Powerful external constraints on the ability of a company to create wealth for its
shareholders are local or overseas governments, or government regulators.
An exam scenario may concern an entity which trades internationally. You need to
be able to discuss the particular factors that will impact on such an entity's
financial strategy.
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57
PROGRESS TEST
Fill in the following at (A), (B) and (C) in the equation below:
Nominal rate of interest
Real rate of interest
Rate of inflation
1+(A)
1 = (C)
1+(B)
What effect does a high interest rate have on the exchange rate?
Fill in the blanks in the statement below, using the words in the box. (Words may
be used more than once.)
Treasury management may be defined as 'the corporate handling of all (1)
___________________ matters, the generation of external and internal (2)
___________________ for business, the management of (3) ___________________ and cash
flow, and the complex strategies, policies and procedures of (4)
___________________' .
A treasury department may be managed either as a (5) ______________________
centre or a (6) _______________________ centre.
A (7) _______________________ treasury department has the role of ensuring that
individual operating units have all the funds they need at the right time.
Futures and options might be employed in (8) ________________________ risk
management.
Acquisitions and sales
________________________ .
of
businesses
fall
within
the
area
of
(9)
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CA Sri Lanka
Corporate
finance
Centralised
Profit
Financial
Liquidity
Cost
Currency/ies
Funds
Why might a treasurer choose not to 'hedge' against the risk of a foreign exchange
movement?
10
CA Sri Lanka
59
% interest
rate
Yield curve
Term to maturity
60
It attracts foreign investment, thus increasing the demand for the currency. The
exchange rate rises as a result.
(1) Financial (2) Funds (3) Currencies (4) Corporate finance (5) Cost (6) Profit (7)
Centralised (8) Currency (9) Corporate finance (10) Liquidity
Because they think it likely that a profit will be made in refraining from hedging
the risk.
10
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CHAPTER
INTRODUCTION
We start this chapter by revising ratio analysis and other methods of performance
measurement. You are unlikely to get a question that solely involves calculating and
analysing ratios in this paper. You may be asked, for example, to use ratio analysis to
ascertain whether an organisation has met its objectives.
Cash forecasting is vital to ensure that sufficient funds will be available when they are
needed to sustain the activities of an enterprise, at an acceptable cost.
Although you will have encountered forecasts before, don't neglect this chapter, as the
examiners have highlighted this topic as important. You may well get a compulsory
question on forecasting.
In Section 3 we look at how you should prepare forecast financial statements.
Section 5 deals with the links between the cash requirements forecast and decisions on
financing.
Knowledge Component
1
Corporate Financial Objectives and their Measurement
1.2
1.2.1
1.2.2
61
CHAPTER CONTENTS
LEARNING
OUTCOME
1 Performance analysis
1.2.2
2 Cash forecasts
1.2.1
1.2.1
1.2.2
5 Financing requirements
1.2.2
1 Performance analysis
In Chapter 1 we looked at financial objectives. The aim of this chapter is to
determine whether an entity will meet its objectives. Ratios provide a means of
systematically analysing financial statements. You will have covered much of this
section in your earlier studies, so the material here is designed to refresh your
memory.
62
(a)
(b)
Suppliers and loan creditors are interested in receiving the payments due
to them, so will want to know how liquid the business is.
(c)
Managers are interested in ratios that indicate how well the business is
being run, and also how the business is doing in relation to its competitors.
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(b)
(c)
(d)
(e)
Manipulation
Any ratio including profit may be distorted by choice of accounting
policies. For smaller companies, working capital ratios may be distorted
depending on whether a big customer pays, or a large supplier is paid, before
or after the year end.
(f)
Other information
Ratio analysis on its own is not sufficient for interpreting company
accounts, and there are other items of information that should be looked at.
We shall consider this further below.
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63
64
CA Sri Lanka
This gives a more restricted view of capital than ROCE, but the same principles
apply.
ROCE = Asset turnover Profit margin.
This is sometimes known as the DuPont model or DuPont analysis.
Figure 3.1
DuPont model
Other current
assets
+
Fixed assets
Sales
(turnover)
Current assets
Assets
Inventory
+
Asset turnover
Accounts
receivable
+
Cash and
equivalents
Sales
(turnover)
Return on
investment
Operating
expenses
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Earnings before
interest and tax
Non-operating
income
Sales
(turnover)
Profit margin
65
Asset turnover
Asset turnover =
Sales
Sales
or
Total assets less current liabilities
Capital employed
This measures how efficiently the assets have been used. This is amended to just
non-current assets for capital-intensive businesses.
Profit margin
Profit margin = PBIT %
Sales
Debt:equity
Debt:equity ratio = Interest bearing net debts % (>100% = high)
Shareholders' funds
Or simply Value of debt
Value of equity
Operating gearing (leverage)
Gearing =
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CA Sri Lanka
1.6 Liquidity
FORMULA TO LEARN
Current ratio
Current ratio =
Current assets
Current liabilities
Trade receivables
365
Credit sales
Inventory
365
Cost of sales
Lead times
Seasonal fluctuations in orders
Alternative uses of warehouse space
Bulk buying discounts
Likelihood of inventory perishing or becoming obsolete
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67
+
+
EPS
Dividend per share
This shows how safe the dividend is, or the extent of profit retention. Variations
are due to maintaining dividend when profits are declining.
The converse of dividend cover is the dividend payout ratio.
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CA Sri Lanka
P/E ratio
P/E ratio = Market price per share
EPS
The higher the better here: it reflects the confidence of the market in high
earnings growth and/or low risk. A rise in EPS will cause an increase in P/E ratio,
but maybe not to the same extent.
P/E ratio will be affected by interest rate changes; a rise in rates will mean a fall in
the P/E ratio as shares become less attractive. P/E ratio also depends on market
expectations and confidence.
Earnings yield
Earnings yield =
EPS
%
Market price per share
This shows the dividend yield if there is no retention of profit. It allows you to
compare companies with different dividend policies, showing growth rather
than earnings.
Net assets per share
Net assets per share =
Net assets
No of shares
Earnings
100
Shareholders' funds
Earnings are after interest, tax and any preference dividends. A high return on
shareholders' funds suggests that the company is profitable and has more funds
available for equity shareholders.
Total shareholder return
Investors are also interested in current market price, past and future returns and
security of investment.
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69
QUESTION
Ratios
Calculate liquidity and working capital ratios from the accounts of a manufacturer
of products for the construction industry, and comment on the ratios.
Revenue
Less cost of sales
Gross profit
Current assets
Inventory
Receivables (note 1)
Short-term investments
Cash at bank and in hand
Creditors: amounts falling due within one year
Loans and overdrafts
Taxes
Dividend
Payables (note 2)
Net current assets
20X8
Rs Mn
2,065.0
1,478.6
586.4
20X7
Rs Mn
1,788.7
1,304.0
484.7
119.0
400.9
4.2
48.2
572.3
109.0
347.4
18.8
48.0
523.2
49.1
62.0
19.2
370.7
501.0
35.3
46.7
14.3
324.0
420.3
71.3
102.9
20X8
Rs Mn
329.8
236.2
20X7
Rs Mn
285.4
210.8
Notes
1
2
Trade receivables
Trade payables
ANSWER
Current ratio
Quick ratio
Receivables collection period
Inventory turnover period
Payables payment period
70
20X8
20X7
572.3
= 1.14
501.0
453.3
= 0.90
501.0
329.8
365 = 58 days
2,065.0
119.0
365 = 29 days
1, 478.6
236.2
365 = 58 days
1, 478.6
523.2
= 1.24
420.3
414.2
= 0.99
420.3
285.4
365 = 58 days
1,788.7
109.0
365 = 31 days
1,304.0
210.8
365 = 59 days
1,304.0
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1.8 Overtrading
Overtrading occurs when a business tries to do too much too quickly with too
little long-term capital. The result is the business trying to support too large a
volume of trade with the capital resources at its disposal.
Symptoms of overtrading are as follows.
(a)
(b)
There is a rapid increase in the volume of current assets and possibly also
non-current assets. Inventory turnover and accounts receivable turnover might
slow down, in which case the rate of increase in inventories and accounts
receivable would be even greater than the rate of increase in sales.
(c)
(d)
(i)
(ii)
A bank overdraft, which often reaches or even exceeds the limit of the
facilities agreed by the bank
(ii)
(iii) The business might have a liquid deficit, that is, an excess of current
liabilities over current assets
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71
(b)
(c)
The company could abandon ambitious plans for increased sales and more
non-current asset purchases until the business has had time to consolidate
its position, and build up its capital base with retained profits
The nature of any increase in share capital and accumulated profits will be of
interest including share issues and substantial profit retentions. If a
company has issued shares in the form of a dividend, are there obvious
reasons why this should be so? For example, does the company need to
retain capital within the business because of poor trading in the previous
year, making the directors reluctant to pay out more cash dividend than
necessary?
(c)
Two aspects to look out for are whether or not loans are secured and the
redemption dates of loans.
(d)
Contingencies
Contingencies are conditions which exist at the balance sheet date where
the outcome will be confirmed only on the occurrence or non-occurrence of
one or more uncertain future events. For example, a pending lawsuit.
(e)
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CA Sri Lanka
current assets and investments. Knowledge of such events allows the analyst
to 'update' the latest published figures by taking account of their potential
impact.
2 Cash forecasts
Forecasting is used to set shareholder expectations, for performance evaluation
and to analyse financing requirements. In the exam you could be expected to
produce a forecast statement of comprehensive income, a forecast statement of
financial position and/or a cash flow forecast.
A company must know when it might need to borrow and for how long, not just
what amount of funding could be required.
This forecast calls for some prediction of the amount/value of each item in the
company's statement of financial position, excluding cash and short-term
investments, as these are what we are trying to predict. A forecast is prepared by
taking each item in the statement of financial position, and estimating what its
value might be at the future date. The assumptions used are critical, and the
following guidelines are suggested.
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73
(a)
If there are any, they should be taken at their current value unless there is
good reason for another treatment.
(b)
Current assets
(ii)
The firm can assume that the operating cycle will more or less remain
the same.
Current liabilities
74
(i)
(ii)
CA Sri Lanka
Non-current creditors
Accumulated profits
CA Sri Lanka
(i)
(ii)
75
A surplus of share capital and reserves over net assets (total assets minus
total liabilities). If this occurs, the company will be forecasting a cash
surplus.
(b)
A surplus of net assets over share capital and reserves. If this occurs, the
company will be forecasting a funding deficit.
50
20
30
50
20
50
100
Non-current liabilities
5% bonds
Deferred tax
Current liabilities
Total equity and liabilities
20
10
120
20
10
30
60
190
30
90
240
The company is expecting to increase its total assets in the next year by
Rs. 90 million (Rs. 280 million Rs. 190 million) but expects accumulated profits
for the year to be Rs. 20 million (Rs. 50 million Rs. 30 million) and current
liabilities to increase by Rs. 30 million. There is an excess of net assets over share
capital and reserves amounting to Rs. 40 million (Rs. 280 million Rs. 240
million), which is a funding deficit. The company must consider ways of
obtaining extra cash (eg by borrowing) to cover the deficit. If it cannot, it will need
76
CA Sri Lanka
to keep its assets below the forecast amount, or to have higher short-term
payables.
A revised projected statement of financial position can then be prepared by
introducing these new sources of funds. This should be checked for realism (eg by
ratio analysis) to ensure that the proportion of the statement made up by noncurrent assets and working capital etc is sensible.
Sales
Opening receivables ( received in year)
Closing receivables (outstanding at year end)
Cash in
Cost of sales
Closing inventory (purchased, but not used, in year)
Opening inventory (used, but not purchased, in year)
Purchases in year
Opening payables ( paid in year)
Closing payables (outstanding at year end)
Cash out
Profit/operational cash flow
CA Sri Lanka
Profit
Rs
200,000
170,000
30,000
Operational
cash flow
Rs
200,000
15,000
(24,000)
191,000
170,000
21,000
(12,000)
179,000
11,000
(14,000)
176,000
15,000
77
Opening
Closing
Rs
30,000
12,000
(21,000)
(9,000)
(Increase)/decrease in receivables
Opening
Closing
15,000
(24,000)
(9,000)
Increase/(decrease) in payables
Closing
Opening
14,000
(11,000)
3,000
15,000
QUESTION
GH Co
You are a consultant working for a company called GH Co, which started trading
four years ago in 20X3 and which manufactures plastic rainwater drainage goods.
You have the following information.
78
(a)
Revenue and cost of sales are expected to increase by 10% in each of the
financial years ending 31 December 20X7, 20X8 and 20X9. Operating
expenses are expected to increase by 5% each year.
(b)
The company expects to continue to be liable for tax at the marginal rate of
30%. You can assume that tax is paid or refunded 12 months after the year
end.
(c)
The ratios of receivables to sales and trade payables to cost of sales will
remain the same for the next three years.
(d)
CA Sri Lanka
(e)
The company plans for dividends to grow at 25% in each of the financial years
20X7, 20X8 and 20X9.
(f)
The company plans to purchase new machinery to the value of Rs. 500,000
during 20X7, to be depreciated straight line over ten years. The company
charges a full year's depreciation in the first year of purchase of its assets.
Tax allowable depreciation at 25% reducing balance is available on this
expenditure.
(g)
Inventory was purchased for Rs. 35,000 at the beginning of 20X7. The value
of inventory after this purchase is expected to remain at Rs. 361,000 for the
foreseeable future.
(h)
No decision has been made on the type of finance to be used for the
expansion programme. The company's directors believe that they can raise
new medium-term secured bonds if necessary.
(i)
(b)
(c)
A summary of the financial statements for the year to 31 December 20X6 is set out
below.
GH CO
SUMMARISED STATEMENT OF COMPREHENSIVE INCOME
FOR THE YEAR TO 31 DECEMBER 20X6
Revenue
Less cost of sales
Gross profit
Less operating expenses
Less interest
Less tax liability
Net profit
Dividends declared
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Rs '000
1,560
(950)
610
(((325)
((30)
(77)
178
68
79
Rs '000
750
326
192
50
1,318
500
128
110
300
1,038
135
145
1,318
Required
(b)
Prepare cash flow forecasts for the years 20X7, 20X8 and 20X9, and
estimate the amount of funds which will need to be raised by the company to
finance its expansion.
Notes
80
You should ignore interest or returns on surplus funds invested during the
three-year period of review.
You may ignore the timing of cash flows within each year and you should not
discount the cash flows.
CA Sri Lanka
ANSWER
(a)
Actual
Forecast
20X6
20X7
20X8
20X9
Rs '000 Rs '000 Rs '000 Rs '000
1,560
1,716
1,888
2,076
(950) (1,045) (1,150) (1265)
610
671
738
811
(325)
(341)
(358)
(376)
(50)
(50)
(50)
285
(30)
255
(77)
178
(68)
110
128
238
280
(30)
250
(53)
197
(85)
112
238
350
330
(30)
300
(77)
223
(106)
117
350
467
385
(30)
355
(100)
255
(133)
122
467
589
500
238
738
500
350
850
500
467
967
500
589
1,089
34.6%
29.4%
31.0%
32.6%
It is assumed that the company does not account for deferred taxation.
Actual
Forecast
20X6
20X7
20X8
20X9
Rs '000 Rs '000 Rs '000 Rs '000
255
250
300
355
Profit before tax
50
50
50
Add back depreciation
(94)
(70)
(125)
Less tax allowance (25% reducing
balance)
255
175
256
335
Taxable profit
Tax at 30%
CA Sri Lanka
77
53
77
100
81
(b)
There are many ways of computing the cash flow forecasts. However, some
ways are quicker than others. Our answer shows one of the quickest
methods first. Remember that you will need to complete calculations in the
exam as quickly as possible.
The 20X6 statement of financial position figure for 'other payables (including
tax and dividends)' is simply the sum of tax and dividends in the statement
of comprehensive income. It is assumed that this will continue to be the case
in the following three years. The annual change in net current assets can be
computed as follows.
Changes in net current assets
Actual
20X6
Rs '000
326
192
Forecast
20X7
20X8
20X9
Rs '000 Rs '000 Rs '000
361
361
361
211
232
256
(135)
(148)
(163)
(180)
(145)
(138)
(183)
(233)
238
286
247
204
48
(39)
(43)
20X7
Rs '000
112
50
(48)
(500)
(386)
50
(336)
20X8
Rs '000
117
50
20X9
Rs '000
122
50
39
43
206
(336)
(130)
215
(130)
85
The company will need to find finance of Rs. 336,000 in 20X7 but this can be
completely repaid in the following two years. However, interest costs have
been ignored in this computation.
82
CA Sri Lanka
Answers by both of these methods are shown here, for comparison, but you
should practise producing forecasts as quickly as possible.
Appendices
20X8
Rs '000
20X9
Rs '000
1,697
1,867
2,052
1,032
341
35
500
30
77
68
2,083
1,135
358
1,248
376
30
53
85
1,661
30
77
106
1,837
20X7
20X8
20X9
Rs '000 Rs '000 Rs '000
(386)
206
215
50
(336)
(130)
(336)
(130)
85
LKAS 7 format
CA Sri Lanka
20X7
Rs '000
20X7
20X8
20X9
Rs '000 Rs '000 Rs '000
289
374
428
(30)
(30)
(30)
(68)
(85)
(106)
(53)
(77)
(77)
114
206
215
(500)
(386)
206
215
83
QUESTION
JK Co produces smoke alarms for residential and office premises. The most recent
statement of financial position of the company is set out below.
STATEMENT OF FINANCIAL POSITION AS AT 30 NOVEMBER 20X2
Rs Mn
Non-current assets
Freehold buildings at cost
Less accumulated depreciation
Plant and machinery at cost
Less accumulated depreciation
Current assets
Inventory
Trade receivables
Bank
Less payables: amounts falling due
within one year
Trade payables
Taxation
Dividends
Rs Mn
24.4
4.4
37.9
12.9
39.0
20.0
8.3
67.3
12.0
4.5
7.8
24.3
Rs Mn
20.0
25.0
45.0
43.0
88.0
Capital and reserves
84
Rs Mn
20.0
68.0
88.0
CA Sri Lanka
During the year to 30 November 20X2, the sales revenue for the business was
Rs. 240m.
As a result of recent changes in government legislation, it has been predicted that
the market for smoke alarms will increase significantly in the short term. The
directors of JK Co are planning to expand the business significantly during the
forthcoming year in order to exploit these new market conditions. The following
forecasts and assumptions for the forthcoming year have been prepared by the
directors.
(a)
Sales for the forthcoming year will be 25% higher than the previous year.
Sales are expected to be spread evenly over the year.
(b)
(c)
To prepare for the expansion in output, new machinery costing Rs. 57m will
be purchased at the beginning of the year and a long-term loan will be taken
out immediately to help finance this purchase. At the end of the year, the
long-term debt to equity ratio is planned to be 1:3.
(d)
The average receivables collection period will be three times that of previous
years and the average payment period for creditors will be one and a half
months.
(e)
The value of inventory at the end of the year will be Rs. 18m lower than at the
beginning of the year.
(f)
Depreciation charges for freehold buildings and plant and machinery are
calculated using the reducing balance method and will be 5% and 20%
respectively. Other expenses for the period will be Rs. 54.6m. There will be no
prepayments or accruals at the end of the year.
(g)
Dividends will be announced at the end of the year and the dividend payout
ratio will be 50% which is in line with previous years. The tax rate will be
30% of net profits before taxation. The dividend and tax will be paid after
the year end.
All workings should be in Rs. millions and should be made to one decimal place.
Workings must be clearly shown.
Required
(a)
CA Sri Lanka
(i)
(ii)
85
(b)
Discuss briefly the financial performance and position of the business using
the financial statements prepared in (a) above.
ANSWER
(a)
(i)
(ii)
JK CO
FORECAST STATEMENT OF FINANCIAL POSITION
AS AT 30 NOVEMBER 20X3
Rs Mn
Non-current assets
Freehold buildings at cost
Less accumulated depreciation
Rs Mn
Rs Mn
24.4
(5.4)
19.0
94.9
(29.3)
65.6
84.6
Current assets
Inventory (39 18)
Trade receivables (W1)
86
21.0
75.0
96.0
CA Sri Lanka
Rs Mn
Payables: amounts falling due within one year
19.2
Bank overdraft (W4)
24.0
Trade payables (W2)
5.4
Taxation payable
6.3
Dividend payable
Rs Mn
Rs Mn
54.9
41.1
125.7
Payables: amounts falling due after more than one year
Loan (W3)
Total net assets
Share capital and reserves
Ordinary shares of Re. 1
Accumulated profits (68 + 6.3)
Total equity and reserves
(31.4)
94.3
20.0
74.3
94.3
Workings
Trade receivables
Trade payables
CA Sri Lanka
87
Loan
Rs Mn
20.0
68.0
6.3
94.3
Share capital
Reserves as at 30 November 20X2
Accumulated profit, 20X3
Share capital and reserves at 30.11.20X3
31.4
57.0
25.6
Cash
Tutorial note. The cash balance can be calculated as the 'missing
figure' to make the net assets equal the share capital and
reserves. A proof of the cash position, however, is shown here.
Rs Mn
Operating profit
Add back depreciation (1.0 + 16.4)
Reduction in inventory
Increase in receivables (75 20)
Increase in trade payables (24 12)
Cash flow from operations
Tax paid
Dividends paid
Machinery purchase
Loan raised
Loan repaid
Cash flow in the year
Cash at start of year
Cash at end of year
(b)
Rs Mn
18.0
17.4
35.4
18.0
(55.0)
12.0
(25.0)
10.4
(4.5)
(7.8)
(57.0)
57.0
(25.6)
(27.5)
8.3
(19.2)
The profit after tax next year will be Rs. 12.6 million, giving a return on
equity of (12.6/94.3) 13.4% and a profit margin on sales of (12.6/300) 4.2%.
In the previous year, the profit after tax was Rs. 15.6 million (double the
dividend), with a ROE of (15.6/88) 17.7% and a profit/sales ratio of
(15.6/240) 6.5%.
The forecast profit is therefore lower, with a lower ROE and a lower
profit/sales ratio, despite a 25% increase in sales.
Liquidity is also expected to deteriorate. The company is forecasting a bank
overdraft of Rs. 19.2 million at the end of November 20X3, compared to a
88
CA Sri Lanka
positive cash balance the previous year. The company will have to ensure
that bank overdraft facilities are available if it goes ahead with its plan to
increase sales.
The company will also have some long-term debt capital, having been
ungeared in the year to 30 November 20X2.
On the basis of the forecasts, it is questionable whether there is any financial
benefit to be obtained from expanding sales, and the company management
should review its plans urgently, before implementing them.
Note. The discussion/explanation part of a forecasting question will be
worth a significant proportion of the marks on offer, so make sure you
practise answering these parts, in addition to the calculations.
CA Sri Lanka
89
How the predicted changes will affect demand. The links may not be easy
to forecast. Businesses should consider separately the effect of major
changes on each type of product.
(b)
How the business will respond to changes in variables. For example, will
the business automatically adjust prices upwards by the rate of inflation, or
will it try to hold prices? What will its competitors do? If raw material prices
increase, will the business try to change suppliers? What effect will this have
on payment patterns?
90
CA Sri Lanka
CASE STUDY
Singapore Airlines provides sensitivity analysis in its annual reports. For example,
an extract from its 2011/12 annual report shows the sensitivity of passenger
revenue to changes in key variables.
Passenger load factor is a measure of the amount of utilisation of the total
available capacity of an aircraft.
Passenger yield is a measure of the average fare paid per mile, per passenger,
calculated by dividing passenger revenue by passenger miles.
108.4
83.9
A change in the price of fuel of US$1 per barrel affects Singapore Airlines' annual
fuel cost by about SGD 37 million.
5 Financing requirements
Cash deficits will be funded in different ways, depending on whether they are
short or long term. Sources of finance will be covered in detail in later chapters of
the Study Text. Businesses should also have procedures for investing cash
surpluses with appropriate levels of risk and return.
5.1 Deficiencies
Any forecast deficiency of cash will have to be funded.
CA Sri Lanka
(a)
(b)
(c)
92
CA Sri Lanka
CHAPTER ROUNDUP
Cash deficits will be funded in different ways, depending on whether they are
short or long term. Sources of finance will be covered in detail in later chapters of
the Study Text. Businesses should also have procedures for investing cash
surpluses with appropriate levels of risk and return.
CA Sri Lanka
93
PROGRESS TEST
Return on equity = ?
If a business is in financial difficulties, what type of assets should be sold off first?
94
CA Sri Lanka
10
11
12
CA Sri Lanka
95
96
Return on equity =
+
+
Total sales
Cash sales, perhaps as a percentage of total sales
Credit sales, perhaps as a percentage of total sales
Rate of growth in sales, or seasonal variations in sales
Time taken by receivables to pay what they owe
Purchases on credit
Wages and salaries
Other cash expenses
Dividends
Taxation payments
Capital expenditure
CA Sri Lanka
20X3
20X4
ROCE
18
= 17%
105.6
16.5
= 13.4%
123.2
Net
operating
profit
margin
18
= 10%
180
16.5
= 8.9%
185.0
10
Asset
turnover
Sales
Capital employed
180
= 1.7 times
105.6
185
= 1.5 times
123.2
11
Current
ratio
Current assets
Current liabilities
13.6
= 1.6 : 1
8.4
11.9
= 1.3 : 1
9.2
12
Profitability
Return on capital employed has fallen from 20X3 to 20X4, caused by a decrease
in operating profit and an increase in capital employed. The fall in operating
profit may have been caused by an increase in costs, while the new investment
programme will have caused an increase in capital employed.
Asset turnover has fallen. Sales have only increased by 2.8% between 20X3 and
20X4 so the new investment programme may not yet have had a significant effect
on sales.
In the short term, the investment programme has increased assets and costs but
has not yet influenced sales.
Liquidity
The current ratio has deteriorated so the firm's ability to meet its short-term
obligations from its short-term resources has been reduced. The expenditure on
the investment programme may have decreased the cash balance between 20X3
and 20X4, causing the deterioration in liquidity.
CA Sri Lanka
97
98
CA Sri Lanka
100
CA Sri Lanka
CHAPTER
INTRODUCTION
One of the most important learning outcomes in this paper is that you
should be able to 'recommend alternative financial strategies for an
organisation'. The syllabus requires you to assess the implications for
shareholder value of alternative financial strategies. We start by looking
at short-term financial strategy in the form of working capital
management.
Knowledge Component
2
Corporate Financing Strategies
2.1
2.1.1
2.2
Working capital
management
2.2.1
2.2.2
101
CHAPTER CONTENTS
LEARNING
OUTCOME
2.1.1
2.2.1
2.1.1
4 Managing inventories
2.2.1
2.2.1
2.2.1
2.2.2
2.2.1
102
CA Sri Lanka
CA Sri Lanka
103
If the turnover periods for inventories and accounts receivable lengthen, or the
payment period to accounts payable shortens, then the operating cycle will
lengthen and the investment in working capital will increase.
Months
1.0
(2.5)
2.0
1.5
2.0
The company's cash operating cycle is two months. This can be illustrated
diagrammatically as follows.
104
CA Sri Lanka
Figure 4.1
0
Goods
purchased
2.5 3
4.5
Goods sold
to customers
Suppliers
paid
Cash received
from customers
The cash operating cycle is the period between the suppliers being paid and the
cash being received from the customers.
4 Managing inventories
An economic order quantity can be calculated as a guide to minimising costs in
managing inventory levels. However, bulk discounts can mean that a different
order quantity minimises inventory costs.
Almost every company carries inventories of some sort, even if they are only
inventories of consumables such as stationery. For a manufacturing business,
inventories in the form of raw materials, work in progress and finished goods,
may amount to a substantial proportion of the total assets of the business.
Some businesses attempt to control inventories on a scientific basis by balancing
the costs of inventory shortages against those of inventory holding. The 'scientific'
control of inventories may be analysed into three parts.
CA Sri Lanka
(a)
The economic order quantity (EOQ) model can be used to decide the
optimum order size for inventories which will minimise the costs of ordering
inventories plus inventory holding costs.
(b)
(c)
Uncertainty in the demand for inventories and/or the supply lead time may
lead a company to decide to hold buffer inventories in order to reduce or
eliminate the risk of 'stock-outs' (running out of inventory).
105
INVENTORY COSTS
Holding costs
Procuring costs
Ordering costs
Delivery costs
Shortage costs
Cost of inventory
QCh C0 D
+
Q
2
The more orders are made each year, the higher the ordering costs, but the
lower the holding costs (as less inventory is held).
(b)
QCh C0 D
+
2
Q
The order quantity, EOQ, which will minimise these total costs, is:
106
CA Sri Lanka
FORMULA TO LEARN
EOQ =
2C0D
Ch
2C0D
=
Ch
22040,000
= 2,000 units
0.4
2,000
Ordering costs
Handling costs
CA Sri Lanka
107
If an order is placed too late, the organisation may run out of inventory, a
stock-out, resulting in a loss of sales and/or a loss of production.
(b)
If an order is placed too soon, the organisation will hold too much inventory,
and inventory holding costs will be excessive.
Use of a re-order level builds in a measure of safety inventory and minimises the
risk of the organisation running out of inventory. This is particularly important
when the volume of demand or the supply lead time are uncertain.
The average annual cost of such a safety inventory would be:
Quantity of safety
inventory
(in units)
Inventory holding
cost
per unit per annum
The diagram below shows how the inventory levels might fluctuate with this
system. Points marked 'X' show the re-order level at which a new order is placed.
The number of units ordered each time is the EOQ. Actual inventory levels
sometimes fall below the safety inventory level, and sometimes the re-supply
arrives before inventories have fallen to the safety level. On average, however,
extra inventory holding will approximate the safety inventory. The size of the
safety inventory will depend on whether stock-outs (running out of inventory) are
allowed.
Figure 4.2
Inventory
level
Reorder level
Safety inventory level
Time
108
CA Sri Lanka
The maximum level acts as a warning signal to management that inventories are
reaching a potentially wasteful level.
Buffer safety inventory = Re-order level (Average usage Average lead time)
The buffer safety level acts as a warning to management that inventories are
approaching a dangerously low level and that stock-outs are possible.
Average inventory = Buffer safety inventory +
Re-order amount
2
This formula assumes that inventory levels fluctuate evenly between the buffer
safety (or minimum) inventory level and the highest possible inventory level (the
amount of inventory immediately after an order is received, safety inventory and
re-order quantity).
= 2 weeks
Re-order level
= 15,000 units
CA Sri Lanka
109
Average inventory
Re-order amount
2
50,000
= 27,600 units
2
This approach assumes that a business wants to minimise the risk of stock-outs at
all costs. In the modern manufacturing environment, stock-outs can have a
disastrous effect on the production process.
If, however, you are given a question where the risk of stock-outs is assumed to be
worth taking, and the costs of stock-outs are quantified, the re-order level may not
be calculated in the way described above. For each possible re-order level, and
therefore each possible level of buffer inventory, calculate:
The costs of holding buffer inventory per annum
The costs of stock-outs (Cost of one stock-out Expected number of stockouts per order Number of orders per year)
The expected number of stock-outs per order reflects the various levels by which
demand during the lead time could exceed the re-order level.
110
CA Sri Lanka
and ordering costs are Rs. 300 an order. The supplier offers a 3% discount for
orders of 60 units or more, and a discount of 5% for orders of 90 units or more.
What is the cost-minimising order size?
Solution
(a)
Rs
25,000
750
750
26,500
QUESTION
Bulk orders
Required
Calculate whether the company should order 1,000 units at a time in order to
secure an 8% discount.
CA Sri Lanka
111
ANSWER
The total annual cost at the economic order quantity of 500 units is as follows.
Rs
384,000
Purchases 4,000 Rs. 96
2,400
Ordering costs Rs. 300 (4,000/500)
2,400
Holding costs Rs. 96 10% (500/2)
388,800
The total annual cost at an order quantity of 1,000 units would be as follows.
Rs
353,280
Purchases Rs. 384,000 92%
1,200
Ordering costs Rs. 300 (4,000/1,000)
4,416
Holding costs Rs. 96 92% 10% (1,000/2)
358,896
The company should order the item 1,000 units at a time, saving Rs. (388,800
358,896) = Rs. 29,904 a year.
Reduced inventory levels mean that a lower level of investment in working capital
will be required.
JIT will not be appropriate in some cases. For example, a restaurant might find it
preferable to use the traditional economic order quantity approach for staple nonperishable food inventories but adopt JIT for perishable and 'exotic' items. In a
hospital, a stock-out could quite literally be fatal and so JIT would be quite
unsuitable.
You may be required to evaluate the benefits of introducing a JIT arrangement,
given certain assumptions about the costs and benefits.
112
CA Sri Lanka
CASE STUDY
Japanese car manufacturer Toyota was the first company to develop JIT (JIT was
originally called the Toyota production system). After the end of the Second World
War in 1945, Toyota recognised that it had much to do to catch up with the US
automobile manufacturing industry. The company was making losses. In Japan,
however, consumer demand for cars was weak, and consumers were very
resistant to price increases. Japan also had a bad record for industrial disputes.
Toyota itself suffered from major strike action in 1950.
The individual credited with devising JIT in Toyota from the 1940s was Taiichi
Ohno, and JIT techniques were developed gradually over time.
Ohno identified seven wastes, and worked to eliminate them from operations in
Toyota. Measures that were taken by the company included the following.
CA Sri Lanka
(a)
The aim of reducing costs was of paramount importance in the late 1940s.
Toyota was losing money, and market demand was weak, preventing price
rises. The only way to move from losses into profits was to cut costs, and
cost reduction was probably essential for the survival of the company.
(b)
The company aimed to level the flow of production and eliminate unevenness in
the work flow. Production levelling should help to minimise idle time while at
the same time allowing the company to achieve its objective of minimum
inventories.
(c)
The factory layout was changed. Previously all machines, such as presses,
were located in the same area of the factory. Under the new system, different
types of machines were clustered together in production cells.
(d)
(e)
(f)
The kanban system was eventually introduced, but a major problem with
its introduction was the elimination of defects in production. The kanban
system is a 'pull' system of production scheduling. Items are only produced
when they are needed. If a part is faulty when it is produced, the production
line will be held up until the fault is corrected.
113
Aibee buys a widget for Rs. 1,000 on 1 January 20X1, but does not pay until
31 December 20X1. Zygo relies on overdraft finance, which costs it 10% pa.
The effect is:
Rs
Net profit on sale of widget
100
Overdraft cost Rs. 1,000 10% pa
(100)
Actual profit after 12 months' credit
Nil
In other words, the entire profit margin has been wiped out in 12 months.
(b)
If Aibee had paid after six months, the effect would be:
Net profit
Overdraft cost Rs. 1,000 10% pa 6/12 months
Rs
100
(50)
50
114
If the cost of borrowing had been 18%, then the profit would have been
absorbed before seven months had elapsed. If the net profit were 5% and
borrowing costs were 15%, the interest expense would exceed the net profit
after four months.
CA Sri Lanka
QUESTION
Cost of receivables
Winterson Tools has an average level of accounts receivable of Rs. 2m at any time
representing 60 days outstanding. (Their terms are 30 days.) The firm borrows
money at 10% a year. The managing director is proud of the credit control: 'I only
had to write off Rs. 10,000 in bad debts last year', she says proudly.
Required
Explain whether she is right to be proud.
ANSWER
The managing director may be proud of the low level of bad debts, but customers
are taking an extra month to pay and this has a cost. At any one time, there is
Rs. 1m more money outstanding than there should be (30/60 days Rs. 2m) and
this costs Rs. 100,000 in interest charges (10% Rs. 1m).
The level of total credit can then have a significant effect on profitability. That
said, if credit considerations are included in pricing calculations, extending credit
can, in fact, increase profitability. If offering credit generates extra sales, then
those extra sales will have additional repercussions on:
(a)
(b)
The amount of money the company owes to its accounts payable (as it will
be increasing its supply of raw materials)
CA Sri Lanka
(a)
(b)
The procedures for controlling credit to individual customers and for debt
collection.
(c)
(d)
The cost of the additional finance required for any increase in the volume
of accounts receivable (or the savings from a reduction in accounts
receivable) this cost might be bank overdraft interest, or the cost of longterm funds (such as loan inventory or equity).
115
(e)
(f)
The ways in which the credit policy could be implemented for example:
(g)
(i)
(ii)
A discount could be offered for early payment the cost would be the
amount of the discounts taken.
New customers should give two good references, including one from a
bank, before being granted credit.
(b)
(c)
A new customer's credit limit should be fixed at a low level and only
increased if their payment record subsequently warrants it.
(d)
(e)
116
(i)
(ii)
CA Sri Lanka
(f)
(g)
The company could send a member of staff to visit the company concerned,
to get a first-hand impression of the company and its prospects. This would
be advisable in the case of a prospective major customer.
(b)
(c)
CA Sri Lanka
117
Customer
Alpha
Beta
Gamma
Delta
Limit
Rs '000
100
50
35
250
435
Utilisation
Rs '000
90
35
21
125
271
%
90
70
60
50
62.2
This might also contain other information, such as days sales outstanding.
Reviewed in aggregate, this can reveal the following.
(a)
(b)
(c)
The 'tightness' of the policy (it might be possible to increase profitable sales
by offering credit; on the other hand, perhaps the firm offers credit too
easily)
(b)
118
CA Sri Lanka
Rs. 10
Rs. 8.50
Rs. 2,400,000
The required rate of return on investments is 20%. Assume that the 25% increase
in sales would result in additional inventories of Rs. 100,000 and additional
accounts payable of Rs. 20,000.
Advise the company on whether or not to extend the credit period offered to
customers, if:
(a)
(b)
Existing customers do not change their payment habits, and only the new
customers take a full two months' credit
Solution
The change in credit policy is justifiable if the rate of return on the additional
investment in working capital would exceed 20%.
Extra profit
Contribution/sales ratio
Increase in sales revenue (25% Rs. 240,000)
Increase in contribution (15% Rs. 600,000)
(a)
CA Sri Lanka
15%
Rs. 600,000
Rs. 90,000
Rs
500,000
(200,000)
300,000
100,000
400,000
20,000
380,000
Rs. 90,000
= 23.7% required return of 20%
Rs. 380,000
119
(b)
Extra investment, if only the new accounts receivable take two months' credit
Rs
100,000
100,000
200,000
(20,000)
180,000
Rs. 90,000
= 50% required return of 20%
Rs. 180,000
In both case (a) and case (b) the new credit policy appears to be worthwhile.
QUESTION
Extension of credit
ANSWER
Current accounts receivable (1 month)
Accounts receivable after implementing the proposal (2 months)
Increase in accounts receivable
Financing cost (70,000 12.5%)
Annual contribution from additional sales (12 months 20%
Rs. 10,000)
Annual net benefit from extending credit period
120
Rs
(50,000)
120,000
70,000
(8,750)
24,000
15,250
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The overall debt collection policy of the firm should be such that the
administrative costs and other costs incurred in debt collection do not exceed the
benefits from incurring those costs.
Collecting debts is a two-stage process.
(a)
(b)
121
(v)
122
(a)
(b)
The interest charges saved or incurred as a result of the changes in the cash
flows of the company
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Thus:
(a)
(b)
(c)
(d)
Since the company can invest at 20% a year, the value of a reduction in
accounts receivable (a source of funds) is 20% of Rs. 1,835,616 each year in
perpetuity, that is, Rs. 367,123 a year.
(e)
Summary
Value of reduction in accounts receivable each year
Less discounts allowed each year (2% 50% Rs. 12,000,000)
Net benefit of new discount policy each year
Rs
367,123
120,000
247,123
100 t
1 %
(100 d)
Where:
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123
QUESTION
Cost of discount
ANSWER
The percentage cost of the discount =
100
(100 2)
365
20
= 1.0204118.25 1
= 1.446 1
= 44.6%
Grabbit Quick Co achieves current annual sales of Rs. 1,800,000. The cost of sales
is 80% of this amount, but bad debts average 1% of total sales, and the annual
profit is as follows.
Rs
1,800,000
Sales
(1,440,000)
Less cost of sales
360,000
(18,000)
Less bad debts
342,000
Profit
The current debt collection period is one month, and the management consider
that if credit terms were eased (Option A), the effects would be as follows.
124
CA Sri Lanka
Present
policy
1 month
1%
Option A
25%
2 months
3%
The company requires a 20% return on its investments. The costs of sales are 75%
variable and 25% fixed. Assume there would be no increase in fixed costs from the
extra revenue; and that there would be no increase in average inventories or
accounts payable. Which is the preferable policy, Option A or the present one?
Solution
The increase in profit before the cost of additional finance for Option A can be
found as follows.
(a)
Rs
Increase in contribution from additional sales
25% Rs. 1,800,000 40%*
Less increase in bad debts (3% Rs. 2,250,000) Rs. 18,000
Increase in annual profit
180,000
(49,500)
130,500
Rs
375,000
(150,000)
225,000
Rs. 45,000
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125
5.10 Factoring
Some companies use factoring and invoice discounting to help short-term
liquidity or to reduce administration costs. Insurance, particularly of overseas
debts, can also help reduce the risk of bad debts.
A factor is defined as 'a doer or transactor of business for another', but a factoring
organisation specialises in trade debts, and manages the debts owed to a client (a
business customer) on the client's behalf.
Factoring is an arrangement to have debts collected by a factor company, which
advances a proportion of the money it is due to collect.
(a)
(b)
Credit protection for the client's debts, whereby the factor takes over the
risk of loss from bad debts and so 'insures' the client against such losses.
This is known as a non-recourse service. However, if a non-recourse
service is provided the factor, not the firm, will decide what action to take
against non-payers.
(c)
126
(a)
The business can pay its suppliers promptly, and so be able to take
advantage of any early payment discounts that are available.
(b)
(c)
(d)
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(e)
The managers of the business do not have to spend their time on the
problems of slow paying accounts receivable.
(f)
The business does not incur the costs of running its own sales ledger
department, and can use the expertise of debtor management that the
factor has.
A company makes annual credit sales of Rs. 1,500,000. Credit terms are 30 days,
but its debt administration has been poor and the average collection period has
been 45 days with 0.5% of sales resulting in bad debts which are written off.
A factor would take on the task of debt administration and credit checking, at an
annual fee of 2.5% of credit sales. The company would save Rs. 30,000 a year in
administration costs. The payment period would be 30 days.
The factor would also provide an advance of 80% of invoiced debts at an interest
rate of 14% (3% over the current base rate). The company can obtain an overdraft
facility to finance its accounts receivable at a rate of 2.5% over the base rate.
Should the factor's services be accepted? Assume a constant monthly turnover.
Solution
It is assumed that the factor would advance an amount equal to 80% of the
invoiced debts, and the balance 30 days later.
(a)
The current situation is as follows, using the company's debt collection staff
and a bank overdraft to finance all debts.
Credit sales
Average credit period
Rs. 1,500,000 pa
45 days
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24,966
7,500
30,000
62,466
127
(b)
The cost of the factor. 80% of credit sales financed by the factor would be
80% of Rs. 1,500,000 = Rs. 1,200,000. For a consistent comparison, we must
assume that 20% of credit sales would be financed by a bank overdraft. The
average credit period would be only 30 days. The annual cost would be as
follows.
Rs
Factor's finance 30/365 Rs. 1,200,000 14%
13,808
Overdraft 30/365 Rs. 300,000 13.5%
3,329
17,137
Cost of factor's services: 2.5% Rs. 1,500,000
37,500
Cost of the factor
54,637
(c)
Conclusion. The factor is cheaper. In this case, the factor's fees exactly equal
the savings in bad debts (Rs. 7,500) and administration costs (Rs. 30,000).
The factor is then cheaper overall because it will be more efficient at
collecting debts. The advance of 80% of debts is not needed, however, if the
company has sufficient overdraft facility because the factor's finance charge
of 14% is higher than the company's overdraft rate of 13.5%.
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CA Sri Lanka
A client should only want to have some invoices discounted when they have a
temporary cash shortage, and so invoice discounting tends to consist of one-off
deals. Confidential invoice discounting is an arrangement whereby a debt is
confidentially assigned to the factor, and the client's customer will only become
aware of the arrangement if they do not pay their debt to the client.
If a client needs to generate cash, they can approach a factor or invoice discounter,
who will offer to purchase selected invoices and advance up to 75% of their value.
At the end of each month, the factor will pay over the balance of the purchase
price, less charges, on the invoices that have been settled in the month.
(a)
When goods are sold abroad, the customer might ask for credit. Exports take
time to arrange, and there might be complex paperwork. Transporting the
goods can be slow, if they are sent by sea. These delays in foreign trade
mean that exporters often build up large investments in inventories and
accounts receivable. These working capital investments have to be financed
somehow.
(b)
The risk of bad debts can be greater with foreign trade than with domestic
trade. If a foreign debtor refuses to pay a debt, the exporter must pursue the
debt in the debtor's own country, where procedures will be subject to the
laws of that country.
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129
(a)
(b)
(c)
Discounting bills of exchange. This is where a bank buys the bill before it is
due and credits the value of the bill after a discount charge to the company's
account.
(d)
Methods of minimising bad debt risks are broadly similar to those for domestic
trade. An exporting company should vet the creditworthiness of each customer,
and grant credit terms accordingly.
5.12.3 Export factoring
The buyer (a foreign buyer, or a Sri Lankan importer) and the seller (a Sri Lankan
exporter or a foreign supplier) first of all agree a contract for the sale of the goods,
which provides for payment through a documentary credit. The buyer then
requests a bank in their country to issue a letter of credit in favour of the
exporter. The issuing bank, by issuing its letter of credit, guarantees payment to
the beneficiary.
130
CA Sri Lanka
You might be wondering why export credit insurance should be necessary, when
exporters can pursue non-paying customers through the courts in order to
obtain payment. The answer is that:
(a)
(b)
There are various reasons why non-payment might happen. (Export credit
insurance provides insurance against non-payment for a variety of risks in
addition to the buyer's failure to pay on time.)
Not all exporters take out export credit insurance because premiums are very high
and the benefits are sometimes not fully appreciated. If they do, they will obtain
an insurance policy from a private insurance company that deals in export credit
insurance.
5.12.7 Overseas accounts receivable; general policies
There are also a number of general credit control policies that can be particularly
important when dealing with overseas customers.
(a)
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Prior to the sale, the customer's credit rating should be checked, and the
terms of the contract specified. One key term may be demanding the use of
an irrevocable letter of credit as a condition of release of goods. The terms
of the remittance and the bank to be used should be specified.
131
(b)
(c)
(d)
The cost of lost cash discounts can be calculated by comparing the saving from the
discount with the opportunity cost of investing the cash used.
132
CA Sri Lanka
The cost of lost cash discounts can also be estimated by the formula:
365
100 t
1 %
(100 d)
Where: d
t
This is the same formula that was used for accounts receivable.
Suppose that X Co can invest cash to obtain an annual return of 25%, and that
there is an invoice from the supplier for Rs. 1,000. The two alternatives are as
follows.
Refuse
Accept
discount
discount
Rs
Rs
Payment to supplier
1,000.0
980
Less: Return from investing Rs. 980 between day 10
and day 45:
Rs. 980 35/365 25%
(23.5)
980
Net cost
976.5
It is cheaper to refuse the discount because the investment rate of return on cash
retained, in this example, exceeds the saving from the discount.
Although a company may delay payment beyond the final due date, thereby
obtaining even longer credit from its suppliers, such a policy would generally be
inadvisable. Unacceptable delays in payment will worsen the company's credit
rating, and additional credit may become difficult to obtain.
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133
134
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Figure 4.3
Conservative
financing
Aggressive
financing
ST financing
ST financing
Non-current assets
time
Fluctuating current assets together with permanent current assets (the core
level of investment in inventory and receivables) form part of the working capital
of the business, which may be financed by either long-term funding (including
equity capital) or by current liabilities (short-term funding).
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(a)
(b)
Aggressive financing approach. Not only are fluctuating current assets all
financed out of short-term sources, but so are some of the permanent
current assets. This policy represents an increased risk of liquidity and
cash flow problems, although potential returns will be increased if shortterm financing can be obtained more cheaply than long-term finance. It
enables greater flexibility in financing.
(c)
135
Industry norms
Products
Management issues
136
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CHAPTER ROUNDUP
All entities need liquid resources to fund working capital needs. Short-term
financial strategy involves planning to ensure enough day-to-day cash flow and is
determined by working capital management. It involves achieving a balance
between the requirement to minimise the risk of insolvency and the requirement
to maximise profit.
The working capital that an organisation holds has to be financed, and investment
in working capital can be a significant drain on the resources that a business has.
Working capital policy involves investment decisions and financing decisions.
The cash operating cycle is the period of time which elapses between the point
at which cash begins to be expended on the production of a product and the
collection of cash from a purchaser.
Uncertainties in demand and lead times taken to fulfil orders mean that
inventory will be ordered once it reaches a re-order level (maximum usage
maximum lead time).
Offering credit has a cost: the value of the interest charged on an overdraft to
fund the period of credit, or the interest lost on the cash not received and
deposited in the bank. An increase in profit from extra sales resulting from
offering credit could offset this cost.
The benefits of action to collect debts must be greater than the costs incurred.
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137
138
Invoice discounting is the purchase (by the provider of the discounting service)
of trade debts at a discount. Invoice discounting enables the company from which
the debts are purchased to raise working capital.
There are different ways in which the funding of the current and non-current
assets of a business can be achieved by employing long- and short-term sources
of funding.
CA Sri Lanka
PROGRESS TEST
WW Co has a current ratio of 2. Receivables are Rs. 3 million and current liabilities
are Rs. 2 million.
What are inventory days if cost of sales is Rs. 10 million per annum?
A
B
C
D
36.5 days
91.25 days
14.6 days
243.3 days
TS Co has daily demand for ball bearings of 40 a day for each of the 250 working
days (50 weeks) of the year. The ball bearings are purchased from a local supplier
for Rs. 2 each. The cost of placing an order is Rs. 64 per order, regardless of the
size of the order. The inventory holding costs, expressed as a percentage of
inventory purchase price, is 25% per annum.
What is the economic order quantity?
A
B
C
D
XYZ Co has annual credit sales of Rs. 20 million and accounts receivable of Rs. 4
million. Working capital is financed by an overdraft at 12% interest per year.
Assume 365 days in a year.
What is the annual financial effect if management reduces the collection period to
60 days by offering an early settlement discount of 1% that all customers adopt?
A
B
C
D
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139
ABC Co offers an early settlement discount of 2% to its customers if they pay cash
instead of taking 60 days' credit.
What is the annualised percentage cost of this discount to ABC?
A
B
C
D
10
140
12%
13%
6%
18%
CA Sri Lanka
To reduce the risk of system breakdown by holding high levels of working capital.
The core level of investment in inventory and receivables. This is the minimum
level of current assets that an entity needs to continue operation.
Aggressive working capital financing implies a relatively high amount of shortterm finance which is risky because it may not be renewed when required, and if
renewed, the finance % payable may change from previously.
Long-term finance is expensive the per annum rates are higher, because
long-term loans are viewed as riskier from the lenders' perspective. In additional,
long-term finance is less likely to be in the form of a 'drawdown' facility in other
words, with an overdraft, borrowers are only charged for the amount they borrow
under their facility. With long-term loans, the full amount tends to be borrowed
immediately, whether it is all required at that point or not.
The answer is A.
Current ratio = current assets/current liabilities = 2
Here = (Rs. 3m + inventory)/Rs. 2m = 2
So inventory = Rs. 1m
If cost of sales is Rs. 10m then inventory days = (1/10) 365 = 36.5 days.
The answer is C.
Annual demand = 40 250 = 10,000 ball bearings = D
Order cost = Rs. 64 = Co
Holding cost per year per unit = 25% of Rs. 2 = Rs. 0.50 = Ch
EOQ =
2C0D
Ch
26410,000
0.5
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141
The answer is B.
The current collection period is 4/20 365 = 73 days.
Therefore a reduction to 60 days would be a reduction of 13 days.
Hence 13/365 Rs. 20m = Rs. 712,329 reduction in receivables.
Finance cost saving = Rs. 712,329 12% = Rs. 85,479.
Cost of discount = 1% Rs. 20 million = Rs. 200,000 per annum.
Net cost = Rs. 200,000 Rs. 85,479 = Rs. 114,521.
The answer is B.
The annual cost is:
365
100 t
1 %
100 d
142
The answer is A. Aggressive working capital finance means using more short-term
finance (and less long-term). Short-term finance is cheaper but it is risky it may
not be renewed when required and finance rates may change when they are
renewed. C describes a conservative financing policy. D is describing a more
aggressive working capital investment policy (not finance).
CA Sri Lanka
CHAPTER
INTRODUCTION
In Part B of this study text we consider various aspects of financing decisions. In
the first few chapters of this part, we shall look at how businesses determine
their long-term capital structure, before moving on to examine the
consequences of choosing a particular capital structure.
When sources of long-term finance are used, large sums are usually involved,
and so the financial manager needs to consider all the options available with
care, looking at the possible effects on the company in the long term.
In this chapter, we describe the different forms of share capital, and go on to
consider other long-term sources of finance in Chapters 6 and 7. The learning
outcomes require you to identify and evaluate optimal strategies for the
satisfaction of long-term financing requirements. You should therefore
concentrate on the reasons why different methods are used and their
advantages and disadvantages.
Knowledge Component
2
Corporate Financing Strategies
2.3
Equity financing
2.3.1
2.3.2
2.3.5
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CHAPTER CONTENTS
1 Capital markets
LEARNING
OUTCOME
2.3.1
2.3.1, 2.3.2
3 Rights issues
2.3.1, 2.3.2
2.3.5
1 Capital markets
The aim of this section is to give you an insight into the role of capital markets in
helping businesses and to introduce you to some important terminology.
Primary markets
As primary markets, they enable organisations to raise new finance, by
issuing new shares or new debentures. Capital markets make it easier for
companies to raise new long-term finance than if they had to raise funds
privately by contacting investors individually. In Sri Lanka, a company must
have public company status (be a plc) to be allowed to raise finance from the
public on a capital market.
(b)
Secondary markets
As secondary markets, they enable existing investors to sell their
investments, should they wish to do so. The marketability of securities is a
very important feature of the capital markets, because investors are more
willing to buy investments if they know that they could sell them easily,
should they wish to.
144
CA Sri Lanka
(c)
Realisation of value
When a company comes to the stock market for the first time, and 'floats' its
shares on the market, the owners of the company can realise some of the
value of their shares in cash, because they will offer a proportion of their
personally held shares for sale to new investors.
(d)
GOVERNMENT
(budget deficit)
CA Sri Lanka
Intermediaries
Banks
Building societies
Insurance companies
and pension funds
Unit trust/investment
trust companies
Suppliers
of funds
INDIVIDUALS
(as savers and
investors)
FIRMS
(with long-term
funds to invest)
Stock exchanges
Venture capital
organisations
GOVERNMENT
(budget surplus)
145
Easier to
seek growth
by acquisition
Improved marketability
of shares
Enhanced public
image
Original owners
realising holding
(b)
(c)
146
CA Sri Lanka
In May 2012, Facebook launched one of the largest IPOs ever on the Nasdaq stock
exchange, at $38 per share, valuing the company at $104 billion. Many questioned
whether this was overly ambitious, given that the company's previous year net
income figure was $1 billion. As a result, the share price fell in early trading and
fell further over the next four months to a low of $17.55 per share in September
2012. Since then, the share price has recovered, and on 19 August 2014 it was
$75.29.
147
How many shares would be issued, and how much in total would be raised, if
LMN Co chooses:
(i) To maximise the total amount raised?
(ii) To issue exactly 4,000,000 shares?
(b)
Mr X, a private investor, has applied for 12,000 shares at a price of Rs. 5.50
and has sent a cheque for Rs. 66,000 to the issuing house that is handling the
issue. In both cases (a)(i) and (ii), how many shares would be issued to Mr X,
assuming that any partial acceptance of offers would mean allotting shares
to each accepted applicant in proportion to the number of shares applied
for? How much will Mr X receive back out of the Rs. 66,000 he has paid?
Solutions
(a)
Price
Rs
6.00
5.50
5.00
4.50
4.00
3.50
3.00
(i)
148
Cumulative number
of shares applied for
50,000
150,000
450,000
900,000
2,000,000
3,500,000
6,000,000 (4,000,000 max)
Amount raised if
price is selected, before
deducting issue costs
Rs
300,000
825,000
2,250,000
4,050,000
8,000,000
12,250,000
12,000,000
To maximise the total amount raised, the issue price should be Rs. 3.50.
The total raised before deducting issue costs would be Rs. 12,250,000.
CA Sri Lanka
(b)
(ii)
To issue exactly 4,000,000 shares, the issue price must be Rs. 3.00. The
total raised would be Rs. 12,000,000, before deducting issue costs.
(i)
(ii)
2.3 A Placing
A placing is an arrangement whereby the shares are not all offered to the public,
but instead, the sponsoring market maker arranges for most of the issue to be
bought by a small number of investors, usually institutional investors such as
pension funds and insurance companies.
2.3.1 The choice between an offer for sale and a placing
Is a company likely to prefer an offer for sale of its shares, or a placing?
CA Sri Lanka
(a)
(b)
(c)
(d)
However, most of the shares will be placed with a relatively small number
of (institutional) shareholders, which means that most of the shares are
unlikely to be available for trading after the flotation, and that
institutional shareholders will have control of the company.
149
2.4 An introduction
By this method of obtaining a quotation, no shares are made available to the
market, neither existing nor newly created shares; nevertheless, the stock market
grants a quotation. This will only happen where shares in a large company are
already widely held, so that a market can be seen to exist. A company might want
an introduction to obtain greater marketability for the shares, a known share
valuation for inheritance tax purposes and easier access in the future to additional
capital.
2.5 Underwriting
A company about to issue new securities in order to raise finance might decide to
have the issue underwritten. Underwriters are financial institutions which agree
(in exchange for a fixed fee, perhaps 2.25% of the finance to be raised) to buy at
the issue price any securities which are not subscribed for by the investing
public.
Underwriters remove the risk of a share issue being under-subscribed, but at a
cost to the company issuing the shares. It is not compulsory to have an issue
underwritten. Ordinary offers for sale are most likely to be underwritten although
rights issues may be as well.
150
Underwriting costs
Stock market listing fee (the initial charge) for the new securities
Fees of the issuing house, solicitors, auditors and public relations consultant
Charges for printing and distributing the prospectus
Advertising in national newspapers
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Current market
conditions
WHAT PRICE
TO SET?
Future trading
prospects
Companies will be keen to avoid overpricing an issue, which could result in the
issue being undersubscribed, leaving underwriters with the unwelcome task of
having to buy up the unsold shares.
On the other hand, if the issue price is too low then the issue will be
oversubscribed and the company would have been able to raise the required
capital by issuing fewer shares.
The share price of an issue is usually advertised as being based on a certain P/E
ratio, the ratio of the price to the company's most recent earnings per share figure
in its audited accounts. The issuer's P/E ratio can then be compared by investors
with the P/E ratios of similar quoted companies.
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151
When a company's directors look for help from a venture capital institution, they
must recognise that:
(a)
(b)
(c)
152
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3 Rights issues
A rights issue is a way for a company to raise funds. You will need to understand
how it works and be able to do the necessary price calculations.
A rights issue is the raising of new capital by giving existing shareholders the
right to subscribe to new shares in proportion to their current holdings. These
shares are usually issued at a discount to market price. A shareholder not wishing
to take up a rights issue may sell the rights.
A dilution is the reduction in the earnings and voting power per share caused by
an increase or potential increase in the number of shares in issue.
CA Sri Lanka
(a)
Rights issues are cheaper than offers for sale to the general public. This is
partly because no prospectus is generally required (provided that the issue
is for less than 10% of the class of shares concerned), partly because the
administration is simpler and partly because the cost of underwriting will
be less.
(b)
153
market price, to make them attractive to investors. A rights issue secures the
discount on the market price for existing shareholders, who may either keep
the shares or sell them if they wish.
(c)
(d)
The finance raised may be used to reduce gearing in book value terms by
increasing share capital and/or to pay off long-term debt which will reduce
gearing in market value terms.
(b)
(c)
During the time between the announcement of the rights issue and the
date of subscription the market price of shares may fall, and the issue
price of rights will be above the market price, with the result that the rights
issue will fail.
(d)
QUESTION
Rights issue
ABC Co can achieve a profit after tax of 20% on the capital employed. At present
its capital structure is as follows.
Rs Mn
200
200,000 ordinary shares
100
Retained earnings
300
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CA Sri Lanka
The directors propose to raise an additional Rs. 126 million from a rights issue.
The current market price is Rs. 1,800.
Required
(a)
Calculate the number of shares that must be issued if the rights price is:
Rs. 1,600; Rs. 1,500; Rs. 1,400 and Rs. 1,200.
(b)
ANSWER
The earnings at present are 20% of Rs. 300 million = Rs. 60 million. This gives
earnings per share of Rs. 300. The earnings after the rights issue will be 20% of
Rs. 426 million = Rs. 85.2 million.
No. of new shares
EPS
Rights price
(Rs. 126 million rights
(Rs. 85.2 million total
Dilution
price)
no. of
shares)
Rs
Rs
Rs
1,600
78,750
306
+6
1,500
84,000
300
1,400
90,000
294
6
1,200
105,000
279
21
Note that at a high rights price the earnings per share are increased, not diluted.
The breakeven point (zero dilution) occurs when the rights price is equal to the
capital employed per share:
Rs. 300 million 200,000 = Rs. 1,500.
3.4 The market price of shares after a rights issue: the theoretical
ex-rights price
After the announcement of a rights issue, share prices generally fall.
This temporary fall is due to uncertainty in the market about the consequences
of the issue, with respect to future profits, earnings and dividends.
After the issue has actually been made, the market price per share will normally
fall, because there are more shares in issue and the new shares were issued at a
discount price.
When a rights issue is announced, all existing shareholders have the right to
subscribe for new shares, and so there are rights attached to the existing
shares. The shares are therefore described as being traded as 'cum rights'. On the
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155
first day of dealings in the newly issued shares, the rights no longer exist and the
old shares are now 'ex rights' (without rights attached).
In theory, the new market price will be the consequence of an adjustment to allow
for the discount price of the new issue, and a theoretical ex-rights price can be
calculated (the shares are ex rights because the new shares have been issued and
the rights no longer exist).
QUESTION
XYZ Co has 1,000,000 ordinary shares of Rs. 100 in issue, which have a market
price on 1 September of Rs. 210 per share. The company decides to make a rights
issue, and offers its shareholders the right to subscribe for one new share at
Rs. 150 each for every four shares already held. After the announcement of the
issue, the share price fell to Rs. 195, but by the time just prior to the issue being
made, it had recovered to Rs. 200 per share. This market value just before the
issue is known as the cum-rights price.
Required
Calculate the theoretical ex-rights price.
ANSWER
Value of the portfolio for a shareholder with 4 shares before the rights issue:
Rs
800
150
950
So the value per share after the rights issue (or TERP) is:
Rs. 950
= Rs. 190
5
FORMULA TO LEARN
An alternative method would be to use the following formula:
Theoretical ex-rights price =
156
1
((4 Rs. 200) + Rs. 150) = Rs. 950 = Rs. 190
4+1
5
CA Sri Lanka
+
(N +1)
Yield on existing funds
(N +1)
QUESTION
Calculate the yield-adjusted theoretical ex-rights price using the same data for
XYZ Co as above, with the additional information that rate of return on new funds
= 12%, and on existing funds = 8%.
ANSWER
200 4 150 0.12
Yield-adjusted theoretical ex-rights price =
+
= Rs. 205.
5 5 0.08
Note: An exam question may give you the net present value of the project which
the rights issue has been raised for. The yield adjusted ex-rights price will then
simply be:
Original market capitalisation of the company + NPV of the project + Proceeds of rights issue
New number of shares in issue
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157
This means that the value of a right attaching to each existing share is Rs. 10. If a
holder of four existing shares exercises their rights to buy one new share, and then
sells it, their gain will be 190 150 = Rs. 40, in other words (4 Rs. 10) or the
difference between the theoretical ex-rights price and the rights issue price.
The value of rights is the theoretical gain a shareholder would make by
exercising their rights.
QUESTION
(a)
(i)
(ii)
(b)
158
CA Sri Lanka
ANSWER
(a)
Rs
10.50
1.80
12.30
(b)
(i)
Theoretical ex-rights price = Rs. 12.30/6 shares = Rs. 2.05 per share.
(ii)
The value of the rights for each new share is Rs. 2.05 Rs. 1.80 =
Rs. 0.25. The value of the rights for each existing share is therefore
Rs. 0.25/5 shares = Rs. 0.05 per share.
Rights issue
Number of shares in issue (Rs. 50 million/Rs. 0.25 per
share)
New shares in rights issue (1 for 5)
Total number of shares after the issue
200
40
240
Rs Mn
50
(15)
35
This means buying the new shares at the rights price. Shareholders who do
this will maintain their percentage holdings in the company by subscribing
for the new shares.
(b)
159
their shares will be less (on the assumption that the actual market price after
the issue is close to the theoretical ex-rights price).
(c)
For example, a shareholder may sell enough of their rights to enable them to
buy the remaining rights shares they are entitled to with the sale proceeds,
and so keep the total market value of their shareholding in the company
unchanged.
(d)
Do nothing
The expected rate of return on the investment (and the risk associated
with it)
(b)
The return obtainable from other investments (allowing for the associated
risk)
QUESTION
Rights issue
BD Co has issued 3,000,000 ordinary shares of Rs. 100 each, which are at present
selling for Rs. 400 per share. The company plans to issue rights to purchase one
new equity share at a price of Rs. 320 per share for every three shares held. A
shareholder who owns 900 shares thinks that he will suffer a loss in his personal
wealth because the new shares are being offered at a price lower than market
value.
Required
On the assumption that the actual market value of shares will be equal to the
theoretical ex-rights price, discuss the effect on the shareholder's wealth if:
(a)
(b)
(c)
160
CA Sri Lanka
ANSWER
Value of the portfolio for a shareholder with 3 shares before the rights issue:
Rs
3 shares @ Rs. 400
1,200
1 share @ Rs. 320
320
4
1,520
So the value per share after the rights issue (or TERP) is 1,520/4 = Rs. 380.
Alternative solution
1
((3 Rs. 400) + Rs. 320)) = Rs. 380 per share.
3+1
Rs
380
(320)
60
Rs. 60
= Rs. 20.
3
We will assume that a shareholder is able to sell his rights for Rs. 20 per existing
share held.
(a)
Rs
18,000
342,000
360,000
Rs. 360,000
The shareholder would neither gain nor lose wealth. He would not be
required to provide any additional funds to the company, but his
shareholding as a proportion of the total equity of the company will be
lower.
(b)
If the shareholder exercises half of the rights (buys 450/3 = 150 shares at
Rs. 320) and sells the other half:
Rs
9,000
Sale value of rights (450 Rs. 20) or (150 Rs. 601)
399,000
Market value of his 1,050 shares, ex rights ( Rs. 380)
408,000
Total value of 900 shares cum rights ( Rs. 400)
Additional investment (150 Rs. 320)
CA Sri Lanka
360,000
48,000
408,000
161
The shareholder would neither gain nor lose wealth, although he will have
increased his investment in the company by Rs. 480.
(c)
If the shareholder does nothing, but all other shareholders either exercise
their rights or sell them, he would lose wealth as follows.
Rs
360,000
Market value of 900 shares cum rights ( Rs. 400)
(342,000)
Market value of 900 shares ex rights ( Rs. 3.80)
18,000
Loss in wealth
It follows that the shareholder, to protect his existing investment, should
either exercise his rights or sell them to another investor. If he does not
exercise his rights, the new securities he was entitled to subscribe for might
be sold for his benefit by the company, and this would protect him from
losing wealth.
Note. Make sure you practise the calculations in this chapter so that you can do
them competently and quickly if required.
A scrip dividend effectively converts retained earnings into issued share capital.
When the directors of a company would prefer to retain funds within the business
but consider that they must pay at least a certain amount of dividend, they might
offer equity shareholders the choice of a cash dividend or a scrip dividend. Each
shareholder would decide separately which to take.
4.1.1 Advantages of scrip dividends
162
(a)
(b)
Investors may be able to obtain tax advantages if dividends are in the form
of shares.
CA Sri Lanka
(c)
(d)
A small scrip issue will not dilute the share price significantly. If however
cash is not offered as an alternative, empirical evidence suggests that the
share price will tend to fall.
(e)
A share issue will decrease the company's gearing, and may therefore
enhance its borrowing capacity.
We discuss scrip dividends further, the dividends paid by the issue of additional
company shares, in Section 2.2 of Chapter 10.
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163
(a)
CASE STUDY
(e)
164
(a)
It can be hard to arrive at a price that will be fair both to the vendors and
to any shareholders who are not selling shares to the company.
(b)
(c)
Some shareholders may suffer from being taxed on a capital gain following
the purchase of their shares rather than receiving dividend income.
CA Sri Lanka
CHAPTER ROUNDUP
This chapter gave you an insight into the role of capital markets in helping
businesses and introduced you to some important terminology.
A rights issue is a way for a company to raise funds. You will need to understand
how it works and be able to do the necessary price calculations.
Scrip dividends, bonus issues and share splits all present opportunities to
restructure equity.
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165
PROGRESS TEST
Which of the following sources of finance to companies is the most widely used in
practice?
A
B
C
D
Bank borrowings
Rights issues
New share issues
Retained earnings
Identify four reasons why a company may seek a stock market listing.
A company's shares have a nominal value of Re. 1 and a market value of Rs. 3. In a
rights issue, one new share would be issued for every three shares at a price of
Rs. 2.60. What is the theoretical ex-rights price?
A company offers to pay a dividend in the form of new shares which are worth
more than the cash alternative which is also offered. What is this dividend in the
form of shares called?
Match A/B to (i)/(ii), to express the difference between a share split and a bonus
issue.
A
B
(i)
(ii)
Which of the following is least likely to be a reason for seeking a stock market
flotation?
A
B
C
D
A bonus issue
A share split
CA Sri Lanka
2,000
1,500
300
3,800
10,350
Total assets
Ordinary shares (nominal value 50c)
Reserves
12% loan notes 2X12
Current liabilities
Trade payables
Overdraft
Total equity and liabilities
Other information:
Price/earnings ratio of Tirwen Co:
Overdraft interest rate:
Tax rate:
Sector averages: debt/equity ratio (book value):
interest cover:
Rs '000
6,550
2,000
1,500
4,500
1,100
1,250
2,350
10,350
15.24
7%
30%
100%
6 times
Ignoring issue costs and any use that may be made of the funds raised by the
rights issue, calculate the theoretical ex-rights price per share.
10
What alternative actions are open to the owner of 1,000 shares in Tirwen Co as
regards the rights issue? Determine the effect of each of these actions on the
wealth of the investor.
11
Calculate the current earnings per share and the revised earnings per share if the
rights issue funds are used to redeem some of the existing loan notes.
CA Sri Lanka
167
A(i); B(ii)
The answer is C. Shareholders have the option of renouncing the rights and selling
them on the market.
Issue price of new shares = 85% Rs. 4.00 = Rs. 3.40. The theoretical ex-rights
price = ((5 Rs. 4.00) + Rs. 3.40)/6 = Rs. 3.90.
The value of rights per existing share = (Rs. 3.90 Rs. 3.40)/5 = Rs. 0.10
10
Choices open to the investor are to either refuse the offer, take up the offered
rights or sell the rights (or a combination).
If the investor does not subscribe to the offer, a loss of Rs. 100 will occur, being the
difference between the value of 1,000 shares before the rights issue (Rs. 4,000)
and the value of 1,000 shares after the rights issue (Rs. 3,900).
If the investor takes up the offered rights, they will purchase an additional 200
shares at Rs. 3.40 = Rs. 680. This will give the investor 1,200 shares at Rs. 3.90
each = Rs. 4,680. This is equal to the sum of the value of 1,000 shares before the
rights issue (Rs. 4,000) plus the cash subscribed. As a result there is no overall
change in wealth. Some cash has merely been transferred into shares.
If the rights are sold (1,000 rights at Rs. 0.10 each) then again there is no overall
change in wealth. The Rs. 100 proceeds plus the value of the shares after the rights
issue (1,000 shares at Rs. 3.90 each = Rs. 3,900) is the same as the value of the
holding before the rights issue. Part of the wealth has been converted from shares
into cash.
11
168
CA Sri Lanka
If this is entirely used to redeem loan notes, this will save Rs. 2,500,000 @ 12% =
Rs. 300,000.
Rs
1,500,000
Rs. 1.05m grossed up for 30% tax rate
Earnings before tax
540,000
Rs. 4.5m @ 12%
Loan note interest
87,500
Rs. 1.25m @ 7%
Overdraft interest
2,127,500
Current PBIT
(327,500)
Rs. 540k + Rs. 87.5k Rs. 300k
Revised interest cost
1,800,000
Revised profit before tax
(540,000)
Tax at 30%
1,260,000
Revised profit after tax
Total new shares (No.)
4,800,000
Revised EPS
26.25
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169
170
CA Sri Lanka
CHAPTER
INTRODUCTION
As well as being financed by its owners, the shareholders, a company is
likely to be financed by lenders who provide it with debt finance. We
look in this chapter at the most important forms of long-term debt
finance. We examine the practical factors that determine whether
lenders provide finance, how much they provide and on what terms.
Remember that you may need to use the detail in this chapter to explain
why organisations choose particular sources of finance. You must always
make recommendations that are suitable for the specific type of entity,
so the last two sections look at the specific financing for multinationals
and small entities.
Knowledge Component
2
Corporate Financing Strategies
2.4
Debt financing
2.4.1
2.4.2
171
CHAPTER CONTENTS
1 Medium-term finance
LEARNING
OUTCOME
2.4.1
2 Long-term debt
2.4.1, 2.4.2
3 Convertible securities
2.4.1, 2.4.2
4 Warrants
2.4.1
2.4.1
2.4.1
1 Medium-term finance
This section explains loan finance and how a lender will decide what interest rate
to charge a customer.
(b)
(c)
They are particularly useful for small entities who can have problems
raising capital
CA Sri Lanka
It is higher risk lending than bank loans so tends to attract a higher rate of
interest. There may also be warrants attached (see Section 4) entitling the holder
to subscribe for future equity.
1.3 Creditworthiness
From the lender's viewpoint, the interest rate charged on loan finance will
normally reflect the risk associated with the loan, and an assessment of a
company's creditworthiness will be made.
Risk issue
Purpose
Amount
Repayment
Time period
Security
2 Long-term debt
In this section we look at the terminology used to describe long-term debt and the
different types of debt finance that are available.
2.1 Bonds
The term bonds describes various forms of long-term debt a company may issue.
Bonds come in various forms, including:
Redeemable
Irredeemable
Floating rate
Zero coupon
Convertible
Bonds have a nominal value, which is the debt owed by the company, and
interest is paid at a stated 'coupon' on this amount. For example, if a company
issues 10% bonds, the coupon will be 10% of the nominal value of the bonds, so
CA Sri Lanka
173
that Rs. 100 of bonds will receive Rs. 10 interest each year. The rate quoted is the
gross rate, before tax.
Unlike shares, debt is often issued at par, ie with Rs. 100 payable per Rs. 100
nominal value. Where the coupon rate is fixed at the time of issue, it will be set
according to prevailing market conditions given the credit rating of the company
issuing the debt. Subsequent changes in market (and company) conditions will
cause the market value of the bond to fluctuate, although the coupon will stay
at the fixed percentage of the nominal value.
2.2 Debentures
A debenture is a written acknowledgement of a debt by a company, usually given
under its seal and normally containing provisions as to payment of interest and
the terms of repayment of principal. A bond may be secured on some or all of the
assets of the company or its subsidiaries.
Debentures are defined as the written acknowledgement of a debt incurred by a
company, normally containing provisions about the payment of interest and the
eventual repayment of capital. The terms of the bond are set out in a trust deed.
2.3 Security
Bonds will often be secured. Security may take the form of either a fixed charge
or a floating charge.
(a)
Fixed charge
Security would be related to a specific asset or group of assets, typically
land and buildings. The company would be unable to dispose of the asset
without providing a substitute asset for security, or without the lender's
consent.
(b)
Floating charge
With a floating charge on certain assets of the company (for example
inventory or receivables), the lender's security in the event of a default of
payment is whatever assets of the appropriate class the company then owns
(provided that another lender does not have a prior charge on the assets).
The company would be able, however, to dispose of its assets as it chose
until a default took place. In the event of default, the lender would probably
appoint a receiver to run the company rather than lay claim to a particular
asset.
174
CA Sri Lanka
Not all bonds are secured. Investors are likely to expect a higher yield with
unsecured bonds to compensate them for the extra risk. The rate of interest on
unsecured bonds may be around 1% or more higher than for secured debt.
CA Sri Lanka
(a)
The advantage for borrowers is that zero coupon bonds can be used to raise
cash immediately, and there is no cash repayment until redemption date.
The cost of redemption is known at the time of issue, and so the borrower
can plan to have funds available to redeem the bonds at maturity.
(b)
The advantage for lenders is restricted, unless the rate of discount on the
bonds offers a high yield. The only way of obtaining cash from the bonds
before maturity is to sell them, and their market value will depend on the
remaining term to maturity and current market interest rates.
175
The tax advantage of zero coupon bonds is the same as that for deep discount
bonds.
176
CA Sri Lanka
Required
Calculate the market value of the bonds.
Solution
You need to use the redemption yield cost of debt as the discount rate, and
remember to use an annuity factor for the interest. We are discounting over 14
periods using the quarterly discount rate (8%/4).
Period
Cash flow
114
14
Rs
3,000
110,000
Interest
Redemption
Discount
factor
2%
12.106
0.758
Present
value
Rs
36,318
83,380
119,698
Cash flow
Discount
factor @ 5%
Present
value
Rs
Discount
factor @ 7%
Present
value
Rs
1.000
4.329
0.784
(94.00)
21.64
78.40
6.04
1.000
4.100
0.713
(94.00)
20.50
71.30
(2.20)
Rs
0
15
5
NPV
(94)
5
100
6.04
2% = 6.47%.
(6.04 + 2.20)
Yield to maturity = 5% +
For irredeemable debt, the yield to maturity (YTM) can be calculated as:
YTM = (Annual interest/Current market value) 100%
CA Sri Lanka
177
0
1
2
3
4
178
Market value
Interest
Interest
Interest
Interest and
redemption
HUF cash
flow
$
(100)
6
6
6
114
Exchange rate
1.6000
1.6000/1.02 = 1.5686
1.5686/1.02 = 1.5378
1.5378/1.02 = 1.5076
1.5076/1.02 = 1.4780
Rs cash
flow
Rs
(62.50)
3.83
3.90
3.98
77.13
CA Sri Lanka
Rs cash
flow
(62.50)
3.83
3.90
3.98
77.13
DF
8%
1.000
0.926
0.857
0.794
0.735
PV
(62.50)
3.55
3.34
3.16
56.69
4.24
DF
10%
1.000
0.909
0.826
0.751
0.683
PV
(62.50)
3.48
3.22
2.99
52.68
(0.13)
If the redemption is to take place using current funds (assuming there are
enough available), the business needs to consider the alternative uses to
which these funds could be put.
(b)
The company may decide to issue new debt to replace the old debt. The
company will incur issue costs using new debt, and will also need to consider
the future pattern of interest rates.
(c)
Alternatively, the company could use an issue of equity to provide the funds
for redemption. Issue costs will again be a factor, and the directors will need
to consider whether to issue shares to new shareholders, or use a rights
issue to existing shareholders.
(d)
If the redeemable debt has been issued on the stock market, it can be bought
and hence redeemed by the company at any time. The directors will choose
to redeem it if other possible sources of finance have a lower cost.
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179
FORMULA TO LEARN
Ignoring tax, the value of irredeemable debt is:
P0 = i
kd
Where: P0 is the ex-interest market value of debt
i is the annual interest charge
kd is the cost of debt (required return by debt holders)
With tax, the value of irredeemable debt is:
P0 =
i (1 t)
Kdnet
180
CA Sri Lanka
3 Convertible securities
Convertible securities are a hybrid of debt and equity. They can be converted to
ordinary shares at some future date.
QUESTION
Convertible debt
The 10% convertible bonds of PW Co are quoted at Rs. 142 per Rs. 100 nominal.
The earliest date for conversion is in four years' time, at the rate of 30 ordinary
shares per Rs. 100 nominal. The share price is currently Rs. 4.15. Annual interest
on the bonds has just been paid.
Required
(a)
(b)
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181
ANSWER
(a)
(b)
17.50
100% = 14%
124.50
The share price would have to rise by 14% before the conversion rights became
attractive.
3.3 The issue price and the market price of convertible bonds
A company will aim to issue bonds with the greatest possible conversion
premium as this will mean that, for the amount of capital raised, it will, on
conversion, have to issue the lowest number of new ordinary shares. The
premium that will be accepted by potential investors will depend on the
company's growth potential and the prospects for a sizeable increase in the share
price.
Convertible bonds issued at par normally have a lower coupon rate of interest
than straight debt. This lower yield is the price the investor has to pay for the
conversion rights. It is, of course, also one of the reasons why the issue of
convertible bonds is attractive to a company, particularly one with tight cash flows
around the time of issue, but an easier situation when the notes are due to be
converted.
When convertible bonds are traded on a stock market, their minimum market
price or floor value will be the price of straight bonds with the same coupon rate
of interest. If the market value falls to this minimum, it follows that the market
attaches no value to the conversion rights.
The actual market price of convertible bonds will depend on:
The price of straight debt
The current conversion value
The length of time before conversion may take place
The market's expectation as to future equity returns and the risk associated with
these returns
Most companies issuing convertible bonds expect them to be converted. They
view the notes as delayed equity. They are often used either because the
182
CA Sri Lanka
Solutions
(a)
Interest
Interest
Interest
Redemption value
Cash flow
Rs
10
10
10
110
Discount
factor 8%
0.926
0.857
0.794
0.794
Present
value
Rs
9.26
8.57
7.94
87.34
113.11
The estimated market value is Rs. 113.11 per Rs. 100 of debt. This is also the
floor value.
CA Sri Lanka
183
(b)
Interest
Interest
Interest
Value of 40 shares
Cash
flow/value
Rs
10
10
10
120
Discount
factor
8%
0.926
0.857
0.794
0.794
Present
value
Rs
9.26
8.57
7.94
95.28
121.05
The estimated market value is Rs. 121.05 per Rs. 100 of debt.
184
(a)
(b)
The issuer can pay lower interest than on straight debt. This may be
significant if funds are tight during the early years of issue of the bonds. They
are usually issued by high-growth companies who do not want the burden
of high interest payments.
(c)
(d)
(e)
There may be provisions in the issue terms allowing the issuer to force
conversion if the market price of the bonds is greater than the conversion
price.
(f)
If the company issued straight bonds initially and then equity to redeem the
bonds, two lots of issue costs would be paid, whereas with convertible debt,
issue costs would only be paid once.
(g)
CA Sri Lanka
If the company had waited for funds, and the market price increases
significantly above the conversion price, it would be better off issuing
shares at a higher price, rather than having to issue shares at the lower
conversion terms.
(b)
The company has to repay the debt if the share price does not increase.
(c)
(d)
4 Warrants
Share warrants are another form of debt sweetener which give their holder the
right to apply for new shares at a specified exercise price in the future.
CA Sri Lanka
(a)
(b)
Warrants make a bond issue more attractive and may make an issue of
unsecured bonds possible where adequate security is lacking.
185
(c)
(b)
(c)
The company has less control over the exercise of warrants than it does
over the exercise of share capital.
186
CA Sri Lanka
An SL company might borrow money from a bank or from the investing public, in
SL rupees. However, it might also borrow in a foreign currency, especially if it
trades abroad, or if it already has assets or liabilities abroad denominated in a
foreign currency. When a company borrows in a foreign currency, the loan is
known as a eurocurrency loan. (As with euro-equity, it is not only the euro that is
involved, and so the 'euro-' prefix is a misnomer.) Banks involved in the
eurocurrency market are not subject to central bank reserve requirements or
regulations in respect of their involvement.
The eurocurrency markets involve the depositing of funds with a bank outside
the country of the currency in which the funds are denominated and re-lending
these funds for a fairly short term, typically three months, normally at a floating
rate of interest.
Eurocredits are medium- to long-term international bank loans which may be
arranged by individual banks or by syndicates of banks. Syndication of loans
increases the amounts available to hundreds of millions, while reducing the
exposure of individual banks.
5.3 Eurobonds
A eurobond is a bond sold outside the jurisdiction of the country in whose
currency the bond is denominated.
In recent years, a strong market has built up which allows very large companies to
borrow in this way, long-term or short-term. Again, the market is not subject to
national regulations.
Eurobonds are long-term loans raised by international companies or other
institutions and sold to investors in several countries at the same time.
Eurobonds are normally repaid after 5-15 years, and are for major amounts of
capital, ie Rs. 10 million or more.
Note. Dont make the common mistake of thinking that eurobonds are issued in
Europe or only denominated in euros.
5.3.1 How are eurobonds issued?
CA Sri Lanka
Step 1
Step 2
Step 3
The underwriting syndicate then organise the sale of the bond; this
normally involves placing the bond with institutional investors.
Eurobonds are 'bearer instruments', which means that the owner does not
have to declare their identity.
(b)
Interest is paid gross and this has meant that eurobonds have been used by
investors to avoid tax.
(c)
(d)
They are often cheaper than a foreign currency bank loan because they can
be sold on by the investor, who will therefore accept a lower yield in return
for this greater liquidity.
(e)
They are also extremely flexible. Most eurobonds are fixed rate but they can
be floating rate or linked to the financial success of the company.
(f)
They are typically issued by companies with excellent credit ratings and are
normally unsecured, which makes it easier for companies to raise debt
finance in the future.
(g)
Eurobond issues are not normally advertised because they are placed with
institutional investors and this reduces issue costs.
188
CA Sri Lanka
Whatever the details provided to potential investors, SMEs have neither the
business history nor larger track record that larger organisations possess.
(b)
(c)
(d)
(e)
A common problem is often that banks will be unwilling to increase loan funding
without an increase in security given (which the owners may be unwilling or
unable to give), or an increase in equity funding (which may be difficult to
obtain).
Certain trends in various countries may be more helpful for small businesses.
(a)
(b)
Note. Make sure that your financing recommendations are suitable for the type of
entity in the scenario and not just a 'brain-dump' of types of finance.
You are not expected to have knowledge of any specific government scheme but
you may gain credit in the exam for relevant discussion of available schemes in
your own country.
CA Sri Lanka
189
CHAPTER ROUNDUP
190
This chapter explained loan finance and how a lender will decide what interest
rate to charge a customer.
This chapter also looked at the terminology used to describe long-term debt and
the different types of debt finance that are available.
Convertible securities are a hybrid of debt and equity. They can be converted to
ordinary shares at some future date.
Share warrants are another form of debt sweetener which give their holder the
right to apply for new shares at a specified exercise price in the future.
Large companies with excellent credit ratings use the euromarkets to borrow in
any foreign currency using unregulated markets organised by merchant banks.
This market is much bigger than the market for domestic bonds.
In this exam you must always suggest suitable finance for the specific needs of the
entity in the scenario. Small- and medium-sized entities have specific problems
obtaining finance which are very different to large, multinational entities.
CA Sri Lanka
PROGRESS TEST
Which of the following comparisons between bonds and preference shares is not a
true statement?
A
Bonds are more attractive to investors because they are secured against
assets.
A company has 12% bonds in issue, which have a market value of Rs. 135 per
Rs. 100 nominal value. What is:
(a)
(b)
An investor has the option of redeeming a company's 11% loan notes 2008/2010
at any date between 1 January 2008 and 31 December 2010 inclusive.
True
False
Convertible securities are fixed return securities that may be converted into zero
coupon bonds/ordinary shares/warrants. (Delete as appropriate.)
Do borrowers benefit from floating rate bonds when interest rates are rising or
falling?
What is the value of Rs. 100 12% debt redeemable in three years' time at a
premium of 20 cents per Rs if the debtholder's required return is 10%?
What are the main factors lenders will consider when deciding whether to offer
loan finance?
CA Sri Lanka
191
11
192
12
13
CA Sri Lanka
The answer is D.
(a)
(b)
Ordinary shares
The answer is B. The holder has the option to convert, but they will only convert if
it is advantageous for them to do so. If the share price falls, the bonds may run
their full term and need to be redeemed in the same way as other forms of debt.
Falling
12%
Rs. 12
8
Discount
factor @
10%
Years
13 Interest
3 Redemption premium
Rs
12
120
2.487
0.751
Present
value
Rs
29.84
90.12
119.96
Purpose
Amount
Repayment
Term
Security
10
17.50
100% = 14%.
124.50
11
The share price would have to rise by 14% before the conversion rights became
attractive.
12
CA Sri Lanka
193
The market value of Rs. 100 of the convertible debt will be the discounted present
value of the expected future income stream.
Discount
Present
Cash flow
factor 8%
value
Year
Rs
Rs
10
9.26
1
Interest
0.926
10
8.57
2
Interest
0.857
10
7.94
3
Interest
0.794
110
87.34
3
Redemption value
0.794
113.11
The estimated market value is Rs. 113.11 per Rs. 100 of debt. This is also the floor
value.
13
194
CA Sri Lanka
CHAPTER
INTRODUCTION
In this chapter, we consider the option of leasing an asset.
As well as looking at the advantages and disadvantages of different
types of lease compared with other forms of credit finance, we shall be
discussing the tax and cash flow implications of leasing. You need to
know how to determine whether an organisation should lease or buy an
asset.
Knowledge Component
2
Corporate Financing Strategies
2.5
Lease financing
2.5.1
2.5.2
195
CHAPTER CONTENTS
LEARNING
OUTCOME
2.5.1
2.5.2
(b)
The lessee has possession and use of the asset on payment of specified
rentals over a period.
(c)
(d)
196
(a)
(b)
CA Sri Lanka
(c)
The period of the lease is fairly short, less than the expected economic
life of the asset, so that at the end of one lease agreement, the lessor can
either lease the same equipment to someone else, and obtain a good rent for
it, or sell the equipment secondhand.
With an operating lease, the lessor, often a finance house, purchases the
equipment from the manufacturer and then leases it to the user (the lessee) for
the agreed period.
CA Sri Lanka
(a)
(b)
The lease has a primary period, which covers all or most of the useful
economic life of the asset. At the end of this primary period, the lessor would
not be able to lease the asset to someone else, because the asset would be
worn out. The lessor must therefore ensure that the lease payments during
the primary period pay for the full cost of the asset as well as providing the
lessor with a suitable return on their investment.
(c)
The lessee may be able to continue to lease the asset for an indefinite
secondary period, in return for a very low nominal rent, sometimes called a
'peppercorn rent'. Alternatively, the lessee might be allowed to sell the asset
on a lessor's behalf (since the lessor is the owner) and to keep most of the
sale proceeds, paying only a small percentage (perhaps 10%) to the lessor.
197
198
CA Sri Lanka
2
2
2
2
8
Capital
Rs Mn
5.71
1.144
4.566
1.315
3.251
1.512
1.739
1.739
Interest
Rs Mn
0.856
0.685
0.488
0.261
2.29
199
Step 1
Step 2
Add the digits. A quick method of adding the digits is to use the
formula n(n+1)/2, where n is the number of periods of borrowing.
Step 3
4
3
2
1
200
CA Sri Lanka
(b)
The lessor invests finance by purchasing assets from suppliers and makes
a return out of the lease payments from the lessee. Provided that a lessor can
find lessees willing to pay the amounts they want to make their return, the
lessor can make good profits. They will also get capital allowances on their
purchase of the equipment.
(c)
(i)
If the lessee does not have enough cash to pay for the asset, and would
have difficulty obtaining a bank loan to buy it, renting is the only option
if they are to have the use of it at all.
(ii)
Finance leases are cheaper than bank loans. Surveys suggest that this
is a major reason why leases are used. The logic is that the lessor is
prepared to lend at a lower cost because they possess greater
security, ie the ownership of the asset.
(a)
The leased equipment does not have to be shown in the lessee's published
balance sheet, and so the lessee's balance sheet shows no increase in its
gearing ratio.
(b)
The equipment is leased for a shorter period than its expected useful life.
If the equipment becomes out of date before the end of its expected life, the
lessee does not have to keep on using it, and it is the lessor who must bear
the risk of having to sell obsolete equipment.
(c)
Not surprisingly perhaps, a major growth area in operating leasing has been in
computers and office equipment (such as photocopiers and fax machines) where
technology is continually improving.
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201
CASE STUDY
The aircraft leasing industry has come to the fore after several aviation downturns
in recent years. Lessors' ownership of the world's civil aircraft fleet has increased
from 12 per cent in 1990 to 36 per cent in 2010, according to Boeing, the plane
maker.
Some aircraft lessors are predicting their share of the global fleet will rise to as
much as 50 per cent by 2015, partly because some airlines may find it harder to
secure financing for their jets due to economic circumstances. Lessors make most
of their money through the charges paid by airlines that use their jets.
Source: The Financial Times (UK), 17 January 2012
(a)
(b)
The future borrowing capacity of the firm will be reduced, since the
property if owned could be used to provide security for a loan.
(c)
(d)
The real cost is likely to be high, particularly as there will be frequent rent
reviews.
202
CA Sri Lanka
QUESTION
Lease vs loan
Explain the cash flow characteristics of a finance lease, and compare it with the
use of a bank loan. Your answer should include some comment on the significance
of a company's anticipated tax position on lease versus buy decisions.
ANSWER
A finance lease is an agreement between the user of the leased asset and a
provider of finance that covers the majority of the asset's useful life. Key features
of a finance lease are as follows.
(a)
The provider of finance is usually a third-party finance house and not the
original provider of the equipment.
(b)
The lessee is responsible for the upkeep, servicing and maintenance of the
asset.
(c)
The lease has a primary period, which covers all or most of the useful
economic life of the asset. At the end of the primary period, the lessor would
not be able to lease the equipment to someone else because it would be
worn out.
(d)
It is common at the end of the primary period to allow the lessee to continue
to lease the asset for an indefinite secondary period, in return for a very
low nominal rent, sometimes known as a 'peppercorn' rent.
The cash flow implications of this form of lease are therefore as follows.
(a)
(b)
(c)
If the equipment were acquired using a medium-term bank loan, the cash
flow patterns would be similar to those that would arise using a finance
lease. However, if the loan were subject to a variable rate of interest, this
would introduce a further source of variability into the cash flows. The main
difference between the two approaches would be that the company could
claim tax-allowable depreciation on the purchase cost of the equipment.
CA Sri Lanka
203
The cost of capital that should be applied to the cash flows for the financing
decision is the cost of borrowing. We assume that if the organisation decided to
purchase the equipment, it would finance the purchase by borrowing funds
(rather than out of retained funds). We therefore compare the cost of borrowing
with the cost of leasing by applying this cost of borrowing to the financing cash
flows.
The cost of borrowing does not include the interest repayments on the loan, as
this is dealt with via the cost of capital.
2.1.1 Example: Simple
GW Co has decided to invest in a new machine which has a ten-year life and no
residual value. The machine can either be purchased now for Rs. 50 million, or it
can be leased for ten years with lease rental payments of Rs. 8 million per annum
payable at the end of each year.
The cost of capital to be applied is 9% and taxation should be ignored.
Present value of leasing costs
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CA Sri Lanka
The company could purchase the machine for cash, using bank loan facilities
on which the current rate of interest is 13% before tax.
(b)
The company could lease the machine under an agreement which would
entail payment of Rs. 4.8 million at the end of each year for the next five
years.
The rate of tax is 30%. If the machine is purchased, the company will be able to
claim a tax depreciation allowance of 100% in year 1. Tax is payable with a year's
delay.
Cash flows are discounted at the after-tax cost of borrowing, which is at 13%
70% = 9.1%, say 9%.
The present value (PV) of purchase costs
Year
0
5
2
Item
Equipment cost
Trade-in value
Tax savings, from allowances
30% Rs. 20 million
Cash
flow
Rs Mn
(20)
4
Discount
factor @ 9%
1.000
0.650
0.842
NPV of
purchase
PV
Rs Mn
(20)
2.6
5.052
(12.348)
CA Sri Lanka
PV
Rs Mn
(18.672)
5.139
(13.533)
205
Working
Rs
4.486
(0.917)
3.569
0
Rs Mn
1
Rs Mn
2
Rs Mn
3
Rs Mn
4
Rs Mn
5
Rs Mn
6
Rs Mn
20
(4)
20
1.000
(4.8)
0.917
(6)
(4.8)
1.44
(9.36)
0.842
20
(1.182)
(4.402)
(7.881)
(4.8)
(4.8)
1.44
(3.36)
0.772
(4.8)
1.44
(3.36)
0.708
(4.8)
1.44
(7.36)
0.650
1.44
1.44
0.596
(2.594)
(2.379)
(4.784)
0.858
The negative NPV indicates that the lease is unattractive and the purchasing
decision is better, as the net savings from not leasing outweigh the net costs of
purchasing.
Note. In this exam, speed is of the essence and you may find it much quicker to do
a single calculation, especially if you then have to do a sensitivity analysis.
2.1.3 Example: A more complicated example with taxation
Using the information from Example 2.1.2 (apart from the tax payment date), now
assume that the company can claim tax depreciation allowances of 25% on a
reducing balance basis over the machine's five-year life if it is purchased.
Depreciation is tax deductible and LW Co uses straight-line depreciation in its
accounts. The interest element of the lease payments is also tax deductible.
The rate of tax is 30%, payable in the year of the relevant profits.
206
CA Sri Lanka
Tax treatment of leases varies in different countries and you need to read the
information in an exam question very carefully. The examiners have commented
that the tax aspects of these calculations have caused difficulties.
Tax depreciation allowances
Year
Value at
start of year
Rs Mn
20
15
11.25
8.37
8.437 2.109 4
1
2
3
4
5
25%
depreciation
Rs Mn
5.000
3.750
2.813
2.109
Balance 2.328
30% tax
allowance
Rs Mn
1.500
1.125
0.844
0.633
0.698
Purchase cost
Tax allowances
Trade-in value
Net cash flow
Discount factor 9%
PV
Total
0
Rs Mn
(20)
(20)
1.000
(20)
(13.523)
1
Rs Mn
2
Rs Mn
3
Rs Mn
4
Rs Mn
5
Rs Mn
1.5
1.125
0.844
0.633
1.5
0.917
1.376
1.125
0.842
0.947
0.844
0.772
0.652
0.633
0.708
0.448
0.698
4
4.698
0.650
3.054
Leasing cost
Depreciation costs =
20m 4m
= Rs. 3.2 million
5
0.218
IRR = 6% + (0.218 0.320) 1 = 6.4%
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207
Opening
balance
Rs Mn
20.000
16.480
12.735
8.750
4.510
Implicit
interest at
6.4%
Rs Mn
1.280
1.055
0.815
0.560
0.289
End of year
debt
Rs Mn
21.280
17.535
13.550
9.310
4.799
Closing
balance
Rs Mn
16.480
12.735
8.750
4.510
(0.001)
Repayment
Rs Mn
4.8
4.8
4.8
4.8
4.8
Rounding means that the final closing balance does not exactly equal zero.
NPV of leasing costs
Year 1
Rs Mn
(4.800)
0.960
Lease payments
Tax relief on
depreciation
0.384
Tax relief on implicit
interest
(3.456)
Net cash flows
Discount factor @ 9%
0.917
(3.169)
PV
(13.949)
Total
Year 2
Rs Mn
(4.800)
0.960
Year 3
Rs Mn
(4.800)
0.960
Year 4
Rs Mn
(4.800)
0.960
0.317
0.245
0.168
(3.523)
0.842
(2.966)
(3.595)
0.772
(2.775)
(3.672)
0.708
(2.600)
Year 5
Rs Mn
(4.800)
0.960
0.87
(3.753)
0.650
(2.439)
The organisation's liquidity at the time the decision is made may be important.
If the business is suffering cash flow difficulties, lease payments may offer a
smoother cash flow than one big lump sum.
(b)
Cost of capital
208
CA Sri Lanka
(c)
Running expenses
Lease or buy calculations normally assume that the running costs are the
same under each alternative. This may not be so. Expenses like
maintenance and insurance may differ between the alternatives.
(d)
Trade-in value
209
(0.280)
Conclusion. The leasing payments proposed are not justifiable for the lessor if it
seeks a required rate of return of 12%, since the resulting NPV is negative.
QUESTION
Lease or buy
ANSWER
The financing decision will be appraised by discounting the relevant cash flows at
the after-tax cost of borrowing, which is 10% 70% = 7%.
(a)
Purchase option
Item
Year
0
2
(b)
Cost of machine
Tax saved from taxallowable depreciation
30% Rs. 63,000
Cash
flow
Rs '000
(63,000)
Discount
factor
7%
1.000
Present
value
Rs '000
(63,000)
18,900
0.873
16,500
(46,500)
Leasing option
Present
value
Rs '000
(67,740)
18,990
(48,750)
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CA Sri Lanka
The purchase option is cheaper, using a cost of capital based on the after-tax
cost of borrowing. On the assumption that investors would regard
borrowing and leasing as equally risky finance options, the purchase option
is recommended.
CA Sri Lanka
211
CHAPTER ROUNDUP
212
Leasing is a commonly used source of finance, especially for small- or mediumsized entities. It is a form of debt finance that can be very useful where capital is
rationed.
CA Sri Lanka
PROGRESS TEST
Operating leases and finance leases are distinguished for accounting purposes.
Which of the following statements is not true of an operating lease?
A
The period of the lease is less than the expected economic life of the asset.
The lessee is normally responsible for servicing and maintaining the leased
equipment.
Who is responsible for the servicing of a leased asset in the case of:
(a)
(b)
An operating lease?
A finance lease?
The lessee
or
The lessor
Finance lease
Operating lease
Lender credit
Vendor credit
A hire purchase contract is a contract for the hire of an asset that contains a
provision giving the hirer an option to acquire legal title to the asset on the
fulfilment of certain conditions stated in the contract.
True
False
CA Sri Lanka
213
CA Sri Lanka
Under Alternative 2, both the accounting depreciation and the interest element
of the finance lease payments are tax deductible.
Once a decision on the payment method has been made and the new system is
installed, AB will commission a post-completion audit (PCA).
7
Explain the reasons for your choice of discount factor in the present value
calculations.
Discuss other factors that AB should consider before deciding on the method of
financing the acquisition of the system.
CA Sri Lanka
215
(a)
(b)
True
Working
The lessor
The lessee
Rs
15,750
11,813
8,859
36,422
26,578
The financing decision will be appraised by discounting the relevant cash flows at
the after-tax cost of borrowing, which is 10% 70% = 7%.
(a)
Purchase option
Year
Item
Cost of machine
Tax saved from tax allowable
depreciation
30% Rs. 15,750
30% Rs. 11,813
30% Rs. 8,859
30% Rs. 26,578
2
3
4
5
(b)
Cash
flow
Rs
(63,000)
4,725
3,544
2,658
7,973
Discount
factor
7%
Present
value
1.000
Rs
(63000)
0.873
0.816
0.763
0.713
4,125
2,892
2,028
5,685
(48,270)
Leasing option
14
25
216
Item
Lease costs
Tax savings on lease costs ( 30%)
Cash
flow
Rs
(20,000)
6,000
Discount
factor
7%
3.387
3.165
Present
value
Rs
(67,740)
18,990
(48,750)
CA Sri Lanka
The purchase option is cheaper, using a cost of capital based on the after-tax cost
of borrowing. On the assumption that investors would regard borrowing and
leasing as equally risky finance options, the purchase option is recommended.
7
Alternative 1
This alternative involves paying the whole capital cost up front. We have been told
that the pre-tax cost of borrowing is 7%.
Capital allowances
Annual capital allowance = 25% of cost = 25% of Rs. 25m = Rs. 6.25m
Tax saving on capital allowances = 30% of Rs. 6.25m = Rs. 1.875m
NPV calculation
Year 0
Rs Mn
(25)
0
1.000
(25)
Cost
Capital allowance
Cum. discount factor (5%) (W1)
Discounted cash flow
Years 14
Rs Mn
0
1.875
3.546
6.649
NPV = (18.351)m
Working
CA Sri Lanka
4/10
3/10
2/10
1/10
1.2
0.9
0.6
0.3
217
Alternative approach
Using the actuarial method:
Interest will be charged on the reducing balance of the total capital cost.
Year 1
Rs Mn
18.00
1.44
(7.00)
12.44
Year 2
Rs Mn
12.44
1.00
(7.00)
6.44
Year 3
Rs Mn
6.44
0.52
(7.00)
(0.04)
Annual interest
Accounting depreciation
(Rs. 25/4)
Total available for tax relief
Tax relief at 30%
Year 1
Rs Mn
1.20
Year 2
Rs Mn
0.90
Year 3
Rs Mn
0.60
Year 4
Rs Mn
0.30
6.25
7.45
6.25
7.15
6.25
6.85
6.25
6.55
2.24
2.15
2.06
1.97
NPV calculation
Tutorial note. We are still using the after-tax cost of borrowing as the discount
rate, as leasing can be seen as a direct alternative to borrowing the full amount
and paying up front.
218
CA Sri Lanka
Lease payments
Tax relief
Net cash flow
Dis. factor (5%)
DCF
Year 0
Rs Mn
(7.00)
(7.00)
1.000
(7.00)
Year 1
Rs Mn
(7.00)
2.24
(4.76)
0.952
(4.53)
Year 2
Rs Mn
(7.00)
2.15
(4.85)
0.907
(4.40)
Year 3
Rs Mn
(7.00)
2.06
(4.94)
0.864
(4.27)
Year 4
Rs Mn
1.97
1.97
0.823
1.62
As the NPV of purchasing the POS system is slightly lower than the NPV of leasing,
AB should purchase the system outright.
8
CA Sri Lanka
219
220
CA Sri Lanka
CHAPTER
INTRODUCTION
In this chapter we examine the concept of the cost of capital, which can be used as a
discount rate in evaluating the investments of an organisation.
We firstly base cost of equity calculations on the dividend valuation model. We
then look at a way of establishing the cost of equity that takes risk into account: the
capital asset pricing model.
Don't neglect the cost of debt though, as this often causes students problems, in
particular the distinction between the cost of irredeemable and cost of redeemable
debt.
In the exam you may be asked to calculate the weighted average cost of capital
and its component costs, either as a separate sub-question, or as part of a larger
question, most likely an investment appraisal. Remember that questions won't just
involve calculations; you may be asked to discuss the problems with the methods of
calculation you've used or the relevance of the costs of capital to investment
decisions.
Knowledge Component
2
Corporate Financing Strategies
2.3
2.6
Equity financing
2.3.3
2.3.4
Assess
systematic
(market
wide/non-diversifiable)
and
unsystematic risk (firm specific/diversifiable) and their implications
on equity financing, from a company's viewpoint (beta factor and
expected return) and an investor's view point (basic fundamentals
of a diversified portfolio).
2.6.2
221
LEARNING
OUTCOME
CHAPTER CONTENTS
1 Investment decisions, financing and the cost of capital
2.3.3
2.3.3
2.3.3, 2.3.4
2.6.2
2.6.2
COST OF CAPITAL
It is thus the minimum return that a company should make on its own
investments, to earn the cash flows out of which investors can be paid their
return.
Cost of capital is the minimum acceptable return on an investment, generally
computed as a discount rate for use in investment appraisal exercises. The
computation of the optimal cost of capital can be complex, and many ways of
determining this opportunity cost have been suggested.
222
CA Sri Lanka
If a bank offers to lend money to a company, the interest rate it charges is the
yield that the bank wants to receive from investing in the company, because
it can get just as good a return from lending the money to someone else. In
other words, the interest rate is the opportunity cost of lending for the
bank.
(b)
When shareholders invest in a company, the returns that they can expect
must be sufficient to persuade them not to sell some or all of their shares and
invest the money somewhere else. The yield on the shares is therefore the
opportunity cost to the shareholders of not investing somewhere else.
(b)
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223
(c)
(b)
Retained earnings also have a cost. This is an opportunity cost, the dividend
forgone by shareholders.
224
CA Sri Lanka
model, on the assumption that the market value of shares is directly related to
expected future dividends on the shares.
If the future dividend per share is expected to be constant in amount, then the ex
dividend share price will be calculated by the formula:
P0 =
d
d
d
d
d
+
+
+ ..... = , so ke =
2
3
(1+ k e ) (1+ k e ) (1+ k e )
ke
P0
P0 is the ex-dividend share price (the price of a share where the share's
new owner is not entitled to the dividend that is soon to be paid).
FORMULA TO LEARN
Cost of ordinary (equity) share capital, paying an annual dividend d in perpetuity,
and having a current ex div price P0:
ke = d
P0
We shall look at the dividend valuation model again in Chapter 15, in the context
of valuation of shares.
CA Sri Lanka
225
d 1 + g d0 1 + g
+
+ ....
P0 = 0
1 + k e 1 + k e 2
2
Where:
P0
d0
ke
g
d0 (1 + g)
(k e g)
Re-arranging this, we get a formula for the ordinary shareholders' cost of capital.
FORMULA TO LEARN
Cost of ordinary (equity) share capital, having a current ex div price, P0, having
just paid a dividend, d0, with the dividend growing in perpetuity by a constant g%
per annum:
ke =
d0 (1 + g)
d
+ g or k e = 1 + g
P0
P0
d1 = d0(1+ g)
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CA Sri Lanka
QUESTION
Cost of equity
A share has a current market value of Rs. 96, and the last dividend was Rs. 12. If
the expected annual growth rate of dividends is 4%, calculate the cost of equity
capital.
ANSWER
Cost of equity capital =
=
=
=
12(1+0.04)
+0.04
96
0.13 + 0.04
0.17
17%
Dividends
Rs
150,000
192,000
206,000
245,000
262,350
20X1
20X2
20X3
20X4
20X5
Earnings
Rs
400,000
510,000
550,000
650,000
700,000
Dividends have risen from Rs. 150,000 in 20X1 to Rs. 262,350 in 20X5. The
increase represents four years' growth. (Check that you can see that there are four
years' growth, and not five years' growth, in the table.) The average growth rate, g,
may be calculated as follows. Assume the current market price is Rs. 3.35, in 20X5.
Dividend in 20X1 (1 + g)4 = Dividend in 20X5
(1 + g)4 = Dividend in 20X5
Dividend in 20X1
Rs. 262,350
=
Rs. 150,000
= 1.749
CA Sri Lanka
227
1+g =
1.749 = 1.15
g = 0.15, ie 15%
The growth rate over the last four years is assumed to be expected by
shareholders into the indefinite future, so the cost of equity, ke, is:
d0 (1 + g)
(1.15) + 0.15 = 0.24, ie 24%
+ g = 0.26235
3.35
P0
Where:
QUESTION
Growth rate
The following figures have been extracted from the accounts of CH Co:
Year
Dividends
Rs
100,000
125,000
125,000
160,000
200,000
20X1
20X2
20X3
20X4
20X5
Earnings
Rs
350,000
400,000
370,000
450,000
550,000
Required
You have been asked to calculate the cost of equity for the company. What growth
rate would you use in the calculations?
ANSWER
Let 'g' = rate of growth in dividends.
Dividend in 20X1 (1 + g)4 = Dividend in 20X5
(1 + g)4 = Dividend in 20X5 Dividend in 20X1
(1 + g)4 = 200,000 100,000
(1 + g)4 = 2.0
1+g
1+g
g
228
= 42
= 1.19
= 19%
CA Sri Lanka
Where:
P0
CA Sri Lanka
229
Systematic risk
No. of investments
In return for accepting systematic risk, a risk-averse investor will expect to earn a
return which is higher than the return on a risk-free investment.
The amount of systematic risk in an investment varies between different types of
investment.
230
CA Sri Lanka
(b)
(c)
If an investor holds a balanced portfolio of all the stocks and shares on the
stock market, they will incur systematic risk which is exactly equal to the
average systematic risk in the stock market as a whole.
(d)
CA Sri Lanka
Beta = 1
Share = average risk
Beta > 1
Share > average risk
231
CASE STUDY
The following are examples of beta factors of well-known companies. Note the
differences in betas between companies within the same sector and the
differences in betas across sectors.
Company
Qantas
Cathay Pacific
Singapore Airlines
GlaxoSmithKline
Pfizer
Volkswagen
Honda
Toyota
Sector
Airlines
Airlines
Airlines
Pharmaceuticals
Pharmaceuticals
Auto and truck manufacturers
Auto and truck manufacturers
Auto and truck manufacturers
Beta factor
1.5200
1.0400
0.7696
0.4367
0.7578
1.5100
1.0800
1.1000
(b)
(c)
(b)
(c)
232
CA Sri Lanka
(110 105)+7.6
= 0.12
105
Rm =
(490 480)+39.2
480
= 0.1025
A statistical analysis of 'historic' returns from a security and from the 'average'
market may suggest that a linear relationship can be assumed to exist between
them. A series of comparative figures could be prepared (month by month) of the
return from a company's shares and the average return of the market as a whole.
The results could be drawn on a scattergraph and a 'line of best fit' drawn (using
linear regression techniques) as shown in the diagram below.
Figure 8.4
Return from
individual
company's
share (rj)
Line of best fit
CA Sri Lanka
(a)
The return from the security and the return from the market as a whole will
tend to rise or fall together.
(b)
The return from the security may be higher or lower than the market return.
This is because the systematic risk of the individual security differs from
that of the market as a whole.
233
(c)
The scattergraph may not give a good line of best fit, unless a large number
of data items are plotted, because actual returns are affected by
unsystematic risk as well as by systematic risk.
Note that returns can be negative. A share price fall represents a capital loss,
which is a negative return.
The conclusion from this analysis is that individual securities will be either more
or less risky than the market average in a fairly predictable way. The measure of
this relationship between market returns and an individual security's returns,
reflecting differences in systematic risk characteristics, can be developed into a
beta factor for the individual security.
234
ke
Rf
Rm
CA Sri Lanka
ke = Rf + (Rm Rf)
8 = Rf + ((7 Rf) 1.2)
8 = Rf + 8.4 1.2 Rf
0.2 Rf = 0.4
Rf = 2
B Co:
ke = 2 + ((7 2) 1.8)
= 11%
QUESTION
CAPM
The risk-free rate of return is 7%. The average market return is 11%.
CA Sri Lanka
(a)
(b)
235
ANSWER
(a)
(b)
(b)
(c)
Over time, will tend towards zero for any individual share, and for a
well-diversified portfolio taken as a whole will be 0
(d)
If the alpha value is positive, investors who do not hold shares will be tempted to
buy them (to take advantage of the abnormal return), and investors who do hold
shares will want to hold on to them so share prices will rise. If the alpha value is
negative, investors will not want to buy them, and current holders will want to
sell them, so share prices will fall.
3.7.4 Example: Alpha values
ABC plc's shares have a beta value of 1.2 and an alpha value of +2%. The market
return is 10% and the risk-free rate of return is 6%.
Required return 6% + (10% 6%) 1.2 = 10.8%
Current return = expected return alpha value = 10.8% + 2% = 12.8%
236
(a)
The need to determine the excess return (Rm Rf). Expected, rather than
historical, returns should be used, although historical returns are often used
in practice.
(b)
CA Sri Lanka
(c)
Errors in the statistical analysis used to calculate values. Betas may also
change over time.
(d)
QUESTION
(a)
(b)
Beta factor
Explain what beta measures, and what do betas of 0.5, 1 and 1.5 mean?
Identify the factors that determine the level of beta which a company may
have.
ANSWER
(a)
(b)
The beta of a company will be the weighted average of the beta of its shares
and the beta of its debt. The beta of debt is very low, but not zero, because
corporate debt bears default risk, which in turn is dependent on the
volatility of the company's cash flows.
Factors determining the beta of a company's equity shares include:
(i)
CA Sri Lanka
(ii)
(iii) The company's financial gearing. High borrowing and interest costs
will cause high variations in equity earnings compared with variations
in operating profit, increasing the equity beta as equity returns become
more variable in relation to the market as a whole. This effect will be
countered by the low beta of debt when computing the weighted
average beta of the whole company.
238
i
(given in the exam as PO = i )
kd
P0
CA Sri Lanka
i
(1 + k d net )
i
+
(1 + k d net )2
.....
i + pn
(1 + k d net )n
Cash flow
(Market value)
1n
Interest
Redemption value
Step 2
Step 3
CA Sri Lanka
(a)
If the NPV is positive, use a second rate that is greater than the
first rate.
(b)
If the NPV is negative, use a second rate that is less than the first
rate.
Use the two NPV values to estimate the IRR. The formula to apply is
as follows.
239
FORMULA TO LEARN
NPVa
(b a) %
NPVa NPVb
IRR a +
Where:
Irredeemable
Redeemable at par after 10 years
Ignore taxation.
Solution
(a)
(b)
0
110
10
Market value
Interest
Capital
repayment
Cash
flow
Rs
(90)
10
100
i Rs. 10
=
100% = 11.1%.
P0 Rs. 90
Discount
factor @
10%
1.000
6.145
0.386
PV
Rs
(90.00)
61.45
38.60
Discount
factor @
12%
1.000
5.650
0.322
10.05
PV
Rs
(90.00)
56.50
32.20
(1.30)
10.05
10 +
2 = 11.77%
(10.05 -1.30)
240
CA Sri Lanka
k d net =
i(1 t)
P0
Where:
P0
is the current market price of the debt capital ex interest (that is,
after payment of the current interest)
Therefore if a company pays Rs. 10,000 a year interest on irredeemable debt with
a nominal value of Rs. 100,000 and a market price of Rs. 80,000, and the rate of tax
is 30%, the cost of the debt would be:
10,000
(1 0.30) = 0.0875 = 8.75%
80,000
The higher the rate of tax is, the greater the tax benefits in having debt finance will
be compared with equity finance. In the example above, if the rate of tax had been
50%, the cost of debt would have been, after tax:
10,000
(1 0.50) = 0.0625 = 6.25%
80,000
In the case of redeemable debt, the capital repayment is not allowable for tax. To
calculate the cost of the debt capital to include in the weighted average cost of
capital, it is necessary to calculate an internal rate of return which takes account of
tax relief on the interest.
4.4.1 Example: Cost of redeemable debt with tax
GD Co has Rs. 100,000 6% redeemable bonds in issue. Interest is paid annually on
31 December. The ex-interest market value of the bonds on 1 January 20X5 is
Rs. 93 and the bonds are redeemable at a 10% premium on 31 December 20X9.
The effective rate of tax is 30%.
Required
Calculate the cost of debt.
CA Sri Lanka
241
Solution
Year
0
15
5
Market value
Interest
after tax
Capital
repayment
Cash
flow
Rs
(93)
6 (1 0.3)
Discount
factor @
10%
110
1.000
3.791
PV
Rs
(93.00)
15.92
0.621
68.31
(8.77)
Discount
factor @
5%
1.000
4.329
PV
Rs
(93.00)
18.18
0.784
86.24
11.42
11.42
5
(11.42 -8.77)
= 7.82%
Note. Make sure that you know the difference in methods for calculating the cost
of irredeemable and redeemable debt, as this is often a weakness in exams.
242
CA Sri Lanka
FORMULA TO LEARN
A general formula for the weighted average cost of capital (or k0) is as follows.
VE
WACC = ke
+ kd (1 t)
VE + VD
Where:
ke
kd
VE
VD
VD
VE + VD
Rs Mn
2.500
1.500
1.000
The ordinary shares are currently quoted at Rs. 130 each, the bonds are trading at
Rs. 72 per Rs. 100 nominal and the preference shares at Rs. 52 each. The ordinary
dividend of Rs. 15 has just been paid with an expected growth rate of 10%.
Corporation tax is currently 30%.
Required
Calculate the weighted average cost of capital for this entity.
CA Sri Lanka
243
Solutions
Market values
Rs Mn
2,500
130
50
1,500 (52/100)
1,000 (72/100)
Equity (VE):
Preference shares (VP):
Bonds (VD):
6,500
780
720
8,000
Cost of equity
ke =
do 1+g
15 1+0.1
+g =
+0.1=0.2269=22.69%
Po
130
k p = d = 8 =0.1538=15.38%
Po 52
Cost of bonds
kd =
i 1 t 1210.3
=
=0.1167=11.67%
Po
72
VE
V +V +V
P
D
E
VP
+ kp
V +V +V
P
D
VD
+ kd
V +V +V
P
D
VE + VP + VD = 8,000
Market
values
244
Book
values
CA Sri Lanka
Although book values are often easier to obtain, they are of doubtful economic
significance. It is, therefore, more meaningful to use market values when data
are available. For unquoted companies, estimates of market values are likely to be
extremely subjective, and consequently book values may be used. When using
market values it is not possible to split the equity value between share capital and
reserves, and only one cost of equity can be used. This removes the need to
estimate a separate cost of retained earnings.
Note. Always use market values in an exam question unless you are told
otherwise.
You may need to calculate the market value of equity using the capitalisation of
earnings at the cost of capital.
(b)
(c)
CA Sri Lanka
(a)
(b)
245
debt capital, the perceived financial risk of the entire company might change.
This must be taken into account when appraising investments.
(c)
Many companies raise floating rate debt capital as well as fixed interest
debt capital. With floating rate debt capital, the interest rate is variable, and
is altered every three or six months or so, in line with changes in current
market interest rates. The cost of debt capital will therefore fluctuate as
market conditions vary.
Floating rate debt is difficult to incorporate into a WACC computation, and
the best that can be done is to substitute an 'equivalent' fixed interest debt
capital cost in place of the floating rate debt cost.
Alternatives to using the WACC in investment appraisal include using a riskadjusted WACC by recalculating the cost of equity to reflect a new business risk.
This can be calculated by degearing and regearing betas, which is covered in
Chapter 9. If the capital structure (financial risk) is expected to change
significantly, the adjusted present value method can be used. See Chapter 14 for
more details on this method. Another possible approach if the capital structure is
changed is to use the marginal cost of capital.
(b)
(c)
It can be argued that the current weighted average cost of capital should be used
to evaluate projects, where a company's capital structure changes only very
slowly over time; then the marginal cost of new capital should be roughly equal to
the weighted average cost of current capital.
Where gearing levels fluctuate significantly, or the finance for new project carries
a significantly different level of risks to that of the existing company, there is
good reason to seek an alternative marginal cost of capital.
246
CA Sri Lanka
Market value
Rs Mn
10
2
8
20
2100%
20
= 10%
GB Co's directors have decided to embark on major capital expenditure, which will
be financed by a major issue of funds. The estimated project cost is Rs. 3,000,000,
1/3 of which will be financed by equity, 2/3 of which will be financed by bonds. As a
result of undertaking the project, the cost of equity (existing and new shares) will
rise from 12% to 14%. The cost of preference shares and the cost of existing
bonds will remain the same, while the after tax cost of the new bonds will be 9%.
Required
Calculate the company's new weighted average cost of capital, and its marginal
cost of capital.
Solution
New weighted average cost of capital
Source
Equity
Preference
Existing bonds
New bonds
Market value
Rs Mn
11
2
8
2
23
WACC = 2.52100%
23
= 11.0%
Marginal cost of capital
CA Sri Lanka
= (2.52 2.0)100%
23 20
= 17.3%
247
QUESTION
WACC
(a)
(b)
Explain how this cost of capital is calculated and discuss the components
required. (Detailed mathematical calculations are not required.)
ANSWER
(a)
The weighted average cost of capital (WACC) is the average cost of the
different elements within the capital structure of a company, using
weightings based on the market values of each of the different elements.
In many cases it will be difficult to associate a particular project with a
particular form of finance. A company's funds may be viewed as a pool of
resources. Money is withdrawn from this pool of funds to invest in new
projects and added to the pool as new finance is raised or profits are
retained. Under these circumstances, it might seem appropriate to use an
average cost of capital as a discount rate.
The correct cost of capital to use in investment appraisal is the marginal
cost of the funds raised (or earnings retained) to finance the investment. The
WACC might be considered the most reliable guide to the marginal cost of
capital, but only on the assumption that the company continues to invest in
the future, in projects of a standard level of business risk, by raising funds in
the same proportions as its existing capital structure.
(b)
VE
VD
WACC = ke
+ kd (1 t)
VE + VD
VE + VD
Where:
ke
kd
VE
VD
t
=
=
=
=
=
cost of equity
cost of debt
market value of issued shares
market value of debt
tax rate
The cost of capital is the cost of funds that a company raises and uses, and
the return that investors expect to be paid for putting funds into the
company. It is therefore the minimum return that a company should make
on its own investments to earn the cash flows out of which investors can be
paid their return.
248
CA Sri Lanka
New equity funds are obtained from new issues of shares and from retained
earnings. The costs of these funds are effectively the rate of return required
by shareholders. In the case of retained earnings, the cost is the opportunity
cost of the dividend forgone by the shareholders.
The cost of equity, both for new issues and retained earnings, is often
estimated using the dividend valuation model, on the assumption that the
market value of shares is directly related to expected future dividends on the
shares.
Estimating the cost of fixed interest or fixed dividend capital is much easier
than estimating the cost of ordinary share capital because the interest
received by the holder of the security is fixed by contract and will not
fluctuate.
The cost of debt capital already issued is the rate of interest (the internal
rate of return) which equates the current market price with the discounted
future cash receipts from the security.
Since the interest on debt capital is an allowable deduction for tax
purposes, this should be taken into account in computing the cost of debt
capital, so as to make it properly comparable with the cost of equity.
If a firm has floating rate debt, the cost of an equivalent fixed interest debt
should be substituted. This means debt with a similar term to maturity in a
firm of similar standing. The cost of short-term funds such as bank loans and
overdrafts is the current rate of interest being charged on such funds.
Weightings should be based on market values where possible because they
have greater economic significance than book values.
CA Sri Lanka
249
CHAPTER ROUNDUP
250
The cost of capital is the rate of return that the entity must pay to satisfy the
providers of funds, and it reflects the riskiness of the finance used.
We then looked at the other method of calculating the cost of equity which uses
the capital asset pricing model (CAPM). This model incorporates risk.
The cost of debt is lower than the cost of equity, as debt finance offers a higher
degree of security to its holders. We need to use different techniques to calculate
redeemable and irredeemable debt costs.
CA Sri Lanka
PROGRESS TEST
The cost of capital has three elements. Which of the following is not one of these
elements?
A
B
C
D
A share has a current market value of Rs. 120 and the last dividend was Rs. 10. If
the expected annual growth rate of dividends is 5%, calculate the cost of equity
capital.
The risk-free rate of return is 8%, average market return is 14% and a share's beta
factor is 0.5. What is the cost of equity?
Identify the variables ke, d1, P0 and g in the following dividend valuation model
formula.
ke =
d1
+g
P0
Identify the variables ke, kd, VE and VD in the following weighted average cost of
capital formula.
VE
WACC = ke
+ kd (1 t)
V
+
V
D
E
7
CA Sri Lanka
VD
VE + VD
When calculating the weighted average cost of capital, which of the following is
the preferred method of weighting?
A
Average levels of the market values of debt and equity (ignoring reserves)
over five years
What is the cost of Re. 1 irredeemable debt capital paying an annual rate of
interest of 7%, and having a current market price of Rs. 1.50?
251
A business has a cost of equity of 25%. It has 4 million shares in issue, and has had
for many years.
Its dividend payments in the years 20X9 to 20Y3 were as follows.
End of year
20X9
20Y0
20Y1
20Y2
20Y3
Dividends
Rs '000
220
257
310
356
423
Dividends are expected to continue to grow at the same average rate into the
future.
According to the dividend valuation model, what should be the share price at the
start of 20Y4?
A
B
C
D
10
Rs. 0.96
Rs. 1.10
Rs. 1.47
Rs. 1.73
A business is about to pay a Rs. 0.50 dividend on each ordinary share. Its earnings
per share was Rs. 1.50.
Net assets per share is Rs. 6. Current share price is Rs. 4.50 per share.
What is the cost of equity?
A
B
C
D
11
252
31%
30%
22%
21%
CA Sri Lanka
12
A share in a business has an equity beta of 1.3. MS Co's debt beta is 0.1. It has a
gearing ratio of 20% (debt:equity). The market premium is 8% and the risk-free
rate is 3%. The business pays 30% corporation tax.
What is the cost of equity?
A
B
C
D
13
8.4%
12.2%
13.4%
9.5%
A business has in issue 10% irredeemable loan notes, currently traded at 95%
cum-interest.
If the tax rate changes from 30% to 20% for the company, the cost of irredeemable
debt:
A
B
C
D
14
Increases to 9.4%
Increases to 8.4%
Decreases to 9.4%
Decreases to 8.4%
A business has 10% redeemable loan notes in issue trading at Rs. 90. The loan
notes are redeemable at a 10% premium in five years' time, or convertible at that
point into 20 ordinary shares. The current share price is Rs. 2.50 and is expected
to grow at 10% per annum for the foreseeable future. The business pays 30%
corporation tax.
What is the best estimate of the cost of these loan notes?
A
B
C
D
15
9.8%
7.9%
11.5%
15.2%
Rs. Mn
5
20
7
32
The ordinary shares are currently quoted at Rs. 3.00, and the loan notes at Rs. 90.
IDO Co has a cost of equity of 12% and pays corporation tax at a rate of 30%.
CA Sri Lanka
253
Which of the following are assumed if a company's current weighted average cost
of capital ('WACC') is to be used to appraise a potential project?
1
2
17
Capital structure will remain unchanged for the duration of the project
The business risk of the project is the same as the current business
operations
The project is relatively small in size
A
B
C
D
1 and 2 only
2 and 3 only
1 and 3 only
1, 2 and 3
Which of the following assumptions is not required when using the capital asset
pricing model to estimate the cost of equity for project appraisal?
A
B
C
D
18
10.4%
11.1%
11.7%
11.8%
An 8% irredeemable Rs. 0.50 preference share is being traded for Rs. 0.30 cum-div
currently in a company that pays corporation tax at a rate of 30%.
What is the cost of capital for these preference shares?
A
B
C
D
254
10.8%
15.4%
26.7%
18.7%
CA Sri Lanka
10 (1+0.05)
+ 0.05 = 13.75%
120
The answer is C. Current market values of debt and equity (ignoring reserves).
Cost of debt =
The answer is D.
0.07
= 4.67%
1.50
20X9 to 20Y3 covers four years of growth, so the average annual growth rate =
4
423/220
Ke =
d0 1 + g
+g
P0
Ke g =
P0 =
1 = 0.178 = 17.8%
d0 1 + g
P0
d0 1 + g
Ke g
CA Sri Lanka
255
10
The answer is A.
g = retention rate return on investment.
Retention rate = proportion of earnings retained = (Rs. 1.50- Rs. 0.5)/
Rs. 1.50 = 66.7%
Return on new investment = EPS/net assets per share = Rs. 1.5/Rs. 6 = 0.25 so
25%
g = 66.7% 25% = 16.7%
Ke =
d0 1 + g
+g
P0
$0.501.167 + 0.167
$4.50 $0.50
= 31%
11
The answer is D.
A is incorrect. Systematic risk refers to return volatility.
B is incorrect. This describes total risk, which has both systematic and
unsystematic elements.
C is incorrect. Systematic risk cannot be diversified away.
D is correct. It is the risk generated by undiversifiable systemic economic risk
factors.
12
The answer is C.
The equity beta relates to the cost of equity, hence gearing and the debt beta are
not relevant.
E(ri) = Rf + (E(Rm) Rf) = 3% + (1.3 8%) = 13.4%
13
The answer is A.
Kd = I(1-t)/Po
The loan note pays interest of Rs. 100 nominal 10% = 10%. Ex-interest market
price is Rs. 95 Rs. 10 = Rs. 85.
Before the tax cut Kd = 10(1 0.3)/85 = 8.2%
After the tax cut Kd = 10(1 0.2)/85 = 9.4%
Decreasing tax reduces tax saved therefore increases the cost of debt.
256
CA Sri Lanka
14
The answer is C.
Conversion value: Future share price = Rs. 2.50 (1.1)5 = Rs. 4.03
So conversion value = 20 Rs. 4.03 = Rs. 80.60. The cash alternative = 100 1.1 =
Rs. 110, therefore investors would not convert and redemption value = Rs. 110.
Kd = IRR of the after tax cash flows as follows:
Time
Rs
0
1-5
5
(90)
10(1 0.3) = 7
110
DF 10%
1
3.791
0.621
Present
value 10%
(Rs)
(90)
26.54
68.31
4.85
DF 15%
1
3.352
0.497
Present
value 15%
(Rs)
(90)
23.46
54.67
(11.87)
NPVa
(b a)
NPVa NPVb
4.85
= 10% +
(15% 10%)
(4.85+11.87)
IRR = a +
= 11.5%
15
The answer is C.
Kd = I(1 T)/P0 = 13(1 0.3)/90 = 10.11%
Vd = Rs. 7m (90/100) = Rs. 6.3m
Ke = 12% (given)
Ve = Rs. 3 10m shares = Rs. 30m
Note. reserves are included as part of share price.
The answer is D.
Changes in capital structure will affect the WACC so need to stay constant. The
current WACC reflects a risk premium commensurate with current operations,
hence the new project should be of a similar risk profile to current operations. The
project should be small in size; large projects are both riskier (commanding a risk
premium) and likely to affect the value of equity, in turn affecting the WACC.
CA Sri Lanka
257
17
The answer is D.
A is a necessary assumption. Share price can be used to accurately calculate beta
factors.
B is a necessary assumption. Shareholders only require compensation for
systematic risk, ie that risk that cannot be diversified away.
C is a necessary assumption. Beta factors are estimated using historical data, but
the cost equity is to be used to appraise a future project, hence we need to assume
the historical beta will continue.
D is not a necessary assumption. As long as investors are well diversified, any
individual company need not be. Investors are assumed to invest in a diversified
portfolio of projects; it does not matter how few or how many reside in any one
company.
18
The answer is B.
Ex-div share price = Rs. 0.30 (8% Rs. 0.50) = Rs. 0.26
Kp = Rs. 0.50 8%/Rs. 0.26 = 15.4%
Note. Dividends are not tax deductible hence no adjustment for corporation tax is
required.
258
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CHAPTER
INTRODUCTION
This chapter looks at the impact of capital structure on key ratios of
interest to investors and on the market value of a company. Choosing the
best possible capital structure is a key strategic decision. We also look at
the effects of changing capital structure on the cost of capital. The
technique of gearing and ungearing betas is important for this exam
and will be looked at again later in the context of business valuations.
Knowledge Component
1
Corporate Financial Objectives and Measurement
1.2
1.2.3
2.6
2.6.1
2.6.3
2.6.4
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CHAPTER CONTENTS
LEARNING
OUTCOME
2.6.1
1.2.3, 2.6.3
2.6.1
2.6.4
260
(a)
(b)
(c)
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(d)
(e)
(f)
(g)
(h)
CA Sri Lanka
(a)
(b)
(c)
Indirect financial distress costs can include a loss of sales, higher costs
from suppliers or sale of inventory at below market value.
(d)
(e)
(f)
Heavy borrowing increases the financial risks for ordinary shareholders who
may demand a higher rate of return because an increased interest burden
increases the risks that dividends will not be paid.
(g)
(h)
261
Life cycle issues are therefore important. Young, growing companies tend to have
unpredictable and unstable cash flows, so debt finance is less appropriate than
for mature companies.
2.1 Gearing
In Chapter 3, we revised gearing briefly. You should remember that the financial
risk of a company's capital structure can be measured by a gearing ratio, a debt
ratio or debt:equity ratio and by the interest cover. A gearing ratio should not
be given without stating how it has been defined.
Note. You need to be able to explain and calculate the level of financial gearing
using alternative measures. The question may specify how gearing should be
calculated, eg debt to total value of entity using market values.
Financial gearing measures the relationship between shareholders' capital plus
reserves, and either prior charge capital or borrowings or both.
Commonly used measures of financial gearing are based on the statement of
financial position values of the fixed interest and equity capital. They include:
262
CA Sri Lanka
QUESTION
Gearing
Compute the company's financial gearing ratio from the following statement of
financial position.
Rs Mn
Non-current assets
Current assets
Payables: amounts falling due within one
year
Loans
Bank overdraft
Trade payables
Bills of exchange
Rs Mn
Rs Mn
12,400
1,000
120
260
430
70
880
120
12,520
4,700
500
(5,200)
(300)
(250)
6,770
Rs '000
CA Sri Lanka
1,500
500
2,000
760
1,200
2,810
6,770
263
ANSWER
Rs Mn
Prior charge capital
Preferred shares
Bonds
Long-term bank loans
Prior charge capital, ignoring short-term debt
Short-term loans
Overdraft
Prior charge capital, including short-term interest bearing debt
500
4,700
500
5,700
120
260
6,080
Either figure, Rs. 6,080 million or Rs. 5,700 million, could be used. If gearing is
calculated with capital employed in the denominator, and capital employed is noncurrent assets plus net current assets, it would be better to exclude short-term
interest bearing debt from prior charge capital. This is because short-term debt is
set off against current assets in arriving at the figure for net current assets.
Equity = 1,500 + 760 + 1,200 + 2,810 = Rs. 6,270 million
The gearing ratio can be calculated in any of the following ways.
(a)
(b)
(c)
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Contribution
Profit before interest and tax (PBIT)
CA Sri Lanka
If contribution is high but PBIT is low, fixed costs will be high, and only
just covered by contribution. Business risk, as measured by operating
gearing, will be high.
265
(b)
If contribution is not much bigger than PBIT, fixed costs will be low, and
fairly easily covered. Business risk, as measured by operating gearing, will be
low.
As a general guide, an interest cover of less than three times is considered low,
indicating that profitability is too low given the gearing of the company.
2.2.1 Example: Changing capital structure
You need to be able to demonstrate the impact of changing capital structures
on investor ratios. The following example illustrates how such a question could
be set out.
A summarised statement of financial position of FR Co is as follows.
Assets less current liabilities
Debt capital
Share capital (20 million shares)
Reserves
Rs Mn
150
(70)
80
20
60
80
Rs Mn
21.0
6.0
15.0
4.5
10.5
6.5
4.0
The company is now considering an investment of Rs. 25 million. This will add
Rs. 5 million each year to profits before interest and tax.
(a)
266
There are two ways of financing this investment. One would be to borrow
Rs. 25 million at a cost of 8% per annum in interest. The other would be to
raise the money by means of a 1 for 4 rights issue.
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(b)
(c)
The company does not intend to allow its gearing level, measured as debt
finance as a proportion of equity capital plus debt finance, to exceed 55% as
at the end of any financial year. In addition, the company will not accept any
dilution in earnings per share.
Assume that the rate of taxation will remain at 30% and that debt interest costs
will be Rs. 6 million plus the interest cost of any new debt capital.
Required
(a)
Prepare a profit forecast for next year, assuming that the new project is
undertaken and is financed (i) by debt capital or (ii) by a rights issue.
(b)
Calculate the earnings per share next year, with each financing method.
(c)
Calculate the effect on gearing as at the end of next year, with each financing
method.
(d)
Solution
Current earnings per share are Rs. 10.5 million/20 million shares = 52.5 cents.
If the project is financed by Rs. 25 million of debt at 8%, interest charges will rise
by Rs. 2 million. If the project is financed by a 1 for 4 rights issue, there will be 25
million shares in issue.
Finance
Finance with
with debt
rights issue
Rs Mn
Rs Mn
26.00
26.00
Profit before interest and tax (+ 5.0)
8.00
6.00
Interest
18.00
20.00
5.40
6.00
Taxation (30%)
12.60
14.00
Profit after tax
7.00
8.75
Dividends (35c per share)
5.60
5.25
Retained profits
Earnings (profits after tax)
Number of shares
Earnings per share
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Rs. 12.6m
20 million
63c
Rs. 14.0m
25 million
56c
267
The projected statement of financial position as at the end of the year will be:
Finance
with debt
Rs Mn
180.6
(95.0)
85.6
20.0
65.6
85.6
Finance with
rights issue
Rs Mn
180.25
(70.00)
110.25
25.00
* 85.25
110.25
*The rights issue raises Rs. 25 million, of which Rs. 5 million is represented in the
statement of financial position by share capital and the remaining Rs. 20 million
by share premium. The reserves are therefore the current amount (Rs. 60 million)
plus the share premium of Rs. 20 million plus accumulated profits of Rs. 5.25
million.
Debt capital
Debt capital plus equity finance
Gearing
Finance
with debt
95.0
(95.0 + 85.6)
53%
Finance with
rights issue
70.0
(70.0 + 110.25)
39%
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as interest cover falls, the amount of assets available for security falls and the
risk of bankruptcy increases.
(b)
The cost of equity rises as the level of gearing increases and financial risk
increases.
(c)
The weighted average cost of capital does not remain constant, but
rather falls initially as the proportion of debt capital increases, and then
begins to increase as the rising cost of equity (and possibly of debt) becomes
more significant.
(d)
The traditional view about the cost of capital is illustrated in the following figure.
It shows that the weighted average cost of capital will be minimised at a particular
level of gearing P.
Figure 9.1
Cost of
capital
ke
k0
kd
Where:
ke
kd
k0
Level of gearing
The traditional view is that the weighted average cost of capital, when plotted
against the level of gearing, is saucer shaped. The optimum capital structure is
where the weighted average cost of capital is lowest, at point P.
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269
The total market value would be computed by discounting the total earnings at a
rate that is appropriate to the level of operating risk. This rate would represent
the WACC of the company.
Thus Modigliani and Miller concluded that the capital structure of a company
would have no effect on its overall value or WACC.
3.2.1 Assumptions of net operating income approach
Modigliani and Miller made various assumptions in arriving at this conclusion,
including:
(a)
(b)
(c)
Debt is risk-free and freely available at the same cost to investors and
companies alike.
270
(a)
(b)
The cost of equity rises in such a way as to keep the weighted average
cost of capital constant.
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ko
kd
Level of gearing
ke
ko
k d after tax
0
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Gearing up to 100%
271
This formula shows that the greater the value of debt, the greater the value of the
company, and so supports the idea that a company should be geared as highly as
possible to maximise its value.
FORMULA TO LEARN
A further formula arising from MM's theory is:
keg = k eu +(k eu k d ) Vd (1 T)
Ve
Where:
This formula shows that the cost of equity will increase when the relative value of
debt to equity increases.
FORMULA TO LEARN
MM also came up with an adjusted cost of capital formula as follows:
kadj = keu(1 tL)
Where:
This formula shows that WACC is reduced when gearing increases, ie when more
debt is taken on.
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MM's theory assumes that capital markets are perfect. For example, a
company will always be able to raise finance to fund worthwhile projects.
This ignores the danger that higher gearing can lead to financial distress
costs and agency problems (see Section 1.3).
(b)
(c)
Investors are assumed to act rationally, which may not be the case in
practice.
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273
High
Young company
Mature company
Note. You may need to be able to discuss whether the choice of capital structure
for an entity is likely to affect its overall value.
274
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VD (1 t)
VE
+ d
VE + VD (1 t)
VE + VD (1 t)
Where:
VD
VE
FORMULA TO LEARN
Debt is often assumed to be risk-free and its beta (d) is then taken as zero, in
which case the formula above reduces to the following form.
u = g
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VE
VE
or, without tax, u = g
VE + VD(1 t)
VE + VD
275
Find a company's equity beta in the area the business is moving into
and strip out the effect of gearing to create an ungeared beta.
u = g
VE
VE + VD(1 t)
Step 2
Step 3
FORMULA TO LEARN
kadj = keu(1 tL)
Where:
is equivalent to
VD
VD + VE
276
CA Sri Lanka
(a)
(b)
Find a company's equity beta in the area the business is moving into
and strip out the effect of gearing to create an ungeared beta.
The beta value for the industry is 1.59.
2
u = 1.59
= 1.18
2+(1(1 0.30))
Step 2
Step 3
Use this ungeared keu to calculate the WACC using the MM formula.
kadj = keu(1 tL)
The project will presumably be financed in a gearing ratio of 2:5 debt
to equity, and so:
2
L=
2+5
kadj = 16.9% ( 1 (0.3 2/7) = 15.45%
4.3.3 Approach 2
Step 1
Find a company's equity beta in the area the business is moving into
and strip out the effect of gearing to create an ungeared beta.
u = g
Step 2
VE
VE + VD(1 t)
Regear the beta using the company's gearing using the formula:
g = u + (u - d)
VD (1 t)
VE
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Use this ke geared to calculate the WACC using the formula below.
277
FORMULA TO LEARN
VE
WACC = ke
+ kd (1 t)
VE + VD
VD
VE + VD
Using the information from the example above, the second approach can be used
as follows.
Step 1
u = 1.59
Step 2
2+(1(1
0.30))
= 1.18
Regear the beta to reflect the company's own gearing level of 2:5.
g = 1.18 + 1.18 [(2 0.70)/5] = 1.51
This is a project-specific beta for the firm's equity capital, and so using
the CAPM, we can estimate the project-specific cost of equity as:
keg = 11% + (16% 11%) 1.51 = 18.55%
Step 3
Note. You will need to be able to ungear and regear a beta in order to calculate a
value for a business.
QUESTION
Two companies are identical in every respect, except for their capital structure. XY
has a debt:equity ratio of 1:3, and its equity has a value of 1.20. PQ has a
debt:equity ratio of 2:3. Corporation tax is at 30%.
Required
State a value for PQ's equity.
ANSWER
Estimate an ungeared beta from XY data.
= 0.973
3+(1(1
0.30))
a = 1.20
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CA Sri Lanka
3+(2(10.30))
= 1.427
3
e = 0.973
QUESTION
BW Co is a major international company with its head office in Sri Lanka, wanting
to raise Rs. 150 million to establish a new production plant in India. BW Co
evaluates its investments using NPV, but is not sure what cost of capital to use in
the discounting process for this project evaluation.
The company is also proposing to increase its equity finance in the near future for
SL expansion, resulting overall in little change in the company's market-weighted
capital gearing.
The summarised financial data for the company before the expansion are shown
below.
Statement of consolidated income for the year ended 31 December 20X1
Revenue
Gross profit
Profit after tax
Dividends
Retained earnings
Rs Mn
1,984
432
81
37
44
Non-current assets
Working capital
Medium-term and long-term loans (see note below)
Rs Mn
846
350
1,196
210
986
Shareholders' funds
Rs Mn
225
761
986
These include Rs. 75m 14% fixed rate bonds due to mature in five years time and
redeemable at par. The current market price of these bonds is Rs. 120.00 and they
have a cost of debt of 9%. Other medium- and long-term loans are floating rate
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279
bank loans at the Sri Lankan Inter-Bank Offered Rate (SLIBOR) plus 1%, with a
cost of debt of 7%.
Company rate of tax may be assumed to be at the rate of 30%. The company's
ordinary shares are currently trading at Rs. 3.76.
The equity beta of BW Co is estimated to be 1.18. The systematic risk of debt may
be assumed to be zero. The risk-free rate is 7.75% and market return 14.5%.
The estimated equity beta of the main Indian competitor in the same industry as
the new proposed plant in India is 1.5, and the competitor's capital gearing is 35%
equity and 65% debt by book values, and 60% equity and 40% debt by market
values.
Required
Compute the cost of capital that the company should use as the discount rate for
its proposed investment in India. State clearly any assumptions that you make.
ANSWER
The discount rate that should be used is the weighted average cost of capital
(WACC), with weightings based on market values. The cost of capital should take
into account the systematic risk of the new investment, and therefore it will not be
appropriate to use the company's existing equity beta. Instead, the estimated
equity beta of the main Indian competitor in the same industry as the new
proposed plant will be ungeared, and then the capital structure of BW Co applied
to find the WACC to be used for the discount rate.
Since the systematic risk of debt can be assumed to be zero, the Indian equity beta
can be 'ungeared' using the following expression.
u = g
VE
VE + VD(1 t)
Where:
u =
g =
VE =
VD =
t =
asset beta
equity beta
proportion of equity in capital structure
proportion of debt in capital structure
tax rate
280
60
60+
40
(1
0.30)
= 1.023
CA Sri Lanka
The next step is to calculate the debt and equity of BW Co based on market values.
Rs Mn
Equity
450m shares at Rs. 3.76 cents
1,692.0
Debt: bank loans
(210 75)
135.0
Debt: bonds
(75 million 1.20)
90.0
225.0
Total debt
Total market value
1,917.0
The beta can now be re-geared
g = 1.023 + 1.023 [(225 0.7)/1,692] = 1.118
This can now be substituted into the capital asset pricing model (CAPM) to find
the cost of equity.
ke = Rf + [Rm Rf]
Where:
ke = cost of equity
Rf = risk-free rate of return
Rm = market rate of return
ke = 7.75% + (14.5% 7.75%) 1.118 = 15.30%
1,692
15.3
1,917
135 9 90
+ 7
= 14.4%
+
1,917
1,917
Note. You have been given both costs of debt. In the exam you may well be asked
to calculate the cost of debt.
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281
CHAPTER ROUNDUP
282
We have looked at what proportion of debt and equity an entity should use.
Debt finance can create valuable tax savings which can reduce the cost of capital
and increase shareholder value. However, too much debt increases financial risk.
If an entity changes its capital structure, it will impact on a number of key ratios
such as gearing, interest cover and EPS.
There are two main theories which attempt to explain the effect of changes in
capital structure on cost of capital and therefore the market value of a company.
These are the traditional theory and the net operating income approach
(Modigliani and Miller MM).
MM's theory can be used to calculate the cost of capital in situations where an
investment has differing business and finance risks from the existing business.
Remember from the last chapter that if an entity is investing in projects with
different business risk, it is not appropriate to use the WACC.
CA Sri Lanka
PROGRESS TEST
_________________________ gearing =
Contribution
Profit before interest and tax
What three steps are involved in calculating a project specific cost of capital?
It does not matter, as it will not affect the returns the projects generate.
Why do Modigliani-Miller (with tax) assume increased gearing will reduce the
weighted average cost of capital (WACC)?
A
B
C
D
A
B
C
D
CA Sri Lanka
Director A
Director B
MM (with tax)
traditional view
traditional view
MM (no tax)
MM (no tax)
MM (no tax)
MM (with tax)
traditional view
283
10
0.89
0.84
0.28
0.75
11
12
284
13
4%
7.6%
8.4%
6.3%
As deductions have reduced tax payable to zero, further deductions will not
save tax.
CA Sri Lanka
Financial gearing =
Operating gearing =
Contribution
Profit before interest and tax
Interest cover =
Either:
Step 1
Find a company's equity beta in the area the business is moving into
and strip out the effect of gearing to create an ungeared beta.
u = g
VE
VE + VD(1 t)
Step 2
Step 3
Or:
Step 1
Find a company's equity beta in the area the business is moving into
and strip out the effect of gearing to create an ungeared beta.
Step 2
Regear the beta using the company's gearing using the formula
g = u + (u d)
VD (1 t)
VE
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285
The answer is B. Statement A. Although true, higher gearing increases the cost of
equity (financial risk) therefore this does not in itself explain a reducing WACC.
Statement B is correct. The only difference between MM (no tax) and MM (with
tax) is the tax deductibility of interest payments. MM demonstrated that when a
business does not pay tax, returns are not affected by capital structure. However,
as interest is tax deductible (and dividends are not) paying relatively more
interest will reduce tax payable and increase total returns to investors.
Statement C is similar to Statement A.
Statement D refers to the traditional view. MM assume financial risk is
consistently proportionate to gearing across all levels.
The answer is B. The traditional view has a 'u' shaped weighted average cost of
capital (WACC) curve hence there is an optimal point where WACC is minimised.
MM (with tax) assumes 100% gearing is optimal, so no balance with equity.
MM (no tax) assumes the WACC is unaffected by the level of gearing. It therefore
follows as the WACC is the discount rate for the projects of the business that the
value of the business is unaffected by the gearing decision.
The answer is A. B Co is being used as a proxy company and has a different level of
gearing to TR Co.
Ungear B Co's equity Beta:
u = g
Ve
Ve + Vd 1 t
= 1.05
4
4 +1 1 0.3
= 0.89
10
Ve + Vd (1 T)
Ve
g= 0.89
3+1(1 0.3)
3
g = 1.10
Put into CAPM:
286
Ke
Rf + (rm Rf)
Ke
4 + 1.10(4)
8.4%
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11
The answer is A. An equity beta reflects both business risk and financial risk. An
asset beta only reflects the former.
12
13
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287
288
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290
CA Sri Lanka
CHAPTER
INTRODUCTION
As we've already seen, dividend policy is a key element in overall
financial strategy, here we consider dividend policy in depth, in
particular whether the amounts of profits that a company distributes has
much or little impact on shareholders.
Knowledge Component
3
Dividend Policy and Capital Gains
3.1
Dividend policy
3.1.1
3.1.2
Discuss dividend theories such as dividend irrelevancy theory, birdin-hand theory, tax preference theory, residual theory and pecking
order theory.
3.1.3
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CHAPTER CONTENTS
LEARNING
OUTCOME
3.1.1, 3.1.3
3.1.2, 3.1.3
QUESTION
Retained earnings
Explain the major reasons for using the cash from retained earnings to finance
new investments, rather than to pay higher dividends and then raise new equity
funds for the new investments.
292
CA Sri Lanka
ANSWER
(a)
(b)
(c)
The use of funds from retained earnings avoids the possibility of a change in
control resulting from an issue of new shares.
The need to remain profitable. (Dividends are paid out of profits, and an
unprofitable company cannot forever go on paying dividends out of retained
profits made in the past.)
(b)
(c)
(d)
The effect of inflation, and the need to retain some profit within the
business just to maintain its operating capability unchanged.
(e)
The company's gearing level. (If the company wants extra finance, the
sources of funds used should strike a balance between equity and debt
finance.)
(f)
(g)
(h)
The ease with which the company could raise extra finance from sources
other than retained earnings see below regarding life cycle issues.
(i)
293
Mature companies usually have a stable growth dividend policy. They have less
need to invest in new projects, and investments can and should be financed by
debt.
Almost 20 years after its inception, Microsoft announced that it would pay a
dividend for the first time, in an attempt to address calls for the company to
release some of its $43.4 billion cash surplus to its shareholders. Despite this
news, Microsoft's share price fell by 3% ($1.71). This suggests that the markets
may have taken the announcement as a signal of a reduction in profitable future
investment opportunities for the company.
294
CA Sri Lanka
Note. You should show, whenever relevant in exam answers, that you appreciate
the signalling effect of dividends.
295
clientele consisting of those preferring its particular payout ratio, but one clientele
would be entirely as good as another in terms of the valuation it would imply for
the firm'.
(Modigliani and Miller, 1961 page 431)
In addition, MM state that dividends can be manufactured by shareholders if a
company retains and reinvests. The retention and reinvestment of funds creates
capital growth (an increase in share price) that can be realised by the
shareholder by selling some of their shares.
2.1.4 The case in favour of the relevance of dividend policy (and against
MM's views)
There are strong arguments against MM's view that dividend policy is irrelevant
as a means of affecting shareholder's wealth.
296
(a)
(b)
(c)
Due to imperfect markets and the possible difficulties of selling shares easily
at a fair price, shareholders might need high dividends in order to have
funds to invest in opportunities outside the company.
(d)
Markets are not perfect. Because of transaction costs on the sale of shares,
investors who want some cash from their investments will prefer to receive
dividends rather than to sell some of their shares to get the cash they want.
(e)
(f)
(g)
CA Sri Lanka
Note. Even if you accept that dividend policy may have some influence on share
values, there may be other, more important, influences. Don't be tempted to
regurgitate chunks of theory in the exam; you must focus on the entities involved.
QUESTION
Dividend policy
Profits
Rs Mn
176
200
240
290
444
Dividend
Shares in issue
Rs Mn
88
800,000
104
800,000
120
1,000,000
150
1,000,000
222 (proposed)
1,500,000
Required
Discuss whether a continuation of the same dividend policy as in the past would
be suitable now that the company is quoted on the stock market.
ANSWER
Year
4 years ago
3 years ago
2 years ago
1 year ago
Current year
Dividend as % of profit
50%
52%
50%
52%
50%
The company appears to have pursued a dividend policy of paying out half of
after-tax profits in dividend. This policy is only suitable when a company achieves
a stable earnings per share (EPS) or steady EPS growth. Investors do not like a fall
in dividend from one year to the next, and the fall in dividend per share in the
current year is likely to be unpopular, and to result in a fall in the share price.
The company would probably serve its shareholders better by paying a dividend
of at least Rs. 150 per share, possibly more, in the current year, even though the
dividend as a percentage of profit would then be higher.
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297
(b)
Investors may be able to obtain tax advantages if dividends are in the form
of shares.
(c)
(d)
A small scrip issue will not dilute the share price significantly. If, however,
cash is not offered as an alternative, empirical evidence suggests that the
share price will tend to fall.
(e)
A share issue will decrease the company's gearing, and may therefore
enhance its borrowing capacity.
298
(a)
They are viewed as an isolated distribution of spare cash, a 'one off' hence
avoiding creating an expectation of higher dividends going forwards.
(b)
It reduces the number of shares in issue, reducing the total dividend that
needs to be paid going forwards maintaining dividend per share will be
less expensive when fewer shares are in circulation.
(c)
(d)
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(e)
CA Sri Lanka
They can provide an exit route for investors particularly attractive with
unlisted businesses, as finding a buyer to sell shares to may be difficult.
299
CHAPTER ROUNDUP
300
CA Sri Lanka
PROGRESS TEST
Which of the following are assumptions for Modigliani and Miller's dividend
irrelevance theory?
1
2
3
4
A
B
C
D
1, 2, 3 only
1, 2, 4 only
2, 3, 4 only
1, 2, 3 and 4
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301
10
Three companies (A, B and C) have the following dividend payments history.
Company
A Dividend
A Earnings
B Dividend
B Earnings
C Dividend
C Earnings
20X1
100
200
50
100
nil
400
20X2
110
200
150
300
300
350
20X3
121
201
25
50
nil
500
A
B
C
D
11
Constant growth
Constant pay-out
High pay-out
Constant growth
Constant pay-out
Constant growth
Residual
Residual
Residual
Residual
Random
Random
SD Co increased its gearing and its weighted average cost of capital reduced.
Which of the following theories might explain this?
12
1
2
3
4
A
B
C
D
1, 2 and 3 only
1 and 4 only
1 and 2 only
2 and 4 only
302
Clientele
Scrip dividend
The answer is A. Modigliani and Miller (MM) assume perfect capital markets so
there is no information content in dividend policy. They assume no taxes or tax
preferences so investors will be indifferent between income and capital gains.
They also assume no transaction costs so investors can switch between income
and capital gains costlessly eg if a company withholds a dividend when the
investor would prefer cash, the investor can sell some of their shares (known as
'manufacturing a dividend'). MM's theory is not contingent on the existence or
otherwise of inflation.
The answer is B. The signalling effect alludes to the information content in the
dividend announcement. In semi-strong form capital markets with imperfect
information, investors will 'interpret' dividend announcements and by comparing
them to expectations they will adjust their perceptions of past, current and future
performance.
The answer is C. To incentivise investors to choose the shares alternative for their
dividend, companies can offer an 'enhanced scrip', ie offer more value in shares
than the cash alternative.
10
The answer is A. Company A's dividends are growing at 10% per annum even
though earnings are not.
Company B is paying 50% of its earnings out as a dividend consistently.
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303
Company C's dividends are not obviously connected with reported earnings, so
their policy is either random or residual (ie only paying dividends once
investment plans are budgeted for).
11
12
304
The answer is B. Pecking order theory suggests that as internal funds are free to
raise and immediate, they should be used first. After that, debt is relatively quick
and inexpensive to raise, interest is tax deductible and the cost of debt is lower
than the cost of equity. New equity is relatively expensive, and hence is considered
last.
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CHAPTER
INTRODUCTION
Much of finance theory relies on the concept of an efficient capital
market. In this chapter we examine how share prices are determined,
and consider the various possible degrees of market efficiency and how
this impacts on the organisations financial strategy and decision making.
Knowledge Component
3
Dividend Policy and Capital Gains
3.2
Capital gains/loss
3.2.1
3.2.2
3.2.3
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CHAPTER CONTENTS
1 Share prices and investment returns
2 The efficient market hypothesis
LEARNING
OUTCOME
3.2.1
3.2.2, 3.2.3
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(b)
The analyst will then be able to predict a future share price movement, and so
recommend clients to buy or sell the share before the price change occurs.
In practice, however, share price movements are affected by day-to-day
fluctuations, reflecting:
Supply and demand in a particular period
Investor confidence
Market interest rate movements
Investment analysts want to be able to predict these fluctuations in prices, but
fundamental analysis might be inadequate as a technique.
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307
308
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Allocative efficiency
If financial markets allow funds to be directed towards firms which make the
most productive use of them, then there is allocative efficiency in these
markets.
(b)
Operational efficiency
Transaction costs are incurred by participants in financial markets, for
example commissions on share transactions, margins between interest rates
for lending and for borrowing, and loan arrangement fees. Financial markets
have operational efficiency if transaction costs are kept as low as possible.
Transaction costs are kept low where there is open competition between
brokers and other market participants.
(c)
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The prices of securities bought and sold reflect all the relevant
information which is available to the buyers and sellers: in other words,
309
share prices change quickly to reflect all new information about future
prospects.
(b)
(c)
(d)
(e)
(b)
If a company makes a bad investment, shareholders will find out and so the
price of its shares will fall.
(c)
If interest rates rise, shareholders will want a higher return from their
investments, so market prices will fall.
CA Sri Lanka
This means that individuals cannot 'beat the market' by reading the newspapers or
annual reports, since the information contained in these will be reflected in the
share price.
Tests to prove semi-strong efficiency have concentrated on the speed and
accuracy of stock market response to information and on the ability of the market
to anticipate share price changes before new information is formally
announced. For example, if two companies plan a merger, share prices of the two
companies will inevitably change once the merger plans are formally announced.
The market would show semi-strong efficiency, however, if it were able to
anticipate such an announcement, so that share prices of the companies
concerned would change in advance of the merger plans being confirmed.
Research has suggested that market prices anticipate mergers several months
before they are formally announced, and the conclusion drawn is that the stock
markets in these countries do exhibit semi-strong efficiency.
2.4.3 Strong form efficiency
If a stock market displays a strong form of efficiency, share prices reflect all
information whether publicly available or not.
From past price changes
From public knowledge or anticipation
From specialists' or experts' insider knowledge (eg investment managers)
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311
(b)
The market will identify any attempts to window dress the accounts and
put an optimistic spin on the figures.
(c)
The market will decide what level of return it requires for the risk involved
in making an investment in the company. It is pointless for the company to
try to change the market's view by issuing different types of capital
instruments.
Similarly, if the company is looking to expand, the directors will be wasting their
time if they seek as takeover targets companies whose shares are undervalued,
since the market will fairly value all companies' shares.
Only if the market is semi-strongly efficient, and the financial managers possess
inside information that would significantly alter the price of the company's
shares if released to the market, could they perhaps gain an advantage. However,
attempts to take account of this inside information may breach insider dealing
laws.
The different characteristics of a semi-strong form and a strong form efficient
market thus affect the timing of share price movements, in cases where the
relevant information becomes available to the market eventually. The difference
between the two forms of market efficiency concerns when the share prices
change, not by how much prices eventually change.
Note. Bear the efficient market hypothesis in mind when discussing how a
company's value might be affected by the financing or investment decisions it
takes. Knowledge of what and when information will be incorporated into a
quoted share price is likely to influence how and when information regarding
financial management decisions is made public.
In particular, since current share prices can be crucial to the success or otherwise
of takeover bids and new share issues, it will be important to be aware of how
the market is likely to react to varying levels of information released. The market
may not react predictably, nor in a way a business wants it to, if it does not have
full information.
For listed businesses, strict regulations exist concerning the confidentially, timing,
manner and content of the announcement of price sensitive information. For
example, the Colombo Stock Exchange Listing Rules section 7.1 details precise
regulations concerning the timing of dividend announcements, including what
must be disclosed, when, and how it must be communicated. This ensures that
information reaches the public domain in a controlled manner that is fair to all
investors this is particularly important given that the stock exchange is generally
accepted to be semi-strong efficient because dividend announcements are
reflected in share price in response to such announcements.
312
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CHAPTER ROUNDUP
In this chapter we considered how share prices are determined. There are various
theories which seek to explain share price movements, including fundamental and
technical analysis.
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313
PROGRESS TEST
Which theory of share price behaviour does the following statement describe?
'The analysis of external and internal influences upon the operations of a company
with a view to assisting in investment decisions.'
A
B
C
D
Technical analysis
Random walk theory
Fundamental analysis theory
Chartism
The different 'forms' of the efficient market hypothesis state that share prices
reflect which types of information? Tick all that apply.
Form of EMH
Weak
Semistrong
Strong
No information
All information in past share price record
All other publicly available information
Specialists' and experts' 'insider' knowledge
314
If an investor believes they can beat the market by reading current newspapers,
how efficient do they believe the capital markets to be?
If insider dealing does not facilitate the creation of consistent (if illegal) gains for
the investor, what does this imply about the efficiency of the market?
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3
Form of EMH
Weak
Semistrong
Strong
No information
All information in past share price record
All other publicly available information
Specialists' and experts' 'insider' knowledge
4
At most they must believe it to be weak form efficient. Any more efficient than that
and share price is assumed to already reflect all publicly available information.
It implies the market is strong form efficient. In a strong form efficient market,
price is assumed to reflect all available information, whether publicly or privately
held.
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315
316
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318
CA Sri Lanka
CHAPTER
INTRODUCTION
The first section concentrates on the various phases of projects. Certain key stages will be the same whatever the nature of the
investment. In this chapter we go through the principles of appraising investments numerically. Although you may feel that
these topics are familiar, it is worth working through the examples again to confirm that you do understand them. Examiners'
reports often highlight basic errors of principle in answers to investment appraisal questions. It is likely that NPV calculations
will be set somewhere on virtually every paper.
We then show some of the different methods of assessing and taking account of the risk and uncertainty associated with a
project. Finally, we shall examine the assessment of whether the investment was a success and the wider issues that a postcompletion audit covers.
Knowledge Component
4
Corporate Investment Appraisal
4.1
Projects appraisal
4.1.1
4.1.2
Tax
Asset replacement
4.1.3
4.1.5
319
LEARNING
OUTCOME
CHAPTER CONTENTS
1 Investments and projects
4.1.1
4.1.2, 4.1.3
4.1.2
4.1.5
ENVIRONMENTAL
REVIEW FOR
POSSIBLE INVESTMENT
STRATEGIC
PRIORITIES
KEY CRITERIA
Production
Labour
Sales
Economic environment
IDENTIFY
INVESTMENTS
FINANCIAL APPRAISAL
OF INVESTMENT
AUTHORISATION
OF INVESTMENT
CAPITAL BUDGET
MONITORING OF
INVESTMENT
REVIEW OF
INVESTMENT
320
CA Sri Lanka
QUESTION
Explain why a company might extend its product mix with the introduction of
new products.
ANSWER
(a)
(b)
(c)
(d)
(e)
(f)
To refresh the product portfolio. Some products may become obsolete and
need updating. Others will simply be deleted, and the company will need to
replace them in the product mix in order to maintain brand presence and
profitability.
(d)
(e)
QUESTION
ANSWER
Cost
Example
Hardware costs
Installation
costs
Development
costs
Operating costs
Staff training
Staff recruitment/relocation
Staff salaries and pensions
Redundancy payments
Overheads
Consumable materials (tapes, disks and stationery etc)
Maintenance
Accommodation costs
Heating/power/insurance/telephone
Standby arrangements, in case the system breaks down
CA Sri Lanka
Direct benefits
(a)
(b)
Efficiency savings
(c)
(d)
Possibly, some one-off revenue benefits from the sale of equipment which
the new system does not require. However, computer equipment
depreciates very quickly. It is also possible that the new system will use less
office space, possibly providing an opportunity to sell or rent the spare
space.
Intangible benefits
Many of the benefits are intangible, or impossible to give a money value to.
Improved staff morale from working with a more efficient system
Better management information
Automating routine decisions and tasks should provide more time for
planning
More informed decision making
Further savings in staff time
Benefits accruing from gaining competitive advantage through better quality
and enhanced products
Greater customer satisfaction and loyalty, arising from better customer
service and equity
Better relationships with other supply chain participants
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323
(a)
(b)
(c)
(d)
(e)
(f)
(g)
Clear client focus so that all work is done bearing in mind the needs of
internal and external customers.
Planning
Implementing
Controlling and
completing
We now will look at each of these phases and stages.
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1.5.1 Initiation
Project initiation describes the beginning of a project. At this point, certain
management activities are required to ensure that the project is established with
clear reference terms, an appropriate management structure and a carefully
selected project team.
Projects originate from the identification of a problem or the opportunity to do
something new. It is often not clear precisely what the problem is. The project
team will have to study, discuss and analyse the problem, from a number of
different aspects (eg technical and financial).
At the start of a project, documentation should be drawn up, setting out the terms of
reference for the project.
1.5.2 Formation
The formation stage involves selecting the personnel who will be involved with
the project, including a project manager and perhaps a project team.
1.5.3 Objective setting
Before specific objectives can be set, it is necessary to establish more general
project goals. Clear goals and objectives give team members quantifiable targets
to aim for. This should improve motivation and performance, as attempting to
achieve a challenging goal is more inspiring than simply being told 'do your best'.
CA Sri Lanka
(a)
Clear. For example, 'design the layout of the general sports halls'.
(b)
325
326
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327
Estimated average annual profit, after depreciation, before interest and tax
Average book value of capital employed
100%
The main disadvantages of the ARR are that it uses subjective accounting profits
rather than cash flows; it does not take account of the timing of flows, and it can
be computed under various definitions, which makes comparisons difficult.
QUESTION
ARR
A company has a target accounting rate of return of 20% (using the definition
given above), and is now considering the following project.
Capital cost of asset
Estimated life
Estimated profit before depreciation
Year 1
Year 2
Year 3
Year 4
Rs. 80m
4 years
Rs
20 million
25 million
35 million
25 million
The capital asset would be depreciated by 25% of its cost each year, and will have
no residual value.
Required
Assess whether the project should be undertaken.
ANSWER
Rs
105 million
25 million
6.25 million
80 million
(80 million + 0)
2
40 million
328
CA Sri Lanka
The project would not be undertaken because it would fail to yield the target
return of 20%.
CA Sri Lanka
(a)
(b)
Any costs incurred in the past or any committed costs which will be
incurred regardless of whether the investment is undertaken are not
relevant.
(c)
(d)
329
2.3.2 Discounting
The timing of cash flows is taken into account by discounting them. This
converts a future value into a present value.
The discount rate used is the cost of capital. The net present value is the value
obtained by discounting all cash outflows and inflows of a capital investment
project by the cost of capital. A positive NPV implies the project is acceptable.
FORMULA TO LEARN
Future value S, of a sum X, invested for n periods, compounded at r% interest:
S = X (1+r)n
Present value of Re. 1 payable or receivable in n years, discounted at r% per
annum:
PV =
1
(1 + r)n
1
r
1
1
n
1 + r
QUESTION
NPVs
330
(a)
(b)
(c)
Rs. 5,000 payable each year for five years beginning in a year's time, cost of
capital 16%
(d)
Rs. 5,000 payable each year for five years beginning in two year's time, cost
of capital 16%
(e)
Rs. 5,000 payable each year for five years beginning today, cost of capital
16%
(f)
Rs. 5,000 payable each year for five years beginning in a year's time, cost of
capital 16.5%
CA Sri Lanka
ANSWER
(a)
Rs. 5,000 17% year 2 discount factor = Rs. 5,000 0.731 = Rs. 3,655
(b)
(c)
Rs. 5,000 16% year 5 cumulative discount factor (cdf) = 5,000 3.274 =
Rs. 16,370
(d)
Rs. 5,000 (16% year 6 cdf year 1 cdf) = 5,000 (3.685 0.862) =
Rs. 14,115
(e)
(f)
(1 (1 + 0.165)-5 )
Rs. 5,000 16.5% cdf = 5,000
= Rs. 16,182
0.165
QUESTION
1
= Rs. 3,915
(1.085)3
Purchase of material
LCH Co manufactures product X, which it sells for Rs. 5 a unit. Variable costs of
production are currently Rs. 3 a unit, and fixed costs are 50c a unit. A new machine
is available which would cost Rs. 90,000 but which could be used to make product
X for a variable cost of only Rs. 2.50 a unit. Fixed costs, however, would increase
by Rs. 7,500 a year as a direct result of purchasing the machine. The machine
would have an expected life of four years and a resale value after that time of
Rs. 10,000. Sales of product X are estimated to be 75,000 units a year.
Required
Calculate whether the machine should be purchased (ignore taxation) if LCH
expects to earn at least 12% a year from its investments.
ANSWER
Savings are 75,000 Rs. (3.00 2.50) = Rs. 37,500 a year.
Additional costs are Rs. 7,500 a year.
Net cash savings are therefore Rs. 30,000 a year.
It is assumed that the machine will be sold for Rs. 10,000 at the end of year 4.
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331
Year
Cash flow
Discount factor @ 12%
Present value
NPV
Year 0
Rs
(90,000)
1.000
(90,000)
7,500
Year 1
Rs
30,000
0.893
26,790
Year 2
Rs
30,000
0.797
23,910
Year 3
Rs
30,000
0.712
21,360
Year 4
Rs
40,000
0.636
25,440
The NPV is positive and so the project is expected to earn more than 12% a year
and is therefore acceptable.
2.3.3 The timing of cash flows: conventions used in discounted cash flow
(DCF)
The following guidelines may be applied unless a question indicates that they
should not be.
(a)
(b)
A cash outlay, saving or inflow which occurs during the course of a time
period (say, one year) is assumed to occur all at once at the end of the time
period. Therefore receipts of Rs. 10,000 during the first year are taken to
occur at the end of that year. That point in time is called 'year 1'.
(c)
For non-annual cash flows, the period interest rate r is related to the
annual interest rate R by the following formula.
r = n 1+ R 1
Where n is the number of periods per annum.
For example, if the annual interest rate is 18%, the monthly interest rate r =
12
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(b)
1
(1 + r1 )(1 + r2 )(1 + r3 )
1
= 0.712
1.101.121.14
QUESTION
Rs. 700,000
Rs. 300,000
Rs. 1,000,000
Rs. 250,000
ANSWER
Two months
Interest rate
Discount factor =
1 +0.16 1 = 2.50%
1
= 0.976
1.025
Four months
Interest rate
Discount factor =
1+0.16 1 = 5.07%
1
= 0.952
1.0507
Six months
Interest rate
Discount factor =
CA Sri Lanka
1 +0.16 1 = 7.70%
1
= 0.928
1.0770
333
Time (months)
0
2
4
6
12
Cash flow
Rs
(2,000,000)
700,000
300,000
1,000,0000
250,000
Discount
factor @ 16%
1.000
0.976
0.952
0.928
0.862
Present value
Rs
(2,000,000)
683,200
285,600
928,000
215,500
112,300
334
CA Sri Lanka
QUESTION
ANSWER
Working
Rs Mn
Years 1-5
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85
(30)
55
335
Year 0
Rs Mn
Contribution
Equipment
Working capital
Net cash flows
Discount factor @ 20%
Present value
NPV
(150)
(10)
(160)
1.000
(160)
10.39m
Year 1
Rs Mn
(5)
(5)
0.833
(4.165)
Years 15
Rs Mn
55
Year 5
Rs Mn
10
15
25
0.402
10.050
55
2.991*
164.505
2.3.7 Taxation
Tax allowable depreciation is used to reduce taxable profits, and the consequent
reduction in a tax payment should be treated as a cash saving arising from the
acceptance of a project.
For example, suppose tax-allowable depreciation is allowed on the cost of plant
and machinery at the rate of 25% on a reducing balance basis. Thus if a company
purchases plant costing Rs. 80 million, the subsequent writing down allowances
would be as follows.
Year
1
2
3
4
(25% of cost)
(25% of reducing balance RB)
(25% of RB)
(25% of RB)
Taxallowable
depreciation
Rs Mn
20
15
11.25
8.438
Reducing
balance
Rs Mn
60
45
33.75
25.312
When the plant is eventually sold, the difference between the sale price and the
reducing balance amount at the time of sale will be treated as:
(a)
(b)
The cash saving on the tax-allowable depreciation (or the cash payment for the
charge) is calculated by multiplying the depreciation (or charge) by the tax rate.
336
CA Sri Lanka
Tax-allowable
depreciation
Rs Mn
10
7.5
5.625
4.219
3.164
Having calculated the depreciation each year, the tax savings can be computed.
The year of the cash flow is one year after the year for which the allowance is
claimed.
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337
Tax
allowable
depreciation
Rs Mn
10
7.5
5.625
4.219
7.656
35*
Year of claim
0
1
2
3
4
Tax saved
Rs Mn
3
2.25
1.688
1.266
2.297
Year of tax
payment/
saving (50%
in each)
0/1
1/2
2/3
3/4
4/5
Year 1
Rs Mn
Year 2
Rs Mn
Year 3
Rs Mn
Year 4
Rs Mn
Year 5
Rs Mn
14.000
(2.100)
14.000
(4.200)
14.000
(4.200)
14.000
(4.200)
(2.100)
2.625
14.525
0.926
13.450
1.969
11.769
0.857
10.086
1.477
11.277
0.794
8.954
1.782
16.582
0.735
12.188
1.148
(0.952)
0.681
(0.648)
Purchase of equipment
(40)
Cost savings
Tax on savings
Tax saved on taxallowable dep'n
Net cash flow
Discount factor @ 8%
Present value
1.5
(38.500)
1.000
(38.500)
NPV = Rs. 5.53 million. The NPV is positive and so the purchase appears to be
worthwhile.
2.3.9 An alternative and quicker method of calculating tax payments or
savings
In the above example, the tax computations could have been combined, as follows.
Year 0
Year 1
Year 2
Year 3
Year 4
Rs
Rs
Rs
Rs
Rs
0
14.000
14.000
14.000
14.000
Cost savings
(10.000) (7.500)
(5.625)
(4.219)
(7.656)
Tax-allowable
depreciation
(10.000)
6.500
8.375
9.781
6.344
Taxable profits
3.000
(1.950)
(2.512)
(2.934)
(1.903)
Tax at 30%
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Equipment
Rs
(40.000)
0
1
2
3
4
5
Savings
Rs
14.000
14.000
14.000
14.000
5.000
Tax
Rs
1.500
525
(2.231)
(2.723)
(2.418)
(0.952)
Net
cash flow
Rs
(38.500)
14.525
11.769
11.277
16.582
(0.952)
The net cash flows are exactly the same as calculated previously.
QUESTION
ANSWER
Purchase
Inflation factor
Cash flow after
inflation
Tax on cash inflow
Tax saved on taxallowable depn (W)
Net cash flow
Discount factor
at 11%
Present value
Year 0
Rs
(300,000)
1.000
Year 1
Rs
Year 2
Rs
Year 3
Rs
Year 4
Rs
1.100
1.210
(300,000)
132,000
(33,000)
145,200
(69,300)
159,720
(76,230)
(39,930)
18,750
(281,250)
32,813
131,813
24,609
100,509
42,187
125,677
31,640
(8,290)
1.000
(281,250)
0.901
118,764
0.812
81,613
0.731
91,870
0.659
(5,463)
1.331
339
Year
0
1
2
3
(25% at cost)
(25% of RB)
(25% of RB)
(25% of RB)
Reducing
balance
(RB)
Rs
225,000
168,750
126,562
94,921
Balancing allowance
Rs
94,921
94,921
Year of claim
0
1
2
3
Taxallowable
depreciation
claimed
Rs
75,000
56,250
42,188
126,562
300,000
Tax saved
Rs
37,500
28,125
21,094
63,281
Year of
tax saving
0/1
1/2
2/3
3/4
2.3.10 Inflation
In an inflationary environment, cash flows in a project may be given in money
terms (the actual cash that will arise) or real terms (in today's currency).
Similarly, the required rate of return on an investment may be given as a money
rate of return (including an allowance for a general rate of inflation) or as a real
rate of return (the return required over and above inflation).
If cash flows are given in money terms, the money rate should be used to
discount them (remember: 'money at money'); if the flows are in real terms, the
real rate of return may be used to discount them ('real at real'), although this may
not always result in the same answer.
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CA Sri Lanka
If some of the cost or revenues relating to the project inflate at rates different
from the general rate of inflation, it is not appropriate to discount real flows at
the real rate. Instead, money flows must be computed, by applying the relevant
rates of inflation to the real flows, which must then be discounted at the money
required return.
FORMULA TO LEARN
The two rates of return and the inflation rate are linked by the equation:
(1 + nominal (money) rate of return) = (1 + real interest rate)(1 + inflation rate)
This is often referred to as the Fisher equation.
QUESTION
RCT Co is considering a project which would cost Rs. 5 million now. The annual
benefits, for four years, would be a fixed income of Rs. 2.5million a year, plus other
savings of Rs. 500,000 a year in year 1, rising by 5% each year because of inflation.
Running costs will be Rs. 1 million in the first year, but would increase at 10%
each year because of inflating labour costs. The general rate of inflation is
expected to be 7.5% and the company's required money rate of return is 16%.
Required
State whether the project is worthwhile (ignore taxation).
ANSWER
The cash flows at inflated values are as follows.
Year
1
2
3
4
Fixed
income
Rs Mn
2.5
2.5
2.5
2.5
CA Sri Lanka
Other
savings
Rs Mn
0.5
0.525
0.551
0.579
Running
costs
Rs Mn
(1.000)
(1.100)
(1.210)
(1.331)
Year 2
Rs Mn
1.925
Year 3
Rs Mn
1.841
0.743
1.430
0.641
1.180
Net cash
flow
Rs Mn
2.000
1.925
1.841
1.748
Year 4
Rs Mn
1.748
0.552
0.965
341
Since non-current assets, inventories and other working capital will increase
in money value, the same quantities of assets or working capital must be
financed by increasing amounts of capital.
(b)
Inflation means higher costs and higher selling prices. The effect of higher
prices on demand is not necessarily easy to predict. A company that raises its
prices by 10% because the general rate of inflation is running at 10% might
suffer a serious fall in demand.
(c)
342
NPVa
(b a)
NPVa NPVb
CA Sri Lanka
Where:
QUESTION
IRR
A company is trying to decide whether to buy a machine for Rs. 80,000 which will
save Rs. 20,000 a year for five years and which will have a resale value of
Rs. 10,000 at the end of year 5.
Required
Calculate the IRR of the investment project.
ANSWER
Year
0
15
5
NPV
Cash flow
Rs
(80,000)
20,000
10,000
Discount
factor @
10%
1.000
3.791
0.621
PV of
cash flow
Rs
(80,000)
75,820
6,210
2,030
This is fairly close to zero. It is also positive, which means that the IRR is more
than 10%. We will try 12% next.
Discount
PV of
Year
factor @
Cash flow
12%
cash flow
Rs
Rs
(80,000)
0
(80,000)
1.000
72,100
15
20,000
3.605
5,670
5
10,000
0.567
(2,230)
NPV
This is fairly close to zero and negative. The IRR is therefore greater than 10% but
less than 12%. We shall now use the two NPV values to estimate the IRR, using the
formula.
Internal rate of return = 10 +
CA Sri Lanka
2,030
2,030
-2,230
343
It might be tempting to confuse the IRR and the accounting ROCE. The
accounting ROCE and the IRR are two completely different measures. If
managers were given information about both ROCE (or ROI) and IRR, it
might be easy to get their meanings and significance mixed up.
(b)
It ignores the relative size of investments. Both the following projects have
an IRR of 18%.
Project A
Project B
Rs
Rs
Cost, year 0
350,000
35,000
Annual savings, years 1-6
100,000
10,000
Clearly, project A is bigger (ten times as big) and so more profitable, but if
the only information on which the projects were judged were to be their IRR
of 18%, project B would seem just as beneficial as project A.
(c)
If the cash flows from a project are not conventional (with an outflow at the
beginning resulting in inflows over the life of a project) there may be more
than one IRR. This could be very difficult for managers to interpret. For
example, the following project has cash flows which are not conventional,
and as a result has two IRRs of approximately 7% and 35%.
Year
0
1
2
Project X
Rs '000
(1,900)
4,590
(2,735)
344
CA Sri Lanka
can be reinvested at the cost of capital, and converts all the flows to a single
cash inflow at the end of the project's life.
(d)
The IRR method should not be used to select between mutually exclusive
projects. This follows on from point (b) and it is the most significant and
damaging criticism of the IRR method.
Option A
Rs Mn
(10.200)
6.000
5.000
3.000
Capital outlay
Net cash inflow
Net cash inflow
Net cash inflow
Option B
Rs Mn
(35.250)
18.000
15.000
15.000
Year
0
1
2
3
NPV
Discount
factor @ 16%
1.000
0.862
0.743
0.641
Option A
Present
Cash flow
value
Rs Mn
Rs Mn
(10.200)
(10.200)
6.000
5.172
5.000
3.715
3.000
1.923
+0.61
Option B
Present
Cash flow
value
Rs Mn
Rs Mn
(35.250)
(35.250)
18.000
15.516
15.000
11.145
15.000
9.615
+1.026
However, the IRR of option A is 20% and the IRR of option B is only 18%
(workings not shown). On a comparison of NPVs, option B would be preferred but,
on a comparison of IRRs, option A would be preferred.
Option B should be chosen. This is because the differences in the cash flows
between the two options, when discounted at the cost of capital of 16%, show that
the present value of the incremental benefits from option B compared with
option A exceed the PV of the incremental costs. This can be re-stated in the
following ways.
CA Sri Lanka
345
(a)
The NPV of the differential cash flows (option B cash flows minus option A
cash flows) is positive, and so it is worth spending the extra capital to get the
extra benefits.
(b)
The IRR of the differential cash flows exceeds the cost of capital of 16%, and
so it is worth spending the extra capital to get the extra benefits.
Year
0
1
2
3
4
Cash flow
Rs Mn
(24.500)
15.000
15.000
3.000
3.000
Discount
factor @
10%
1.000
0.909
0.826
0.751
0.683
Present
value
Rs Mn
(24.500)
13.635
12.390
2.253
2.049
5.827
Discount
factor @
25%
1.000
0.800
0.640
0.512
0.410
Present
value
Rs Mn
(24.500)
12.000
9.600
1.536
1.230
(0.134)
5.827
IRR = 10% +
25% 10% = 24.7%
5.827 +0.134
The MIRR is calculated on the basis of investing the inflows at the cost of
capital.
346
CA Sri Lanka
The table below shows the values of the inflows if they were immediately
reinvested at 10%. For example, the Rs. 15 million received at the end of year 1
could be reinvested for three years at 10% pa (multiply by 1.1 1.1 1.1 = 1.331).
Cash
inflows
Rs Mn
15.000
15.000
3.000
3.000
Year
1
2
3
4
Interest
rate
multiplier
1.331
1.21
1.1
1.0
Amount
when
reinvested
Rs Mn
19.965
18.150
3.300
3.000
44.415
The total cash outflow in year 0 (Rs. 24.5 million) is compared with the possible
inflow at year 4, and the resulting figure of 24.5m/44.415m = 0.552 is the discount
factor in year 4. By looking along the year 4 row in present value tables you will
see that this gives a return of 16%. This means that the Rs. 44.415 million received
in year 4 is equivalent to Rs. 24.5 million in year 0 if the discount rate is 16%.
Alternatively, instead of using discount tables, we can calculate the MIRR as
follows.
Total return =
44.415
= 1.813
24.5
CA Sri Lanka
347
Uncertainty
A risky situation is one where we can say that there is a 70% probability that
returns from a project will be in excess of Rs. 100,000 but a 30% probability that
returns will be less than Rs. 100,000. If, however, no information can be provided
on the returns from the project, we are faced with an uncertain situation.
In general, risky projects are those whose future cash flows, and hence the project
returns, are likely to be variable. The greater the variability is, the greater the
risk. The problem of risk is more acute with capital investment decisions than
other decisions for the following reasons.
(a)
348
CA Sri Lanka
(b)
Selling price
Sales volume
Cost of capital
Initial cost
Operating costs
Benefits
The basic approach of sensitivity analysis is to calculate the project's NPV under
alternative assumptions to determine how sensitive it is to changing conditions.
An indication is thus provided of those variables to which the NPV is most
sensitive (critical variables) and the extent to which those variables may
change before the investment results in a negative NPV.
Sensitivity analysis therefore provides an indication of why a project might fail.
Management should review critical variables to assess whether or not there is a
strong possibility of events occurring which will lead to a negative NPV.
Management should also pay particular attention to controlling those variables to
which the NPV is particularly sensitive, once the decision has been taken to accept
the investment.
A simple approach to deciding which variables the NPV is particularly sensitive to
is to calculate the sensitivity of each variable:
Sensitivity =
NPV
%
Present value of project variable
The lower the percentage, the more sensitive is NPV to that project variable
as the variable would need to change by a smaller amount to make the project
non-viable.
CA Sri Lanka
349
Initial
investment
Rs Mn
7
0
1
2
Variable
costs
Rs Mn
Cash
inflows
Rs Mn
Net cash
flows
Rs Mn
(2)
(2)
6.5
6.5
4.5
4.5
Cash flows arise from selling 650,000 units at Rs. 100 per unit. KN Co has a cost of
capital of 8%.
Required
Interpret the sensitivity of the project to changes in variables.
Solution
The PVs of the cash flow are as follows.
Year
Discount
factor 8%
0
1
2
1.000
0.926
0.857
PV of initial
investment
Rs Mn
(7.000)
(7.000)
PV of
variable
costs
Rs Mn
PV of cash
inflows
Rs Mn
(1.852)
(1.714)
(3.566)
6.019
5.571
11.590
PV of net
cash flow
Rs Mn
(7.000)
4.167
3.857
1.024
The project has a positive NPV and would appear to be worthwhile. The sensitivity
of each project variable is as follows.
(a)
Initial investment
Sensitivity =
(b)
Sales volume
Sensitivity =
(c)
1.024
100 = 8.8%
11.590
Variable costs
Sensitivity =
350
1.024
100 = 12.8%
11.590 3.566
Selling price
Sensitivity =
(d)
1.024
100 = 14.6%
7.000
1.024
100 = 28.7%
3.566
CA Sri Lanka
(e)
Cost of capital. We need to calculate the IRR of the project. Let us try discount
rates of 15% and 20%.
Year
0
1
2
PV
Rs '000
(7.000)
3.915
3.402
NPV = 0. 317
Discount
factor 20%
1
0.833
0.694
PV
Rs '000
(7.000)
3.749
3.123
NPV = (0.128)
0.317
IRR = 0.15 +
0.20 0.15 = 18.56%
0.317+0.128
The cost of capital can therefore increase by 132% before the NPV becomes
negative.
The elements to which the NPV appears to be most sensitive are the selling
price followed by the sales volume. Management should thus pay particular
attention to these factors so that they can be carefully monitored.
3.2.2 Weaknesses of this approach to sensitivity analysis
These are as follows.
CA Sri Lanka
(a)
The method requires that changes in each key variable are isolated.
However, management is more interested in the combination of the effects
of changes in two or more key variables.
(b)
(c)
Sensitivity analysis does not examine the probability that any particular
variation in costs or revenues might occur.
(d)
(e)
351
QUESTION
Sensitivity analysis
ANSWER
The PVs of the cash flows are as follows.
Discount
factor @
PV of
Year
plant cost
8%
Rs Mn
0
1.000
(7.000)
1
0.926
2
0.857
(7.000)
PV of
running
costs
Rs Mn
PV of
savings
Rs Mn
(1.852)
(2.143)
(3.995)
5.556
5.999
11.555
PV of
net cash
flow
Rs Mn
(7.000)
3.704
3.856
0.560
The project has a positive NPV and would appear to be worthwhile. Sensitivity of
the project to changes in the levels of expected costs and savings is as follows.
0.560
(a) Plant costs sensitivity = 7.000 100 = 8%
352
(b)
(c)
Savings sensitivity =
0.560
100 = 14%
3.995
0.560
100 = 4.8%
11.555
CA Sri Lanka
CA Sri Lanka
353
Solution
The risk-adjusted NPV of the project would be as follows.
Cash flow
Certainty equivalent
Risk adjusted cash flow
Discount factor @ 5%
risk-free rate
Present value
Year 0
Rs '000
(10,000)
1.00
(10,000)
Year 1
Rs '000
7,000
0.70
4,900
Year 2
Rs '000
5,000
0.60
3,000
Year 3
Rs '000
5,000
0.50
2,500
1.000
(10,000)
0.952
4,665
0.907
2,721
0.864
2,160
NPV = (454,000)
The project is too risky and should be rejected.
Step 2
(b)
Year 1
354
Cash flow
Rs
100,000
200,000
300,000
Probability
0.25
0.50
0.25
1.00
CA Sri Lanka
Year 2
If cash flow
in year 1 is:
Rs
100,000
200,000
300,000
There is a
probability
of:
0.25
0.50
0.25
1.00
0.25
0.50
0.25
1.00
0.25
0.50
0.25
1.00
That the
cash flow
in year 2
will be:
Rs
Nil
100,000
200,000
100,000
200,000
300,000
200,000
300,000
350,000
CA Sri Lanka
355
Step 1
1
1
1
2
2
2
2
Cash flow
Rs '000
100
200
300
100
200
300
350
Discount
factor 10%
0.909
0.909
0.909
0.826
0.826
0.826
0.826
Present
value
Rs '000
90.9
181.8
272.7
82.6
165.2
247.8
289.1
Year 1
Year 2
Total PV
PV of cash
PV of cash
Joint
of cash
flow
Probability
flow
Probability probability inflows
Rs '000
Rs '000
Rs '000
(a)
(b)
(c)
(d)
(b) (d) (a) + (c)
90.9
0.25
0.0
0.25
0.0625
90.9
90.9
0.25
82.6
0.50
0.1250
173.5
90.9
0.25
165.2
0.25
0.0625
256.1
181.8
0.50
82.6
0.25
0.1250
264.4
181.8
0.50
165.2
0.50
0.2500
347.0
181.8
0.50
247.8
0.25
0.1250
429.6
272.7
0.25
165.2
0.25
0.0625
437.9
272.7
0.25
247.8
0.50
0.1250
520.5
272.7
0.25
289.1
0.25
0.0625
561.8
EV of PV of cash inflows
Less project cost
EV of NPV
Step 2
EV of PV
of cash
inflows
Rs '000
5.681
21.688
16.006
33.050
86.750
53.700
27.369
65.063
35.113
344.420
Rs
344,420
300,000
44,420
Measure risk
Since the EV of the NPV is positive, the project should go ahead unless
the risk is unacceptably high. The probability that the project will have
a negative NPV is the probability that the total PV of cash inflows is
less than Rs. 300,000. From the column headed 'Total PV of cash
inflows', we can establish that this probability is 0.0625 + 0.125 +
0.0625 + 0.125 = 0.375 or 37.5%. This might be considered an
unacceptably high risk.
356
CA Sri Lanka
357
working upwards cumulatively from the lowest to the highest cash flow values
and assigning numbers that will correspond to probability groupings as follows.
Rs
40,000
50,000
55,000
60,000
Revenue
Prob
0.15
0.40
0.30
0.15
Random
numbers
0014
1554
5584
8599
*
**
***
Rs
25,000
30,000
40,000
40,000
Running
costs
Prob
0.10
0.25
0.35
0.30
Random
numbers
0009
1034
3569
7099
**
Probability is 0.40 (40%). Random numbers are 40% of range 0099 but
starting at 15.
***
Probability is 0.30 (30%). Random numbers are 30% of range 0099 but
starting at 55.
For revenue, the selection of a random number in the range 00 and 14 has a
probability of 0.15. This probability represents revenue of Rs. 40,000. Numbers
have been assigned to cash flows so that when numbers are selected at random,
the cash flows have exactly the same probability of being selected as is indicated
in their respective probability distribution above.
Random numbers would be generated, for example by a computer program, and
these would be used to assign values to each of the uncertain variables.
For example, if random numbers 378420015689 were generated, the values
assigned to the variables would be as follows.
Calculation
1
2
3
Revenue
Random
number
Value
Rs
37
50,000
20
50,000
56
55,000
Costs
Random
number
84
01
89
Value
Rs
40,000
25,000
40,000
A computer would calculate the NPV may times over using the values established
in this way with more random numbers, and the results would be analysed to
provide the following.
(a)
(b)
The decision whether to go ahead with the project would then be made on the
basis of expected return and risk.
358
CA Sri Lanka
359
Deliveries late;
deliveries on
schedule
Flexibility
measures
Number of people
served and speed of
service
Customer
satisfaction
With other investments, the key success indicators factors are likely to be direct
improvements in production. Likely important measures here include:
360
CA Sri Lanka
QUESTION
Assessment of investment
Discuss the performance measures that are likely to be important in assessing the
success of a new computerised sales processing system.
ANSWER
Important measures are likely to include the following.
(a)
The growth rates in file sizes and the number of transactions processed
by the system. Trends should be analysed and projected to assess whether
there are likely to be problems with lengthy processing time or an inefficient
file structure due to the volume of processing.
(b)
The clerical manpower needs for the system, and deciding whether they
are more or less than estimated.
(c)
(d)
(e)
A check of the error rates for input data. High error rates may indicate
inefficient preparation of input documents, an inappropriate method of data
capture or poor design of input media.
(f)
(g)
CA Sri Lanka
361
If a manager asks for and gets approval for a capital project, and knows that
in due course the project will be subject to a post-completion audit, then the
manager will be more likely to pay attention to the benefits and the costs
than if no post audit were threatened.
(b)
If the post audit takes place before the project life ends, and if it finds that
the benefits have been less than expected because of management
inefficiency, steps can be taken to improve efficiency and earn greater
benefits over the remaining life of the project. Alternatively, the
post-completion audit may highlight those projects which should be
discontinued.
(c)
A post-completion audit can help to identify managers who have been good
performers and those who have been poor performers.
(d)
(e)
(f)
The original estimates may be more realistic if managers are aware that
they will be monitored, but post-completion audits should not be unfairly
critical.
362
(a)
(b)
This means that it may not be possible to identify separately the costs
and benefits of any particular project or, due to uncertainty, to identify the
costs and benefits at all.
CA Sri Lanka
(c)
(d)
(e)
CA Sri Lanka
363
CHAPTER ROUNDUP
364
This chapter revised material that you have covered before and it is essential that
you are completely happy with all of the techniques. There was a brief revision of
each technique and questions for you to brush up your knowledge.
Only if management know for certain what is going to happen in the future can
they appraise a project in the knowledge that there is no risk. However, the future
is uncertain by nature. There are, nevertheless, techniques which can be used to
enable managers to make a judgement on risk and uncertainty.
CA Sri Lanka
PROGRESS TEST
Group the following items that occur in investment appraisal questions under the
following headings.
'Include in investment appraisal' or 'Exclude from investment appraisal'
Depreciation
Sunk costs
Opportunity costs
Allocated costs and revenues
After tax incremental cash flows
Effect of tax allowances
Dividends/interest
Working capital requirements
Which equation links the money rate of return and the real rate of return?
Are cash flows that are given in terms of today's Rs being given in money or real
terms?
10
Give two examples of ways that risk can be measured in probability analysis.
11
Expected values can help an accountant evaluate the range of possible net present
value outcomes.
True
False
CA Sri Lanka
365
12
Selling price inflation and selling cost inflation are expected to be 5% per year and
variable cost inflation is expected to be 4% per year. Additional initial investment
in working capital of Rs. 250,000 will also be needed and this is expected to
increase in line with general inflation.
Other information
CJ Co has a nominal weighted average after-tax cost of capital of 10% and pays
profit tax one year in arrears at an annual rate of 30%. The company can claim
tax-allowable depreciation on a 25% reducing balance basis on the initial
investment.
General rate of inflation: 4.5% per year
Required
Calculate the net present value of Project A and advise on its acceptability if the
project were to be appraised using this method.
The following information relates to questions 13 and 14.
Tanumu Co is considering investing Rs. 50,000 in a new machine with an expected
life of five years. The machine will have no scrap value at the end of five years. It is
expected that 20,000 units will be sold each year at a selling price of Rs. 3.00 per
unit. Variable production costs are expected to be Rs. 1.65 per unit, while
incremental fixed costs, mainly the wages of a maintenance engineer, are expected
to be Rs. 10,000 per year. Tanumu Co uses a discount rate of 12% for investment
appraisal purposes and expects investment projects to recover their initial
investment within two years.
13 Evaluate the sensitivity of the project's net present value to a change in the
following project variables.
(a)
(b)
(c)
Sales volume
Sales price
Variable cost
And discuss the use of sensitivity analysis as a way of evaluating project risk.
366
CA Sri Lanka
14
Poor
0.3
17,500
Normal
0.6
20,000
Good
0.1
22,500
Calculate and comment on the expected net present value of the project.
CA Sri Lanka
367
Opportunity costs
After tax incremental cash flows
Effect of tax allowances
Working capital requirements
Depreciation
Sunk costs
Allocated costs and revenues
Dividends/interest
Real terms
(a)
(b)
(c)
(d)
(e)
(f)
By assigning a range of random number digits to each possible value of each of the
uncertain variables.
(a)
(b)
(c)
Use sensitivity analysis to determine the critical factors within the decisionmaking process
(d)
Selling price
Sales volume
Cost of capital
Initial cost
Operating costs
Benefits
10
11
368
False
CA Sri Lanka
12
Calculation of NPV
Year
Investment
Sales revenue (W1)
Selling costs (W2)
Variable costs (W3)
Before-tax cash flows
Taxation at 30%
Tax benefits (W4)
Working capital (W5)
Project cash flows
Discount factor 10%
Present value
NPV
0
1
2
3
4
5
Rs '000 Rs '000 Rs '000 Rs '000 Rs '000 Rs '000
(3,500)
1,575
1,654
1,736
1,823
(32)
(33)
(35)
(37)
(624)
(649)
(675)
(702)
919
972
1,026
1,084
(276)
(292)
(308)
(325)
263
197
148
443
(250)
(11)
(12)
(12)
(13)
(3,750)
908
947
919
911
118
1.000
0.909
0.826
0.751
0.683
0.621
(3,750)
690
825
782
622
73
(758)
The net present value is negative and therefore Project A is not financially
acceptable.
Workings
1
4
2.431
750,000
1,823,250
4
0.049
750,000
36,750
(3.5m 0.25)
(875,000 0.75)
(656,250 0.75)
(3.5m 875,000
656,250 492,188)
4
0.936
750,000
702,000
Year taken
2
3
4
5
369
0
1
2
3
4
Rs
11,250
11,756
12,286
12,838
13
Year
0
1-5
Investment
Rs
(50,000)
Contribution
Rs
Fixed
costs
Rs
27,000
(10,000)
Net
Rs
(50,000)
17,000
Discount
factor
12%
1.000
3.605
Total
Rs
(50,000)
61,285
11,285
(b)
(c)
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CA Sri Lanka
variables to which the NPV is particularly sensitive, once the decision has
been taken to accept the investment.
14
Expected sales = (17,500 0.3) + (20,000 0.6) + (22,500 0.1) = 19,500 units
Expected contribution = 19,500 units Rs. 1.35 = Rs. 26,325
Year
0
1-5
Investment
Rs
(50,000)
Contribution
Rs
26,325
Fixed
costs
Rs
(10,000)
Net
Rs
(50,000)
16,325
Discount
factor
12%
1.000
3.605
Total
Rs
(50,000)
58,852
8,852
The expected net present value is positive, but it represents a value that would
never actually be achieved, as it is an amalgamation of various probabilities.
Examining each possibility:
Worst case (sales of 17,500 units, 30% probability):
Year
0
1-5
Investment
Contribution
Rs
(50,000)
Rs
Fixed
costs
Rs
23,625
(10,000)
Net
Rs
(50,000)
13,625
Discount
factor
12%
1.000
3.605
Total
Rs
(50,000)
49,118
(882)
0
1-5
Investment
Cont'n
Rs
(50,000)
Rs
30,375
Fixed
costs
Rs
(10,000)
Net
Rs
(50,000)
20,375
Discount
factor
12%
1.000
3.605
Total
Rs
(50,000)
73,452
23,452
The managers of Tanumu will need to satisfy themselves as to the accuracy of this
latest information, but the fact that there is a 30% chance that the project will
produce a negative NPV could be considered too high a risk.
It can be argued that assigning probabilities to expected economic states or sales
volumes gives the managers information to make better investment decisions. The
difficulty with this approach is that probability estimates of project variables can
carry a high degree of uncertainty and subjectivity.
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371
372
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CHAPTER
INTRODUCTION
This chapter looks at the important issues that an entity has to consider
when investing abroad. It exposes the entity to a wider range of risks.
International investment appraisal is highly examinable and adds more
complications to the NPV calculations. A step-by-step logical approach is
required, and this chapter takes you through the techniques.
Knowledge Component
4
Corporate Investment Appraisal
4.1
Projects appraisal
4.1.2
Evaluate investment projects using discounting factor/nondiscounting factor techniques with foreign investments (using
forward exchange rates or country specific discounting factors).
373
CHAPTER CONTENTS
LEARNING
OUTCOME
1 International investment
4.1.2
4.1.2
1 International investment
In this section we look at the reasons why an entity would choose to invest
overseas and the risks and complications involved.
Explanation
Company
Country
Customer
Competition
Currency
374
CA Sri Lanka
Firms may expand by means of new 'start-up' investments, for example the
setting up of an overseas subsidiary to operate a manufacturing plant. This
does allow flexibility, although it may be slow to achieve, expensive to
maintain and slow to yield satisfactory results.
(b)
A firm might take over or merge with established firms abroad. This
provides a means of purchasing market information, market share and
distribution channels. However, the better acquisitions will only be
available at a premium.
(c)
375
376
At one extreme, the parent company might choose to get as much money
as it can from the subsidiary, and as quickly as it can. This would involve
the transfer of all or most of the subsidiary's profits to the parent company.
CA Sri Lanka
(b)
The subsidiary could make a profit and pay a dividend out of profits.
(b)
The parent company could sell goods or services to the subsidiary and
obtain payment. The amount of this payment will depend on the volume of
sales and also on the transfer price for the sales.
(c)
(d)
If the parent company makes a loan to a subsidiary, it can set the interest
rate high or low, thereby affecting the profits of both companies. A high rate
of interest on a loan, for example, would improve the parent company's
profits to the detriment of the subsidiary's profits.
(e)
When the subsidiary is in a country where there are exchange control regulations,
the parent company may have difficulty getting cash from the subsidiary.
1.4.4 Transfer pricing
When a foreign subsidiary makes a profit from goods/services supplied by its
parent company, the profit will be included in the total profits of the multinational
group. The management of the parent company must decide, however, how the
total profit of the group should be divided between the parent company and each
of its subsidiaries, which is likely to depend on the transfer prices adopted.
CA Sri Lanka
377
Exporting may be direct selling by the firm's own export division into the
overseas markets, or it may be indirect through agents, distributors, trading
companies and various other such channels. Exporting may be unattractive
because of tariffs, quotas or other import restrictions in overseas markets,
and local production may be the only feasible option in the case of bulky
products such as cement and flat glass.
(b)
CASE STUDY
1.6 Countertrade
Countertrade is a general term used to describe a variety of commercial
arrangements for reciprocal international trade or barter between companies or
other organisations (eg state controlled organisations) in two or more countries.
Countertrade is a form of trading activity based on other than an arm's-length
goods for cash exchange. Types of countertrade include:
Barter. The direct exchange of goods and services between two parties without
the use of money.
Counterpurchase. A trading agreement in which the primary contract vendor
agrees to make purchases of an agreed percentage of the primary contract
value, from the primary contract purchaser, through a linked counterpurchase
contract.
Offsets. A trading agreement in which the purchaser becomes involved in the
production process, often acquiring technology supplied by the vendor.
378
CA Sri Lanka
(b)
(c)
CA Sri Lanka
379
The use of the host country's finance may make the investment more
acceptable to that country, as not all of the subsidiary's profits will be sent
back to the home country. Perhaps due to specific country exchange
restrictions, there may be limitations on the amount of money that can be
repatriated.
(d)
(b)
(c)
Geographical separation
The geographical separation of the parent company from its subsidiaries
adds to the problems of management control of the group of companies as a
whole.
(d)
Litigation risk
The risk of litigation varies in different countries and, to minimise this risk,
attention should be paid to legislation and regulations covering the
products sold in different countries. Care should be taken to comply with
contract terms.
380
CA Sri Lanka
(e)
(b)
CA Sri Lanka
381
(b)
Total exemption from tax is given in the country where income arises in
the hands of, for example:
(i)
(ii)
Visiting diplomats
Teachers on exchange programmes
(c)
(d)
(e)
(f)
There are clauses which render certain profits taxable in only one rather
than both of the contracting states.
(g)
CA Sri Lanka
may be achieved through exchange controls or limits on the amounts that can be
remitted. These barriers can be avoided/mitigated by the following methods.
(a)
(b)
Subsidiary companies can lend the equivalent of the dividend to the parent
company.
(c)
(d)
Increase the transfer prices paid by the subsidiary to the parent company.
(e)
Overseas governments may put measures in place to stop the above methods
being used.
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383
QUESTION
The /Rs exchange rate in April 2010 was 1.138/Rs. (that is, Re. 1 = 1.138);
inflation in Europe was 1.5% and 3.7% in Sri Lanka.
Required
Calculate the forecast spot rate in each of the next three years for the /Rs.
ANSWER
1.138 1.015/1.037 = 1.114
1.114 1.015/1.037 = 1.090
1.090 1.015/1.037 = 1.067
CA Sri Lanka
Year
Exchange rate
$1 = Rs. 132
CA Sri Lanka
(a)
Convert the project cash flows into Sri Lankan rupees and then discount
at a Rs. discount rate to calculate the NPV, or
(b)
Discount the cash flows in the host country's currency from the project at
an adjusted discount rate for that currency and then convert the resulting
NPV at the spot exchange rate.
385
FORMULA TO LEARN
Adjusted discount rate to use in international budgeting (international Fisher
effect)
1 + annual discount rate B$ Future spot rate A$ / B$ in 12 months' time
=
1 + annual discount rate A$
Spot rate A$ / B$
The approach to be chosen will depend on the available information and the
extent to which forecasts are reliable. Both approaches should give the same
answer, provided that the approach used to predict future exchange rates
(interest rate parity or purchasing power parity) holds true.
2.2.1 Example: Overseas investment appraisal
AB Co, a Sri Lankan company, is considering undertaking a new project in Horavia.
This will require initial capital expenditure of H$1,250m, with no scrap value
envisaged at the end of the five-year lifespan of the project. There will also be an
initial working capital requirement of H$500m, which will be recovered at the end
of the project. Pre-tax net cash inflows of H$800m are expected to be generated
each year from the project.
Company tax will be charged in Horavia at a rate of 40%, with depreciation on a
straight-line basis being an allowable deduction for tax purposes. Horavian tax is
paid at the end of the year following that in which the taxable profits arise.
There is a double taxation agreement between Sri Lanka and Horavia, which
means that no Sri Lankan tax will be payable on the project profits.
The spot rate is H$336/Rs (that is, Re. 1 = H$336), and the rupee is expected to
depreciate against the Horavian dollar by 5% per year.
A project of similar risk recently undertaken by AB Co in Sri Lanka had a required
post-tax rate of return of 16%.
Required
Calculate whether the Horavian project should be undertaken.
386
CA Sri Lanka
Solution
Method 1 conversion of flows into sterling and discounting at sterling
discount rate
Time 0
H$m flows
Capital
Net cash inflows
Taxation (W1)
Exchange rate
(W2)
Rs Mn flows
16% df
PV
Time 1
Time 2
Time 3
Time 4
(1,750)
800
(1,750)
336
800
320
800
(220)
580
305
(5.21)
1.000
(5.21)
2.50
0.862
2.16
1.90
0.743
1.41
Time 5
800
(220)
580
290
800
(220)
580
276
500
800
(220)
1,080
263
2.00
0.641
1.28
2.10
0.552
1.16
4.11
0.476
1.96
Time 6
(220)
(220)
251
(0.88)
0.410
(0.36)
Taxation
Net cash inflow
Less depreciation (1,250/5)
H$m
800
(250)
550 @ 40% = H$220m
Exchange rate
Current spot = H$336/Rs (that is, Re. 1 = H$336). If the Rupee is
depreciating against the H$, this means that the H$ is getting more valuable
in terms of Rs, ie there will be more Rs per H$ or less H$ per Rs.
Thus in one year's time the H$/Rs rate will fall by 5%, to approximately
336/1.05 = 320, etc.
1+ IH 320
=
1.16 336
1 + IH = 1.10
Thus the adjusted discount rate is 10%.
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387
Time 3
Time 4
Time 5
Time 6
580
0.751
435.6
580
0.683
396.1
1,080
0.621
670.7
(220)
0.564
(124.1)
NPV = H$834.6m
Translating this present value at the spot rate gives H$834.6/336 = Rs. 2.48m.
This method is useful if the currency flows are annuities and the adjusted discount
rate is a round number, as the computation can be reduced by the use of annuity
tables.
QUESTION
388
CA Sri Lanka
ANSWER
Time
0
$'000 cash flows
Sales receipts
Costs
Tax allowable depreciation
(brought in to calculate
taxable profit)
$ taxable profit
Taxation
Add back tax allowable
depreciation (as not a
cash flow)
Capital expenditure
(2,000)
Scrap value
Tax on scrap value (W1)
Terminal value
Tax on terminal value
Working capital
(400)
(2,400)
Exchange rates
5:1
Rs. '000 cash flows
From/(to) Ruritania
Additional SL tax (W2)
Additional SL
expenses/income
SL tax effect of SL
expenses/income
Net sterling cash flows
SL discount factors
Present values
(480)
1,600
(1,000)
1,600
(1,000)
1,600
(1,000)
1,600
(1,000)
(500)
100
(500)
100
(35)
(500)
100
(35)
(500)
100
(35)
500
500
500
500
(35)
800
(280)
500
(175)
400
2,265
5:1
600
5:1
565
5:1
565
5:1
120
113
(6)
(100)
113
(6)
(100)
453
(6)
(100)
(98)
(84)
30
30
30
30
37
0.826
31
37
0.751
28
377
0.683
257
(100)
(480)
1
(480)
20
0.909
18
(490)
5:1
(152)
0.621
(94)
Years 1-3
$ taxable profit = $100,000
At Ruritanian $5/Rs exchange rate = Rs. 20,000
Tax at 30% = Rs. 6,000
CA Sri Lanka
389
Year 4
$ taxable profit = $100,000 + $800,000 + $500,000 = $1,400,000
At Ruritanian $5/Rs exchange rate = Rs. 280,000
Tax at 30% = Rs. 84,000
Assume tax is fully payable in both countries.
390
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CHAPTER ROUNDUP
In this chapter we looked at the reasons why an entity would choose to invest
overseas and the risks and complications involved.
CA Sri Lanka
391
PROGRESS TEST
How should the domestic discount rate be adjusted if the foreign project flows are
to be discounted?
The following information relates to questions 6 and 7.
It is currently September 20W9.
Dominique is a multinational group. The head office and parent entity are based
in Country D, which uses currency D$. The group runs a chain of supermarkets
both in Country D and in neighbouring countries. Dominique sources its supplies
from its home country D, neighbouring countries and also from some more distant
countries.
Dominique is funded by a mix of equity and long-term borrowings. The
borrowings are largely floating rate bonds denominated in D$.
Proposed new project
The proposed new project is to open a number of new supermarkets in Country T,
a neighbouring country, which uses currency T$. Market research has already
been undertaken at a cost of D$0.3 million. If the proposed project is approved,
additional logistics planning will be commissioned at a cost of D$0.38 million,
payable at the start of 20X0.
Other forecast project cash flows:
Initial investment on 1 January 20X0
Residual value at the end of 20X4
Net operating cash inflows
20X0
20X1 and 20X2
20X3 and 20X4
T$150 million
T$40 million
T$45 million
Growing at 20% a year from 20X0 levels
Growing at 6% a year from 20X2 levels
Additional information:
On 1 January 20X0, the spot rate for converting D$ to T$ is expected to be
D$1 = T$2.1145. Dominique has received two conflicting exchange rate
forecasts for the D$/T$ during the life of the project as follows:
Forecast A
Forecast B
392
Calculate and discuss the D$ NPV of the project cash flows as at 1 January 20X0
using each of the two different exchange rate scenarios, Forecast A and Forecast B.
Briefly advise Dominique on whether or not it should proceed with the project.
Discuss the likely impact of changes in exchange rates and tax rates on the
performance of the Dominique group as a whole and how this is likely to influence
the financial strategy of the group. No further calculations are required.
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393
Initial investment
Residual value
Cash inflows
Tax at 20%
Tax dep allowance (W1)
Net cash remitted to
Country D
Country D tax 5% (W2)
Net cash flow
Discount factor 12%
DCF
NPV
Exchange rate
NPV in D$
Additional logistics
planning
Net result
394
Year 0
T$m
(150)
(150)
(150)
1.000
(150)
51
2.1145
24.1
(0.38)
Year 1
T$m
Year 2
T$m
Year 3
T$m
Year 4
T$m
Year 5
T$m
45.0
(9.0)
6.0
42.0
54.0
(10.8)
4.8
48.0
64.8
(13.0)
3.8
55.6
68.7
(13.7)
3.1
58.1
40.0
72.8
(14.6)
4.3
102.5
(2.1)
39.9
0.893
35.6
(2.4)
45.6
0.797
36.3
(2.8)
52.8
0.712
37.6
(2.9)
55.2
0.636
35.1
(3.1)
99.4
0.567
56.4
23.72
CA Sri Lanka
Working 1
Year
0 cost
1 20% reducing balance
2 20% reducing balance
3 20% reducing balance
4 20% reducing balance
5 20% reducing balance
Residual value
Balancing allowance
1.8
Working 2
Residual value in year 5 is not subject to tax, therefore additional tax paid in year 5
is calculated on the cash flows net of residual value that is T$102.5m T$40m =
T$62.5m (tax = 5% of T$62.5m = T$3.1m).
Assumption
There is no tax relief on the additional logistics planning costs.
NPV using Forecast B exchange rates
Year 0
T$m
(150)
2.1145
Year 1
T$m
39.9
2.2287
Year 2
T$m
45.6
2.3490
Year 3
T$m
52.8
2.4758
Year 4
T$m
55.2
2.6095
Year 5
T$m
99.4
2.7504
D$m
(70.90)
(0.38)
D$m
17.9
D$m
19.4
D$m
21.3
D$m
21.2
D$m
36.1
1.000
(71.28)
0.893
15.9
0.797
15.5
0.712
15.2
0.636
13.5
0.567
20.5
NPV = D$9.32m
Working 3 exchange rates
Year
0
1
2
3
4
5
CA Sri Lanka
Alternative working
Instead of calculating the individual exchange rates for each year, you could have
adjusted the discount rate for the depreciation in currency. The following formula
is given in the formula sheet.
1 + annual discount rate B$ Future spot rate A$ /B$ in 12 months' time
=
1 + annual discount rate A$
Spot rate A$ /B$
Where:
Year 0 Year 1
T$m
T$m
(150)
39.9
1.000 0.847
(150)
33.8
20.6
2.1145
9.7
(0.38)
9.32
This is the same result as that calculated above using the individual exchange
rates.
Comments on results
The project shows a positive NPV regardless of the forecast exchange rate,
although if the exchange rate remained stable, Dominique's shareholders would
enjoy a greater increase in wealth (D$23.72m rather than D$9.32m).
Dominique should accept the project and go ahead with the proposal of opening
a number of supermarkets in Country T. Even if the exchange rate does fluctuate,
shareholder wealth will still increase by D$9.32m. In fact, it may increase by much
more than that amount, given that forecasts have only been made for five years
396
CA Sri Lanka
and the residual value is quite low. Given the likelihood that the supermarkets will
remain open beyond five years, the NPV may be considerably higher and residual
value likely to be greater than the figure estimated.
In addition, Dominique would be complementing its existing considerable
international spread of supermarkets, therefore it seems wise to proceed with the
project on both financial and geographical grounds.
7
CA Sri Lanka
397
398
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CHAPTER
INTRODUCTION
In this chapter, we examine some further applications of discounted cash flow (DCF) techniques. An
enterprise may be faced with more investment opportunities than it can finance with the capital available,
and we look first at how capital rationing may affect the investment decision.
We then examine various techniques that can be used to deal with complications in investment decisions. The
equivalent annual cost method can be used when maintenance costs are an important element in an
investment decision. Real option theory can be used to assist when organisations have to or can make
further decisions after the initial investment decision. The adjusted present value method provides a better
means of taking into account the effects of using loan finance than simple NPV analysis does.
Knowledge Component
4
Corporate Investment Appraisal
4.1
Projects appraisal
4.1.2
4.1.4
4.1.5
399
CHAPTER CONTENTS
LEARNING
OUTCOME
1 Capital rationing
4.1.2
4.1.2
3 Real options
4.1.5
4.1.4
1 Capital rationing
We have seen in the last two chapters that the decision rule with discounted cash
flow (DCF) techniques is to accept all projects which result in positive net
present values (NPVs) when discounted at the company's cost of capital. If an
entity suffers capital rationing, it will not be able to enter into all projects with
positive NPVs because there is not enough capital for all the investments. In this
section we look at techniques to deal with this problem.
Capital rationing is a restriction on an organisation's ability to invest capital
funds, caused by an internal budget ceiling being imposed on such expenditure by
management (soft capital rationing), or by external limitations being applied to
the company, as when additional borrowed funds cannot be obtained (hard
capital rationing).
If an organisation is in a capital rationing situation, it will not be able to invest in
all available projects which have positive NPVs because there is not enough capital
for all of the investments. Capital is a limiting factor.
400
(a)
(b)
CA Sri Lanka
(c)
Management may not want to raise additional debt capital because they
do not wish to be committed to large fixed interest payments.
(d)
(e)
Note that whenever an organisation adopts a policy that restricts funds available
for investment, such a policy may be less than optimal as the organisation may
reject projects with a positive net present value and forgo opportunities that
would have enhanced the market value of the organisation.
Hard capital rationing may arise for one of the following reasons.
(a)
Raising money through the stock market may not be possible if share prices
are depressed.
(b)
(c)
(d)
The costs associated with making small issues of capital may be too great.
(b)
You may also encounter mutually exclusive projects when one, and only one, of
two or more choices of project can be undertaken.
CA Sri Lanka
401
FORMULA TO LEARN
Profitability index =
NPV of project
Initial cash outflow
Note. The cash outflow should be in the year in which capital is rationed. This may
not be year 0, so make sure you read the question carefully.
1.3.1 Example: Single period capital rationing with divisible projects
SF Co has capital of Rs. 130 million available for investment in the forthcoming
period, at a cost of capital of 20%. Capital will be freely available in the future.
Details of six projects under consideration are as follows. All projects are
independent and divisible. Which projects should be undertaken and what NPV
will result?
Present
value of
Investment
inflows at
Project
required
20%
Rs Mn
Rs Mn
P
40
56.5
Q
50
67.0
R
30
48.8
S
45
59.0
T
15
22.4
U
20
30.8
Required
Calculate which projects should be undertaken and the NPV that will result.
Solution
The first step is to rank the projects according to the return achieved from the
limiting factor of investment funds.
PV per Re. 1
Project
PV inflows Investment
invested
Ranking
Rs Mn
Rs Mn
Rs
P
56.5
40
1.41
4
Q
67.0
50
1.34
5
R
48.8
30
1.63
1
S
59.0
45
1.31
6
T
22.4
15
1.49
3
U
30.8
20
1.54
2
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CA Sri Lanka
Investment
Rs Mn
30
20
15
40
25
130
()
Maximum PV =
PV
Rs Mn
48.8
30.8
22.4
56.5
33.5
192.0
Similar to the NPV method, usually giving the same result on individual
projects.
(b)
(b)
The PI method may rank projects incorrectly. (If cash is not rationed, it is
preferable to look at the NPV, which is an absolute measure.)
(c)
CA Sri Lanka
403
process if there are a large number of projects available. We will continue with the
previous example to demonstrate the technique.
1.4.1 Example: Single period capital rationing with non-divisible projects
SF Co now discovers that funds in the forthcoming period are actually restricted to
Rs. 90 million. The directors decide to consider projects P, Q and R only. They wish
to invest only in whole projects, but surplus funds can be invested.
Required
Calculate the combination of projects that will produce the highest NPV at a cost
of capital of 20%.
Solution
The investment combinations we need to consider are the various possible pairs
of projects P, Q and R.
Required
PV of
NPV from
Projects
investment
inflows
projects
Rs Mn
Rs Mn
Rs Mn
P and Q
90
123.5
33.5
P and R
70
105.3
35.3
Q and R
80
115.8
35.8
Highest NPV undertake projects Q and R and invest the unused funds of
Rs. 10 million externally.
QUESTION
Capital rationing
404
CA Sri Lanka
The cash flows given above represent estimated results for maximum possible
investment in each project; lower levels of investment may be undertaken, in
which case all cash flows will be reduced in proportion.
Required
Calculate the optimal set of investment, assuming that capital available is limited
to Rs. 120 million at time 0, and Rs. 240 million at time 1; assume that the
Platinum project and the Emerald project are mutually exclusive. (Hint. Firstly
check in which years capital rationing occurs.)
ANSWER
Optimal investments for BJ Co
First we need to determine in which year(s) capital is rationed, taking account of
the fact that only one of the Platinum and Emerald projects will be undertaken.
Project
Diamond
Sapphire
Platinum
Emerald
Quartz
Total
Capital available
(24)
(84)
240
(6)
(24)
(60)
240
To rank the projects, the basic PI as previously defined cannot be used as this would
PV of inflows
ignore outlays at time 1. One option would be to use a PI defined as PV of outlays
but this is not entirely appropriate as capital is not rationed at time 1.
NPV project
An alternative, used here, is to use a PI defined as: Initial capital invested
It is therefore concluded that effective capital rationing exists only at time 0, ie a
single period of capital rationing situation.
Project
Diamond
Sapphire
Platinum
Emerald
Quartz
CA Sri Lanka
Cash flows
PV of cash flows @ 20%
0
1
2
0
1
2
NPV
Rs Mn Rs Mn Rs Mn Rs Mn Rs Mn
Rs Mn Rs Mn
(24)
(36)
96
(24) (30.0)
66.6
12.6
(48)
6
66
(48)
5.0
45.8
2.8
(60)
(30)
138
(60) (25.0)
95.8
10.8
(48)
(6)
90
(48)
(5.0)
62.5
9.5
(36)
(24)
96
(36) (20.0)
66.6
10.6
PI
Rank
0.525
0.058
0.180
0.198
0.294
1
5
4
3
2
405
In time 0 with only Rs. 100 million available projects would be introduced in order
of profitability as shown.
Platinum without Emerald
Project
Diamond
Quartz
Platinum
Sapphire
Funds utilised and available
Proportion
accepted
%
100
100
100
Nil
Funds used
at Time 0
Rs Mn
24
36
60
Nil
120
Proportion
accepted
%
100
100
100
25
Funds used
at Time 0
Rs Mn
24
36
48
12
120
Total NPV
Rs Mn
12.6
10.6
10.8
Nil
34.0
Diamond
Quartz
Emerald
Sapphire
Funds utilised and available
Total NPV
Rs Mn
12.6
10.6
9.5
0.7
33.4
406
(a)
(b)
CA Sri Lanka
(c)
It may be possible to contract out parts of a project to reduce the initial capital
outlay required.
(d)
The company may seek new alternative sources of capital (subject to any
restrictions which apply to it) for example:
(i)
(ii)
(iii)
(iv)
(v)
(vi)
Venture capital
Debt finance secured on projects assets
Sale and leaseback of property or equipment
Grant aid
More effective capital management
Delay a project to a later period
(a)
'PV of costs' is the purchase cost, minus the present value of any
subsequent disposal proceeds at the end of the item's life.
(b)
The n year annuity factor is at the company's cost of capital, for the
number of years of the item's life.
CA Sri Lanka
407
Rs Mn
Revenues
Costs
Depreciation
Other
Rs Mn
450
100
300
400
50
Profit
The equipment would have a five-year life, and no residual value, and would be
financed by a loan at 12% interest per annum.
Required
Assess, using annualised figures, whether the project is a worthwhile
undertaking. Ignore risk and taxation.
Solution
The annualised capital cost of the equipment is as follows.
Rs. 500 million
Rs. 500 million
=
= Rs. 138.696 million
PV of Re. 1 per annum for yrs 1 to 5 at 12%
3.605
Annual profit = Rs. 450 million Rs. 138.696 million Rs. 300 million = Rs. 11.304
million
Depreciation is ignored because it is a notional cost and has already been taken
into account in the annualised cost.
The project is a worthwhile undertaking, but only by about Rs. 11 million a year
for five years.
Calculate the present value of costs for each replacement cycle over
one cycle only.
These costs are not comparable because they refer to different time
periods, whereas replacement is continuous.
408
CA Sri Lanka
Step 2
Turn the present value of costs for each replacement cycle into an
equivalent annual cost (an annuity).
The equivalent annual costs is calculated as follows.
Year 1
Rs Mn
7.500
Year 2
Rs Mn
11.000
Year 3
Rs Mn
12.500
Year 4
Rs Mn
15.000
15.000
10.000
7.500
2.500
Calculate the present value of costs for each replacement cycle over
one cycle.
Replace
Replace
Replace
Replace
every year
every 2 years
every 3 years
every 4 years
Cash
PV at
Cash
PV at
Cash
PV at
Cash
PV at
Year
flow
10%
flow
10%
flow
10%
flow
10%
Rs Mn
Rs Mn
Rs Mn
Rs Mn
Rs Mn
Rs Mn
Rs Mn
Rs Mn
0
(25.000) (25.000) (25.000) (25.000) (25.000) (25.000) (25.000) (25.000)
1
7.500
6.818
(7.500) (6.818) (7.500) (6.818) (7.500) (6.818)
2
(1.000)
(826) (11.000) (9.086) (11.000) (9.086)
3
(5.000) (3.755) (12.500) (9.388)
(12.500) (8.538)
4
PV of cost
over one
replacement
(32.644)
(44.659)
(58.830)
cycle
(18.182)
CA Sri Lanka
409
Step 2
(b)
(c)
Rs. (32.644)
= Rs. (18.804)
1.736
(d)
Rs. (18.182)
= Rs. (20.002)
0.909
Rs.(44.659)
= Rs.(17.957)
2.487
Rs.(58.830)
= Rs.(18.558)
3.17
The optimum replacement policy is the one with the lowest equivalent annual
cost, every three years.
NPV of project
Annuity factor
For example, project A with an NPV of Rs. 3.75m and a duration of 6 years, given a
3.75
= 0.91. An
discount rate of 12%, will have an equivalent annual annuity of
4.111
alternative project B with an NPV of Rs. 4.45m and a duration of 7 years will have
4.45
an equivalent annual annuity of
= 0.98.
4.564
This method is a useful way to compare projects with unequal lives.
3 Real options
Real options theory is an attempt to incorporate real-life uncertainty and
flexibility into the capital investment decision. A major capital investment may not
always be set in stone.
Real options attempt to incorporate flexibility to adapt decisions in response to
unexpected market developments. It is argued that traditional methods such as
NPV fail to accurately capture the economic value of investments in an
environment of widespread uncertainty and rapid change. The real options
method applies financial options theory to quantify the value of this flexibility.
410
CA Sri Lanka
Figure 14.1
Real
options
Option to
abandon
Option to
follow-on
Option to
wait
CA Sri Lanka
411
For example, the possibility of 'doing nothing for a year' may be more valuable
than a stated alternative because it will allow the resolution of the uncertainty
surrounding legislation or to see if development status is granted on land.
This is equivalent to a call option.
Cash flow
Rs '000
(10,000)
4,800
Discount
factor
1.000
2.487
Present
value
Rs '000
(10,000)
11,938
1,938
Wait option
However, suppose that economic conditions after the first year are expected to
remain the same for the foreseeable future. This means that LB Co Co could wait
one year to see which scenario occurs and then launch the project. This would give
the following NPVs.
412
CA Sri Lanka
Best case
Year
1
2-4
Worst case
Year
1
2-4
Cash flow
Rs '000
(10,000)
6,000
Cash flow
Rs '000
(10,000)
3,000
Discount
factor
0.909
2.261*
Discount
factor
0.909
2.261*
Present
value
Rs '000
(9,090)
13,566
4,476
Present
value
Rs '000
(9,090)
6,783
(2,307)
Year
0 Sale value
1 Opportunity loss of cashflow
2 Opportunity loss of cashflow
Cash flow
Rs '000
6,000
(6,000)
(6,000)
Cash flow
Rs '000
6,000
(3,000)
(3,000)
Discount
factor
1.000
0.909
0.826
Discount
factor
1.000
0.909
0.826
Present
value
Rs '000
6,000
(5,454)
(4,956)
(4,410)
Present
value
Rs '000
6,000
(2,727)
(2,478)
795
This shows that if the cash flows are only Rs. 3 million per year, then the
abandonment option should be taken as this has a positive NPV.
CA Sri Lanka
413
The abandonment option can then be incorporated into the NPV of the project as
follows.
The expected value of the cash flows can be calculated as follows (including the
scrap value for abandoning the project):
Year 1
Probability
0.6
0.4
Year 2
Rs '000
EV
6,000
9,000
3,600
3,600
7,200
Probability
0.6
0.4
Year 3
Rs '000
EV
Probability
6,000
-
3,600
3,600
0.6
0.4
Cash flow
Rs '000
(10,000)
7,200
3,600
3,600
0
1
2
3
Discount
factor
1.000
0.909
0.826
0.751
Rs '000
6,000
-
EV
3,600
3,600
Present
value
Rs '000
(10,000)
6,545
2,974
2,704
2,223
The option to abandon has increased the overall NPV by Rs. 2.223 m Rs. 1.938m
= Rs. 0.285 million.
414
(a)
(b)
(c)
Evaluate the project first of all as if it was all equity financed, and so
as if the company were an all equity company to find the 'base case
NPV'.
Step 2
Equity
Debt (70% of 12%)
WACC
Cost
%
21.6
8.4
Weighting
0.5
0.5
Product
%
10.8
4.2
15.0
Rs '000
36,000
10,800
25,200
CA Sri Lanka
415
Since Rs. 100 million of new investment is being created, the value of the company
will increase by Rs. 100m + Rs. 68m = Rs. 168m, of which 50% must be debt
capital.
The company must raise 50% Rs. 168m = Rs. 84m of 12% debt capital, and (the
balance) Rs. 16m of equity. The NPV of the project will raise the value of this
equity from Rs. 16m to Rs. 84m, thus leaving the gearing ratio at 50:50.
The APV approach to this example is as follows.
Step 1
FORMULA TO LEARN
Cost of ordinary (equity) share capital in a geared firm (with tax):
keg = keu + [keu kd]
VD[1 t]
VE
= 17.647%
Rs. 25.2m
Rs. 100m = Rs. 42.8m
0.17647
Next, we can use an MM formula for the relationship between the value
of geared and ungeared companies, to establish the effect of gearing
on the value of the project. Rs. 84m will be financed by debt.
Vg (APV)
= Vu + TBC
= + Rs. 42.8m + (Rs. 84m 0.30)
= + Rs. 42.8m + Rs. 25.2m
= Rs. 68m
416
CA Sri Lanka
The value TBc (value of debt corporate tax rate) represents the
present value of the tax shield on debt interest, that is the present
value of the savings arising from tax relief on debt interest.
This can be proved as follows.
Annual interest charge = 12% of Rs. 84m = Rs. 10.08m
Tax saving (30% Rs. 10.08) = Rs. 3.024m
Cost of debt (pre-tax) = 12%
Rs. 3.024m
(by coincidence only this
0.12
equals the project net of tax cash flows)
= Rs. 25.2m
TBc = Rs. 84m 0.30 = Rs. 25.2m is a quicker way of deriving the same
value. Note, however, this only works where the interest is payable in
perpetuity. If not, the PV of the tax shield will need to be computed by
the 'long hand' method, above using an appropriate annuity factor.
Note. Make sure you use the cost of debt to discount the tax relief on interest costs
and not the cost of equity.
4.2.2 Example: Further APV
Suppose in the above example the cash flows only lasted for five years, and tax
was payable one year in arrears. Calculate the present value of the tax shield.
Solution
The tax saving will now only last for years 2 to 6. (Remember interest will be paid
in years 1 to 5, but the tax benefits will be felt a year in arrears.)
PV of tax savings = 3.024m Annuity factor years 2 to 6
= 3.024m (Annuity factors years 1 to 6 Annuity factor year 1)
= 3.024m (4.111 0.893)
= Rs. 9.731m
The APV and NPV approaches produce the same conclusion.
CA Sri Lanka
417
In this respect, it is superior to the NPV method. Suppose, for example, that in the
previous example, the entire project were to be financed by debt. The APV of
the project would be calculated as follows.
(a)
(b)
The adjustment to allow for the method of financing is the present value of
the tax relief on debt interest in perpetuity.
DTc = Rs. 100m 0.30 = Rs. 30m
(c)
QUESTION
APV
ANSWER
NPV if all equity financed: Rs. 21,000/0.15 Rs. 100,000
PV of the tax shield: Rs. 60,000 12% 30%/0.12
APV
Rs '000
40,000
18,000
58,000
418
CA Sri Lanka
In the exam, we suggest that you make clear the reasons for choosing the discount
rate that you have chosen to discount the tax relief, and add a comment that an
alternative rate might be used.
The costs of issuing the finance needed for the project may also be brought into
APV calculations.
4.5.2 Example: APV with issue costs
Issue costs will not equal 5% of Rs. 10 million (Rs. 20 million Rs. 10 million). The
Rs. 10 million will be the figure left after the issue costs have been paid. Therefore
Rs. 10 million must be 95%, not 100% of the amount raised, and the issue costs =
5
Rs. 10 million = Rs. 526,316
95
In the above example, the issue costs do not need to be discounted, as they are
assumed to be paid at time 0. The complication comes if issue costs are allowable
for tax purposes.
4.5.3 Example: Further APV with issue costs
Assume in the example above that issue costs are allowable for tax purposes, the
tax is assumed to be 30% payable one year in arrears and the risk-free rate of
return is assumed to be 8%.
Required
Calculate the tax effect of the issuing costs to be included in the APV calculation.
CA Sri Lanka
419
Solution
Projects may yield other incremental benefits, for example increased borrowing or
debt capacity. These benefits should be included in the APV calculations, even if
the debt capacity is utilised elsewhere.
4.5.5 Example: APV with spare debt capacity
Continuing with the NCW Co example, suppose that the project increased the
borrowing capacity of the company by Rs. 6 million, at the risk-free rate of return
of 8%.
Required
Calculate the effect on the APV calculation.
Solution
Remember that we are concerned with the incremental benefit which is the tax
shield effect of the increased debt finance.
Present value of tax shield =
=
=
4.5.6 Subsidy
You may face a situation where a company can obtain finance at a lower interest
rate than its normal cost of borrowing. In this situation, you have to include in the
APV calculation the tax shield effect of the cheaper finance and the effect of the
saving in interest.
4.5.7 Example: Subsidy
GBL Co is about to start a project requiring Rs. 6 million of initial investment. The
company normally borrows at 12%, but a government loan will be available to
finance all of the project at 10%. The risk-free rate of interest is 6%.
420
CA Sri Lanka
Tax is payable at 30% one year in arrears. The project is scheduled to last for four
years.
Required
Calculate the effect on the APV calculation if GBL Co finances the project by means of
the government loan.
Solution
(a)
(b)
We also need to take into account the benefits of being able to pay a lower
interest rate.
Benefits
(c)
APV can be used to evaluate all the effects of financing a product including:
(i) Tax shield
(ii) Changing capital structure
(iii) Any other relevant cost
(b)
CA Sri Lanka
When using APV, you do not have to adjust the WACC using assumptions of
perpetual risk-free debt.
421
422
(a)
(b)
(c)
CA Sri Lanka
CHAPTER ROUNDUP
We have seen in the last two chapters that the decision rule with DCF techniques
is to accept all projects which result in positive NPVs when discounted at the
company's cost of capital.
If an entity suffers capital rationing, it will not be able to enter into all projects
with positive NPVs because there is not enough capital for all the investments. In
this chapter, we looked at techniques to deal with this problem.
When an asset is being replaced with an identical asset, the equivalent annual cost
method is a technique which can be used to determine the best time to replace
the asset.
We have seen that a company's gearing level has implications for its WACC. The
viability of an investment project will depend partly on how the investment is
financed, and how the method of finance affects gearing. The adjusted present
value method provides a better means of taking into account the effects of using
loan finance than simple NPV analysis does.
CA Sri Lanka
423
PROGRESS TEST
True
False
2
(1)
(2)
PV of costs
n year annuity factor
Identify three common types of 'real option' found in relation to capital projects.
What is the best way to find the optimal solution in a situation of single period
rationing with indivisible projects?
What is the best way to find the optimal solution in a situation of single period
rationing with divisible projects?
10
11
PD Co is deciding whether to replace its delivery vans every year or every other
year. The initial cost of a van is Rs. 20,000. Maintenance costs would be nil in the
first year, and Rs. 5,000 at the end of the second year. Secondhand value would fall
from Rs. 10,000 to Rs. 8,000 if it held on to the van for two years instead of just
one. PD Co's cost of capital is 10%.
How often should PD Co replace its vans, and what is the annual equivalent cost
(EAC) of that option?
A
B
C
D
424
Replace every
1
1
2
2
EAC (Rs.)
10,910
12,002
10,093
8,761
CA Sri Lanka
12
A
B
C
D
Statement 2
True
True
False
False
True
False
True
False
4
5
6
5
Rs. 11 million
Rs. 13 million
Rs. 9 million
Rs. 15 million
What is the NPV generated from the optimum investment programme if the
projects were indivisible?
A
B
C
D
CA Sri Lanka
40
30
50
60
NPV
14
Initial cost
Rs. 11 million
Rs. 13 million
Rs. 6 million
Rs. 12 million
425
15
A professional kitchen is attempting to choose between gas and electricity for its
main heat source. Once a choice is made, the kitchen intends to keep to that source
indefinitely. Each gas oven has a net present value (NPV) of Rs. 50,000 over its
useful life of five years. Each electric oven has an NPV of Rs. 68,000 over its useful
life of seven years. The cost of capital is 8%.
Which should the kitchen choose and why?
A
B
C
D
16
17
18
Gas because its average NPV per year is higher than electric
Electric because its NPV is higher than gas
Electric because its equivalent annual benefit is higher
Electric because it lasts longer than gas
A
B
C
D
1 and 2 only
1 and 3 only
1, 2 and 4 only
2, 3 and 4 only
Which of the following are potentially practical ways of attempting to deal with a
capital constraint?
1
2
3
Lease
Joint venture
Delay one or more of the projects
A
B
C
D
1 and 3 only
2 and 3 only
1 and 2 only
1, 2 and 3
426
CA Sri Lanka
The following information concerning current costs and selling price is available:
Selling price
Variable production cost
Fixed production overhead cost
Rs./unit
50
16
25
Annual
inflation
%
3
4
5
CA Sri Lanka
427
(1)
(2)
(a)
The purchase cost, minus the present value of any subsequent disposal
proceeds at the end of the item's life
(b)
The annuity factor at the company's cost of capital, for the number of years
of the item's life
(a)
(b)
(c)
Raising money through the stock market may not be possible if share prices
are depressed.
(b)
(c)
(d)
The costs associated with making small issues of capital may be too great.
Use trial and error and test the NPV available from different project combinations.
10
(a)
Establishing a suitable cost of equity, for the initial DCF computation as if the
project were all-equity financed, and also establishing the all-equity
(b)
(c)
11
The answer is C.
Net present cost of 1-year cycle = 20,000 (10,000 0.909) = Rs. 10,910 cost
Net present cost of 2-year cycle = 20,000 [(8,000 5,000) 0.826]
= Rs. 17,522 cost
EAC 1-year cycle = Rs. 10,910/0.909 = 12,002
EAC 2-year cycle = Rs. 17,522/1.736 = 10,093
The 2-year cycle should be chosen with an equivalent annual cost of Rs. 10,093.
428
CA Sri Lanka
12
13
The answer is B.
Project
1
2
3
4
Initial cost
Rs Mn
40
30
50
60
NPV
Rs Mn
4
5
6
5
Profitability
index*
Ranking
1.10
1.167
1.12
1.08
3
1
2
4
100% of project 2
100% of project 3
50% of project 1
Investment
Rs Mn
30
50
20
100
NPV
Rs Mn
5
6
2
13
14
The answer is A. Projects 2 and 3 give the highest NPV without breaking the Rs.
100 million constraint.
15
The answer is C. The NPVs cannot be directly compared as they relate to different
time periods. Equivalent annual benefits (EAB) should be compared. This is
similar in principle to equivalent annual cost.
EAB gas = Rs. 50,000/AF1-5 = 50,000/3.993 = Rs. 12,522 pa
EAB electric = Rs. 68,000/AF1-7 = 68,000/5.206 = Rs. 13,062 pa
Therefore electric should be chosen, as its equivalent annual benefit is higher.
16
CA Sri Lanka
429
The answer is D. Leasing may be possible. A joint venture partner may provide
additional funding. Although delaying projects will probably reduce their NPV
(time value of money, and competitor response), this may be better than not
investing at all.
18
Calculation of Ke
VD 1 t
VE
u = g
+d
VE + VD 1 t
VE + VD 1 t
2
u = 1.35
2 + 1[1 0.3]
= 1.35 0.741
= 1.00
Ungeared Ke
= Rf + [Rm Rf]
= 4 + (10 4)1
= 10%
Alternative method:
VD
VE
+k d 1 t
VE + VD
VE + VD
WACC = k e
VE + VD
430
CA Sri Lanka
NPV calculation
0
Rs '000
Year
Contribution (W1)
Fixed costs (W2)
Taxation (30%)
Purchase of
machine
Proceeds from sale
Tax benefits (W3)
After-tax cash
flows
10% discount
factor
Present value
Net present value
1
Rs '000
1,220
(919)
301
(90)
211
2
Rs '000
1,563
(965)
598
(179)
419
3
Rs '000
2,003
(1,013)
990
(297)
693
4
Rs '000
2,567
(1,064)
1,503
(451)
1,052
(900)
67
51
38
200
54
278
0.909
470
0.826
731
0.751
1,306
0.683
253
388
549
892
(900)
1.000
(900)
1,182
Workings
Contribution
Year
1
Rs
51.50
16.64
34.86
35,000
1,220,100
2
Rs
53.04
17.31
35.73
43,750
1,563,188
3
Rs
54.63
18.00
36.63
54,688
2,003,221
4
Rs
56.27
18.72
37.55
68,360
2,566,918
Fixed costs
Total fixed production overhead cost in current price terms = 35,000 units
Rs. 25
= Rs. 875,000
Inflated at 5% per year:
Year
Fixed costs
CA Sri Lanka
1
Rs
918,750
2
Rs
964,688
3
Rs
1,012,922
4
Rs
1,063,568
431
Tax benefits
Year
1
2
3
4
Capital allowances
900,000 0.25 = 225,000
225,000 0.75 = 168,750
168,750 0.75 = 126,563
Balancing figure = 179,687
900,000 200,000 = 700,000
432
CA Sri Lanka
434
CA Sri Lanka
CHAPTER
INTRODUCTION
In this chapter we shall be concentrating on methods of calculating the
valuations of organisations of different types. We shall cover the main
methods of valuation in this chapter, and demonstrate how market
efficiency and changing capital structure impact on valuation. The
most important use of valuation techniques is in a merger or acquisition
situation, and therefore Chapter 16 concentrates on these.
You need to be able to use a range of measures in practical situations,
also to discuss why they show different values and which measure is the
most useful.
Knowledge Component
5
Corporate Growth Strategy
5.2
Business valuation,
merger, acquisition and
divestment and other
corporate growth
strategies
5.2.1
5.2.2
5.2.3
435
CHAPTER CONTENTS
LEARNING
OUTCOME
5.2.1
5.2.1
5.2.1
5.2.1
5.2.1
6 Valuation issues
5.2.3
5.2.2
For quoted companies, when there is a takeover bid and the offer price is
an estimated 'fair value' in excess of the current market price of the shares
The company wishes to 'go public' and must fix an issue price for its
shares
(ii)
436
CA Sri Lanka
(c)
(d)
(e)
CA Sri Lanka
437
438
CA Sri Lanka
The techniques we are now going to cover produce a range of values which can
be summarised as follows.
Maximum value
Minimum value
CA Sri Lanka
Rs '000
Rs '000
160,000
80,000
20,000
260,000
20,000
80,000
60,000
15,000
5,000
160,000
439
Rs '000
Current liabilities
Payables
Taxation
Proposed ordinary dividend
Rs '000
Rs '000
60,000
20,000
20,000
(100,000)
12% bonds
Deferred taxation
Total net assets
Ordinary shares of Re. 1
Reserves
4.9% preference shares of Re. 1
Total equity and reserves
60,000
340,000
(60,000)
(10,000)
270,000
80,000
140,000
220,000
50,000
270,000
Required
Calculate the value of an ordinary share using the net assets basis of valuation.
Solution
If the figures given for asset values are not questioned, the valuation would be as
follows.
Rs '000
Rs '000
340,000
Total value of assets less current liabilities
(20,000)
Less intangible asset (goodwill)
320,000
Total value of assets less current liabilities
50,000
Less: Preference shares
60,000
Bonds
10,000
Deferred taxation
120,000
200,000
Net asset value of equity
80,000
Number of ordinary shares
Rs. 2.50
Value per share
440
CA Sri Lanka
Possibilities include:
Historic basis. Unlikely to give a realistic value as it is dependent on the
business's depreciation and amortisation policy.
Replacement basis. If the assets are to be used on an ongoing basis.
Realisable basis. If the assets are to be sold, or the business as a whole broken
up. This will not be relevant if a minority shareholder is selling their stake, as
the assets will continue in the business's use.
The following list should give you some idea of the factors that must be
considered.
CA Sri Lanka
(a)
Do the assets need professional valuation? If so, how much will this cost?
(b)
(c)
How have the current assets been valued? Are all receivables collectable? Is
all inventory realisable? Can all the assets be physically located and brought
into a saleable condition? This may be difficult in certain circumstances
where the assets are situated abroad.
(d)
(e)
Is there an available market in which the assets can be realised (on a breakup basis)? If so, do the balance sheet values truly reflect these break-up
values?
(f)
(g)
(h)
Are there factors that might indicate that the going concern valuation of
the business as a whole is significantly higher than the valuation of the
individual assets?
(i)
441
(b)
(c)
For these reasons, it is always advisable to calculate the net assets per share.
442
CA Sri Lanka
(b)
Security of earnings
A well-established low-risk company would be valued on a higher P/E ratio
than a similar company whose earnings are subject to greater uncertainty.
(c)
Status
If a quoted company (the predator) made a share-for-share takeover bid for
an unquoted company (the target), it would normally expect its own shares
to be valued on a higher P/E ratio than the target company's shares. This is
because a quoted company ought to be a lower-risk company; but in
addition, there is an advantage in having shares which are quoted on a stock
market: the shares can be readily sold. The P/E ratio of an unquoted
company's shares might be around 50% to 60% of the P/E ratio of a similar
public company with a full stock exchange listing.
CA Sri Lanka
(a)
(b)
A single year's P/E ratio may not be a good basis, if earnings are volatile, or
the quoted company's share price is at an abnormal level, due for example to
the expectation of a takeover bid.
443
(c)
If a P/E ratio trend is used, then historical data will be used to value how
the unquoted company will do in the future.
(d)
(b)
(c)
If FL Co is thought to be growing fast, so that its EPS will rise rapidly in the
years to come, the P/E ratio that should be used for the share valuation will
be higher than if only small EPS growth is expected.
(d)
Of course, the P/E ratio on which SD Co bases its offer will probably be lower than
the P/E ratio that FL Co's shareholders think their shares ought to be valued on.
Some haggling over the price might be necessary.
SD Co might decide that FL Co's shares ought to be valued on a P/E ratio of 60%
16 = 9.6; that is, at 9.6 50c = Rs. 4.80 each.
FL Co's shareholders might reject this offer, and suggest a valuation based on a
P/E ratio of, say, 12.5; that is, 12.5 50c = Rs. 6.25.
444
CA Sri Lanka
SD Co's management might then come back with a revised offer, say valuation on a
P/E ratio of 10.5; that is, 10.5 50c = Rs. 5.25.
The haggling will go on until the negotiations either break down or succeed in
arriving at an agreed price.
CA Sri Lanka
(a)
(b)
The type of industry and the prospects of that industry. Use of current P/E
ratios may give an unrealistically low valuation if these ratios are being
affected by a lack of confidence throughout the industry.
(c)
The size of the undertaking and its status within its industry. If an unquoted
company's earnings are growing annually and are currently around
Rs. 300,000 or so, then it could probably get a quote in its own right on the
Alternative Investment Market, and a higher P/E ratio should therefore be
used when valuing its shares.
(d)
(e)
(f)
The reliability of profit estimates and the past profit record. Use of profits
and P/E ratios over time may give a more reliable valuation, especially if
they are being compared with industry levels over that time.
(g)
(h)
The nature of the assets, for example whether some of the non-current
assets are of a highly specialised nature, and so have only a small break-up
value.
(i)
Gearing. A relatively high gearing ratio will generally mean greater financial
risk for ordinary shareholders and call for a higher rate of return on equity.
(j)
The extent to which the business is dependent on the technical skills of one
or more individuals
(k)
same risk and growth characteristics, and has similar policies on significant
areas such as directors' remuneration.
Note. For examination purposes, you should normally take a figure around
one-half to two-thirds of the industry average when valuing an unquoted
company.
3.3.1 Use of predator's P/E ratios
A predator company may sometimes use their higher P/E ratio to value a target
company. This use of a higher P/E ratio is known as bootstrapping. This assumes
that the predator can improve the target's business, which may be a dangerous
assumption to make. The predator's intentions will also be important; the choice
of P/E ratio may depend on whether the predator envisages demerging some of
the target's operations, or retaining them all. It may be better to use an adjusted
industry P/E ratio, or some other method.
3.3.2 Use of forecast earnings
When one company is thinking about taking over another, it should look at the
target company's forecast earnings, not just its historical results.
Forecasts of earnings growth should only be used if:
(a)
There are good reasons to believe that earnings growth will be achieved
(b)
(c)
Forecasts supplied by the target company's directors are made in good faith
and using reasonable assumptions and fair accounting policies
QUESTION
Earnings valuation
Rs. 50
Rs. 72
Rs. 68
20X3
20X4
Rs. 71
Rs. 75
446
Bumblebee, which has a P/E ratio of 15, but is a company with very good
growth prospects.
CA Sri Lanka
(b)
Wasp, which has had a poor profit record for several years, and has a P/E
ratio of 7.
Required
Calculate a suitable range of valuations for the shares of YZ Co.
ANSWER
(a)
Earnings. Average earnings over the last five years have been Rs. 67.2m, and
over the last four years, Rs. 71.5m. There might appear to be some growth
prospects, but estimates of future earnings are uncertain.
A low estimate of earnings in 20X5 would be, perhaps, Rs. 71.5m.
A high estimate of earnings might be Rs. 75m or more. This solution will use
the most recent earnings figure of Rs. 75m as the high estimate.
(b)
P/E ratio. A P/E ratio of 15 (Bumblebee's) would be much too high for
YZ Co, because the growth of YZ Co's earnings is not as certain, and YZ Co is
an unquoted company.
On the other hand, YZ Co's expectations of earnings are probably better than
those of Wasp. A suitable P/E ratio might be based on the industry's average,
10; but since YZ Co is an unquoted company and therefore more risky, a
lower P/E ratio might be more appropriate: perhaps 60% to 70% of 10 = 6
or 7, or conceivably even as low as 50% of 10 = 5.
The valuation of YZ Co's shares might therefore range between:
High P/E ratio and high earnings: 7 Rs. 75m = Rs. 525m, and
Low P/E ratio and low earnings: 5 Rs. 71.500 = Rs. 357.5m.
EPS
100%
Market price per share
This method is effectively a variation on the P/E method (the EY being the
reciprocal of the P/E ratio), using an appropriate earnings yield effectively as a
discount rate to value the earnings:
CA Sri Lanka
447
FORMULA TO LEARN
Market value = Earnings
EY
Exactly the same guidelines apply to this method as for the P/E method. Note that
where high growth is envisaged, the EY will be low, as current earnings will be
low relative to a market price that has built in future earnings growth. A stable
earnings yield may suggest a company with low risk characteristics.
For a takeover bid valuation, it will often be necessary to adjust the profits figure
to allow for expected changes after the takeover. Those arising in an examination
question might include:
(a)
(b)
New levels of interest charges (perhaps because the predator company will
be able to replace existing loans with new loans at a lower rate of interest, or
because the previous owners had lent the company money at noncommercial rates)
(c)
(d)
Note that such adjustments can also apply to earnings used in a P/E valuation
approach.
448
CA Sri Lanka
This figure is the maximum that CB Co should be prepared to pay. The first offer
would probably be much lower.
An ARR valuation might be used in a takeover when the acquiring company is
trying to assess the maximum amount it can afford to pay.
CA Sri Lanka
449
FORMULA TO LEARN
P0 =
d0(1 + g)
d1
or P0 =
(k e g)
(k e g)
Where: d0
g
ke
d0 (1 + g)
P0
=
=
=
=
=
QUESTION
Target paid a dividend of Rs. 250,000 this year. The current return to
shareholders of quoted companies in the same industry as Target is 12%,
although it is expected that an additional risk premium of 2% will be applicable to
Target, being a smaller and unquoted company.
Required
Compute the expected valuation of Target, if:
(a)
(b)
(c)
ANSWER
ke = 12% + 2% = 14% (0.14)
450
(a)
P0 =
d0 Rs. 250,000
=
= Rs. 1,785,714
ke
0.14
(b)
P0 =
CA Sri Lanka
(c)
Time 1
258
Time 2
266
Time 4
274
0.877
226
Rs. 2,185,000
0.769
205
0.675
185
Time 4
onwards
279
8.333
2,325
0.675
1,569
CA Sri Lanka
(a)
(b)
The do figure used does not vary significantly from the trend or risk of
dividends. If do does appear to be a rogue figure, it may be better to use an
adjusted trend figure, calculated on the basis of the past few years'
dividends.
(c)
The estimates of future dividends and prices used, and also the cost of
capital are reasonable. As with other methods, it may be difficult to make a
confident estimate of the cost of capital. Dividend estimates may be made
from historical trends that may not be a good guide for a future if for
example there is a takeover, or derived from uncertain forecasts about
future earnings, which assumes that there are enough profitable projects
in the future to maintain dividend levels.
(d)
(e)
(f)
(g)
451
(h)
(i)
(j)
452
CA Sri Lanka
Solution
The maximum price is one which would make the return from the total
investment exactly 15% over five years, so that the net present value (NPV) at
15% would be 0.
Cash flows ignoring
Year
purchase consideration
Rs '000
(100,000)
0
(80,000)
1
60,000
2
100,000
3
150,000
4
150,000
5
Maximum purchase price
Discount factor
(from tables) @ 15%
1.000
0.870
0.756
0.658
0.572
0.497
Present value
Rs '000
(100,000)
(69,600)
45,360
65,800
85,800
74,550
101,910
Note. You may also need to calculate the value of cash flows in perpetuity using
the formula given to you in the exam.
The business risk of the new investment may not match that of the
investing company. If TP Co is in a completely different line of business from
Diversification, its cash flows are likely to be subject to differing degrees of
risk, and this should be taken into account when valuing them.
(b)
The method of finance of the new investment may not match the current
debt/equity mix of the investing company, which may have an effect on the
cost of capital to be used.
CA Sri Lanka
453
Revenues
Operating costs
Depreciation
Debt repayments and lease obligations
Working capital increases
Taxes
Replacement capital expenditure
Using this model, the value of a company is the sum of future discounted free
cash flows.
You may see other definitions of free cash flow used by different companies.
The advantage of including strategic value as well as existing project value in the
definition of free cash flow is that strategic value can often be a significant
element of company value.
Free cash flows can also be used as an element in ratio calculations. For example,
the dividend cover ratio can be adjusted to take account of free cash flow.
Dividend cover =
454
CA Sri Lanka
Figure 15.1
Corporate objectives
Shareholder value
Value drivers
Sales growth
Margin
Value growth
duration period
Strategic focus
Business
strategy
Cost of
capital
Capital investment
Working capital
Acquisition
Credit rating
Tax rate
Capital structure
Dividend policy
Investment
strategy
Financing
strategy
Key decisions with implications for cash flow and risk are specified. These
may be strategic, operational, related to investment or financial.
(b)
Value drivers are identified as the factors having the greatest impact on
shareholder value, and management attention is focused on the decisions
which influence the value drivers.
Value drivers are identified as being fundamental to the determination of
value:
(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)
CA Sri Lanka
(a)
(b)
(c)
Operating profit
Add depreciation
Less tax on profits
Add sale of assets
Less investment in assets
Free cash flow
456
Year 1
Rs Mn
108
0.926
100
386
Year 2
Rs Mn
120
0.857
103
Year 3
Rs Mn
120
0.794
95
Year 4
Rs Mn
120
0.735
88
CA Sri Lanka
The present value of the free cash flow in perpetuity = 120/0.08 0.735 =
Rs. 1,103m.
Value of LW Co = Rs. (386 + 1,103)m = Rs. 1,489m
5.4.5 Advantages of SVA
(a)
(b)
(c)
(d)
(e)
(b)
The input data may not be easily available from current systems,
particularly to outsiders. It may not be easy to test whether the assumptions on
which the forecasts are based are realistic.
(c)
(d)
457
Interest and tax relief on interest should be excluded from NOPAT, as they
are taken into account in the imputed capital charge.
(b)
Investing cash flows should be excluded from NOPAT but allowed for in
capital employed. These include goodwill, research and development
and advertising, and other expenditure designed to build the business up
over the next few years. The amount added to capital employed should be a
figure that reflects the expenditure that has affected profit this year, say the
research and development charge for the last four years or goodwill that has
previously been written off. (In some calculations, a small charge for
research and development is included in the income statement to reflect the
economic depreciation of the capitalised value.)
(c)
(d)
(b)
458
(a)
EVA may cause managers to avoid projects with poor initial returns or
large initial expenditure (for example, on research and development) if they
are primarily being judged on short-term performance.
(b)
The economic value added approach also suffers from the usual problems of
being based on historical accounting figures that can be distorted.
CA Sri Lanka
(c)
There may be other value drivers that are important, such as noncapitalised goodwill.
The contribution put into the business by investors (the purchase price of
their shares and the re-investment of profits that would otherwise have
been distributed)
(b)
The increase in current market value of their shares resulting from the
contribution
The MVA figure tends to correspond closely to the difference between the market
value of equity and the book value of equity. To assess whether MVA is reasonable,
you need to assess what economic value added will be for several years into the
future; this may not be easy. Market value added also does not adjust for size
differences for comparisons.
CA Sri Lanka
(a)
(b)
(c)
Cash flows are most appropriate for valuing controlling interests, which
might have a significant influence on whether expected cash flows are
attained.
459
NPV/SVA
P/E method
Adjust P/E
P/E EPS
Dividend valuation use target's growth rate, most suitable for valuing
a minority holding
MINIMUM VALUE
QUESTION
Business valuation
460
CA Sri Lanka
Summary financial statistics for the two companies for the most recent financial
year are as follows.
ELW Co
CT Co
Issued shares (million)
4
10
Net asset values (Rs Mn)
7.2
15
Earnings per share (cents)
35
20
Dividend per share (cents)
20
18
Debt:equity ratio
1:7
1:65
Share price (cents)
362
Expected rate of growth in earnings/dividends
9% pa
7.5% pa
Notes
1
The net assets of ELW Co are the net book values of tangible non-current
assets plus net working capital. However:
A recent valuation of the buildings was Rs. 1.5 million above book value.
Inventory includes past editions of text books which have a realisable
value of Rs. 100,000 below their cost.
Due to a dispute with one of their clients, an additional allowance for bad
debts of Rs. 750,000 could prudently be made.
ELW Co uses a discount rate of 15% to appraise its investments, and has
done for many years.
Required
(a)
Compute a range of valuations for the business of ELW Co, using the
information available and stating any assumptions made.
(b)
Assess the strengths and weaknesses of the methods you used in (a) and
their suitability for valuing ELW Co.
ANSWER
(a)
CA Sri Lanka
461
Assets based
Rs '000
7,200
1,500
(850)
7,850
Rs. 1.96
ELW Co
4
35
CT Co
10
362
36.2
20
18.1
The P/E for a similar quoted company is 18.1. This will take account of
factors such as marketability of shares, status of company, growth potential
that will differ from those for ELW Co. ELW Co's growth rate has been
estimated as higher than that of CT Co, possibly because it is a younger,
developing company, although the basis for the estimate may be
questionable.
All other things being equal, the P/E ratio for an unquoted company should
be taken as between one-half to two-thirds of that of an equivalent quoted
company. Being generous, in view of the possible higher growth prospects of
ELW Co, we might estimate an appropriate P/E ratio of around 12, assuming
that ELW Co is to remain a private company.
This will value ELW Co at 12 Rs. 0.35 = Rs. 4.20 per share, a total valuation
of Rs. 16.8m.
Dividend valuation model
The dividend valuation method gives the share price as
CA Sri Lanka
Rs. 0.218
= Rs. 5.45
0.13 0.09
CA Sri Lanka
463
CA Sri Lanka
(a) assumes constant growth rates and constant required rates of return in
perpetuity.
Determination of an appropriate cost of equity is particularly difficult for
an unquoted company, and the use of an 'equivalent' quoted company's data
carries the same drawbacks as discussed above. Similar problems arise in
estimating future growth rates, and the results from the model are highly
sensitive to changes in both these inputs.
It is also highly dependent on the current year's dividend being a
representative base from which to start.
The dividend valuation model valuation provided in (a) results in a higher
valuation than that under the P/E ratio approach. Reasons for this may be:
(a)
(b)
(c)
The cost of equity used in the dividend valuation model was that of CT
Co. The validity of this will largely depend on the relative levels of risk
of the two companies. Although they both operate the same type of
business, the fact that CT Co sells its material externally means it is
perhaps less reliant on a fixed customer base.
(d)
6 Valuation issues
In this section we look at the impact of market efficiency and change in capital
structure on business valuations. We also look at how to value unlisted
companies using geared and ungeared betas. We have looked at all of these issues
but now we relate them to business valuations.
CA Sri Lanka
465
466
CA Sri Lanka
Equity
Debt
Constant
annual
payments
to investors
Rs Mn
27
3
30
dividends
interest
Market
value
Rs Mn
150
30
180
d0
= 27 = 18%
150
P0
Rs. 30m
= Rs. 181.16m
0.1656
CA Sri Lanka
Rs. 30m
= Rs. 178.57m
0.168
467
Method (1), with the lower increase in gearing, had a small associated increase in
the cost of equity, and the WACC went down the impact of more cheaper debt
outweighed the effect of the increased cost of equity. This led to a rise in the total
MV.
Under Method (2), with the percentage of total capital represented by debt more
than doubling, there was a much higher increase in the cost of equity,
accompanied by an increase in the cost of debt. Despite the much higher
proportion of cheap debt, the WACC went up, and the total MV fell.
QUESTION
AB has a WACC of 16%. It is financed partly by equity (cost 18%) and partly by
debt capital (cost 10%). The company is considering a new project which would
cost Rs. 5,000 million and would yield annual profits of Rs. 850 million before
interest charges. It would be financed by a loan at 10%. As a consequence of the
higher gearing, the cost of equity would rise to 20%. The company pays out all
profits as dividends, which are currently Rs. 2,250 million a year.
Required
(a)
(b)
Analyse the increase or decrease in equity value into two causes, the NPV of
the project at the current WACC and the effect of the method of financing.
Ignore taxation. The traditional view of WACC and gearing is assumed in this
exercise.
ANSWER
(a)
Current profits and dividends
Increase in profits and dividends
(Rs. 850,000 less extra interest 10% Rs. 5,000,000)
New dividends, if project is undertaken
New cost of equity
New MV of equity
Current MV of equity
(Rs. 2,250,000 0.18)
Increase in shareholder wealth from project
468
Rs Mn
2,250
350
2,600
20%
Rs Mn
13,000
12,500
500
CA Sri Lanka
(b)
(i)
(ii)
CA Sri Lanka
469
Equity
Debt
(10m shares)
(Rs. 12m of 12% bonds)
NN Co
Rs Mn
36
14
50
(20m shares)
ZZ Co
Rs Mn
15
15
Rs. 35,200,000
= Rs. 3.52 per share
10,000,000
Since the current share price is Rs. 3.60 per share, MM would argue that the
shares in NN Co are currently overvalued by the market, by Rs. 800,000 in total or
8c per share. MM argues that this discrepancy would be rapidly removed by the
process of arbitrage until the equity value of NN Co was as predicted by their
model.
470
CA Sri Lanka
QUESTION
CD and YZ are identical in every respect except for their gearing. The market value
of each company is as follows.
CD
YZ
Rs Mn
Rs Mn
?
24
Equity (5m shares)
(8m shares)
10
Debt (Rs. 20m of 5% bonds)
?
24
Required
Calculate the value of CD's shares, according to MM theory, given a corporation
tax rate of 30%.
ANSWER
Value of CD in total Vg = Vu + TBc where
Vu
Find the equity beta of a similar listed company and strip out the effect
of gearing to create an ungeared beta.
u = g
Step 2
VE
VE + VD(1 t)
Regear the beta using the company's gearing using the formula:
g = u + (u d)
CA Sri Lanka
VD(1 t)
and calculate the ke geared.
VE
471
Step 3
Use this ke geared to calculate the value of the company using the
formula:
P0 =
d0(1 + g)
ke g
2
= 1.2
2
+
1
(1
0.3)
u = 1.62
(2 (1
g = 1.2 + 1.2
0.3))
= 1.54
5
472
CA Sri Lanka
Intangible assets from tangible assets, by the phrase 'do not have physical
substance'.
(b)
CA Sri Lanka
(a)
(b)
(c)
473
474
CA Sri Lanka
the market valuation, and book values are subject to accounting standards which
reflect historic cost and amortisation policies rather than true market values of
tangible non-current assets.
In addition, the accounting valuation does not attempt to value a company as a
whole, but rather as a sum of separate asset values computed under particular
accounting conventions. The market, on the other hand, values the entire company
as a going concern, following its defined strategy.
7.2.2 Tobin's 'q'
The Nobel prize-winning economist James Tobin developed the 'q' method
initially as a way of predicting investment behaviour.
'q' is the ratio of the market capitalisation of the firm (share price number of
shares) to the replacement cost of its assets.
If the replacement cost of assets is lower than the market capitalisation, q is
greater than unity and the company is enjoying higher than average returns on
its investment ('monopoly rents'). Technology and so-called 'human-capital'
assets are likely to lead to high q values.
Tobin's 'q' is affected by the same variables influencing market capitalisation as
the market-to-book method. In common with that method, it is used most
appropriately to make comparisons of the value of intangible assets of companies
within an industry which serve the same markets and have similar tangible noncurrent assets. As such, these methods could serve as performance benchmarks
by which to appraise management or corporate strategy.
7.2.3 Calculated intangible values
NCI Research has developed the method of calculated intangible value (CIV) for
calculating the fair market value of a firm's intangible assets. CIV calculates an
'excess return' on tangible assets. This figure is then used in determining the
proportion of return attributable to intangible assets.
A step-by-step approach would be as follows.
CA Sri Lanka
Step 1
Step 2
Step 3
475
Step 4
Subtract tax from the excess return to give the after-tax premium
attributable to intangible assets.
Step 5
(b)
The choice of discount rate to apply to the excess returns to value the
intangible asset needs to be made with care. To ensure comparability
between companies and industries, some sort of average cost of capital
should perhaps be applied. This again has the potential problems of
distortion.
The value obtainable from licensing out the right to exploit the intangible
asset to a third party
(b)
The royalties that the owner of the intangible asset is relieved from paying
through being the owner rather than the licensee
476
CA Sri Lanka
and unbranded products. The estimated premium profits can then be capitalised
by discounting at a risk-adjusted market rate.
7.3.3 Capitalisation of earnings method
With the capitalised earnings method, the maintainable earnings accruing to
the intangible asset are estimated. An earnings multiple is then applied to the
earnings, taking account of expected risks and rewards, including the prospects
for future earnings growth and the risks involved. This method of valuation is
often used to value publishing titles.
7.3.4 Comparison with market transactions method
This method looks at actual market transactions in similar intangible assets. A
multiple of revenue or earnings from the intangible asset might then be derived
from a similar market transaction.
A problem with this method is that many intangible assets are unique and it
may therefore be difficult to identify 'similar' market transactions, although this
might be done by examining acquisitions and disposals of businesses that include
similar intangible assets.
The method might be used alongside other valuation methods, to provide a
comparison.
CA Sri Lanka
477
CHAPTER ROUNDUP
478
We started by looking at the lowest valuation of a business. The asset basis can be
used to provide a minimum value which can be useful if a business is difficult to
sell.
The dividend valuation method involves the present value of the future
dividends. It will produce a mid-range valuation that is generally more relevant to
small shareholdings rather than the whole company.
The discounted cash flow method calculates the present value of the future cash
flows that will be generated by the new management.
CA Sri Lanka
PROGRESS TEST
Give four circumstances in which the shares of an unquoted company might need
to be valued.
Suggest two circumstances in which net assets might be used as a basis for
valuation of a company.
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479
Revenue in the year to 31 December 20X3 was Rs. 40,250,000 and earnings
(profit after tax) were Rs. 20,188,000. There are five million shares in issue
owned equally by the four directors. No dividends have been paid in any
year to date.
(b)
Net book value of buildings, equipment and vehicles plus net working capital
is Rs. 22,595,000. The book valuations are considered to reflect current
realisable values.
(c)
(b)
(c)
(d)
Assume that book depreciation equals tax depreciation and that profit after
tax equals cash flow.
(e)
The marginal rate of tax is expected to remain at 28% per annum, payable in
the year in which the liability arises.
(f)
Assume from 20X7 onwards that the 20X6 pre-discounted cash flow will
grow at 6% per annum indefinitely. This assumes that no new long-term
capital is raised. If the entity is to grow at a faster rate, then new financing
will be needed.
Industry statistics
The average P/E ratio for the industry, using a very broad definition, is 12 with a
range of 9 to 25. The average cost of capital for the industry is 12%. Cost of capital
figures by individual entity are not available.
Assume you are a financial adviser to SB:
480
10
11
CA Sri Lanka
12
Recommend a suitable valuation figure that could be used for a trade sale or an
IPO.
Use whatever methods of valuation you think appropriate and can be estimated
with the information available.
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481
(a)
(b)
(c)
(d)
The P/E ratio: the multiple of earnings at which a company's shares are traded
(a)
(b)
10
Asset valuation
Total net book value and current realisable value of assets = Rs. 22.6m
Value per share = Rs. 22.6m/5m = Rs. 4.52
P/E ratio valuation
Earnings are Rs. 20.2 million as given in the question.
P/E ratio
6*
9
12
25
Total value
Rs Mn
121.2
181.8
242.4
505.0
Value per
share
Rs
24.24
36.36
48.48
101.00
*This is the lowest P/E ratio in the range multiplied by 2/3 to reflect the unlisted
status of SB.
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CA Sri Lanka
Revenue
Operating costs @ 60%
Profit before tax
Tax @ 28%
Net cash flow
Annuity factor for year
20X7 onwards*
Discount factor @ 12%
Present value
Total value
Value per share
20X4
Rs Mn
52.25
(31.35)
20.90
(5.85)
15.05
0.893
13.44
315.84
Rs. 63.17
20X5
Rs Mn
62.70
(37.62)
25.08
(7.02)
18.06
0.797
14.39
20X6
Rs Mn
75.24
(45.14)
30.10
(8.43)
21.67
0.712
15.43
20X7
Rs Mn
79.75
(47.85)
31.90
(8.93)
22.97
16.667
382.84
0.712
272.58
Asset valuation
The asset valuation reflects current realisable values rather than out-of-date
book values, but it still undervalues the business. This method is most commonly
used to arrive at a break-up value for businesses with a significant amount of
non-current assets. However, it is less appropriate for service businesses, and
in particular for those in which the majority of the value is in the form of human
and/or intellectual capital. In the latter type of company, a net assets valuation can
be attempted if the intangibles are included as assets in the statement of financial
position. However, a significant part of the value of SB resides in its expertise, and
this is not reflected in the company's net asset value.
P/E ratio valuation
This method compares the earnings information of SB with that of other
entities of similar size and characteristics that operate in the same markets, to
arrive at an appropriate market price for the shares.
The problem here is deciding which P/E ratio to use, as there is a wide range of
possibilities.
The lowest value uses the bottom of the range and multiplies it by to reflect
the fact that SB is unquoted. If the shares were to be offered on the open market in
an IPO, it would be prudent to price them at a discount to reflect the fact that the
company would be a new entrant to the stock market, despite a 15-year trading
history. Pricing at a discount will also make the issue more attractive to investors
and thereby help to obtain a good take-up of shares.
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483
If SB were taken over by a competitor, the P/E ratio of that competitor could be
used under the assumption that the new entity would have the same growth
potential.
Historical data is being used which is not necessarily a good indicator of what
will happen in the future.
Cash flow valuation
This method uses the expected future cash flows and a suitable cost of capital
to discount them. It gives the highest valuation, as it is based on optimistic
forecasts.
There are a number of uncertainties surrounding the growth that has been
predicted for SB. For example, the concessions in the Caribbean have not yet been
finalised.
The cost of capital which has been used in the calculations is the average cost of
capital for the industry and this may not be appropriate for SB. The business
risk may be different, especially for growth into a new region. The method of
finance to be used may be different to the average entity in this industry, thus
changing the level of financial risk. It is likely that a higher cost of capital should
we used to reflect the extra risk of SB's business and this would lower the
valuation.
12
Recommendation
The recommended valuation figure is Rs. 300m or Rs. 60 per share. This is
approximately a 5% reduction on the cash flow valuation and reflects the higher
end of the range of P/E ratios for the industry. It allows for potential downside
from the risk associated with SB and potential upside from the growth expected.
It would be sufficiently attractive for investors in an IPO and also to competitors
wanting to take over SB.
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CHAPTER
INTRODUCTION
In this chapter, we are concerned with the issues of business combinations and restructuring
from the point of view of financial management and financial strategy.
Questions in this area are likely to involve some calculations, so you will need to bring in your
knowledge of company valuation. However, questions are unlikely to be purely numerical. Topics
you might be asked to discuss include why companies might choose to make an offer in a particular
form, takeover tactics, the effect on shareholders, the different types of consideration and what
happens after the takeover.
Knowledge Component
5
Corporate Growth Strategy
5.1
Corporate growth
strategies
5.1.1
5.2
Business valuation,
merger, acquisition and
divestment and other
corporate growth
strategies
5.2.4
5.2.5
5.2.6
485
CHAPTER CONTENTS
LEARNING
OUTCOME
5.1.1
5.2.6
3 Payment methods
5.2.4
5.2.5
5 Regulation of takeovers
5.2.6
6 Post-acquisition integration
5.2.5
5.2.5
8 Exit strategies
5.2.4
486
CA Sri Lanka
(b)
CA Sri Lanka
487
The main reasons why one company may wish to acquire the shares or the
business of another may be categorised as follows.
Operating
economies
Management
acquisition
Diversification
Asset backing
Quality of earnings
Finance and
liquidity
Growth
Tax factors
Defensive merger
Strategic
opportunities
Asset stripping
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CA Sri Lanka
Strategic opportunities
Where you are
1.4 Synergies
The following types of synergy may arise:
Operating for example economies of scale and eliminating inefficiency
Financial for example reduced risk through diversification, perhaps giving a
lower cost of capital
Other effects for example management talent or increased market power
The types of synergy that arise through a particular merger or takeover will
depend on the specific scenario. It is important to bear in mind that projected
synergies may not be realised in practice.
CA Sri Lanka
489
(b)
(c)
Alternatively, factors (a) and (b) above could be expressed in terms of:
What is the highest price that it would be worth paying to acquire the
business?
The value of a business could be assessed in terms of:
(i)
(ii)
(iii)
(iv)
Its earnings
Its assets
Its prospects for sales and earnings growth
How it would contribute to the strategy of the 'predator' company
(e)
(f)
(g)
(h)
Would there be any other potential problems arising from the proposed
takeover, such as future dividend policy and service contracts for key
personnel?
Note. In the exam you may be asked to value a company and then discuss the
strategic implications of the proposed acquisition.
490
CA Sri Lanka
(b)
If shareholders, and the stock market in general, think the takeover is not a
good one, the market value of the company's shares is likely to fall. The
company's directors have a responsibility to protect their shareholders'
interests, and are accountable to them at the annual general meeting of the
company.
(b)
(c)
It might reduce the net asset backing per share of the company, because
the target company will probably be bought at a price which is well in excess
of its net asset value.
491
(b)
The offer may be unacceptable because the terms are poor. Rejection of
the offer may lead to an improved bid.
(b)
(c)
(d)
The founder members of the business may oppose the bid, and appeal to
the loyalty of other shareholders.
When a company receives a takeover bid which the board of directors considers
unwelcome, the directors must act quickly to fight off the bid.
492
(a)
(b)
CA Sri Lanka
(c)
(d)
(e)
Making a counter-bid for the predator company (this can only be done if the
companies are of a reasonably similar size)
(f)
(g)
(h)
CASE STUDY
The Swiss pharmaceutical company Roche launched a hostile takeover bid for US
diagnostics company Illumina in early 2012. Illumina adopted defensive tactics
and announced that it would adopt a 'poison pill' to protect its shareholders. This
means that Illumina shareholders can buy new shares if any bidder acquires
15 per cent of the company's shares. This move protects the company by making
Illumina more expensive to acquire. As a result of defensive tactics, Roche let its
offer expire in April 2012.
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493
3 Payment methods
In this section we look at how an acquisition can be financed and discuss the
factors that will influence the choice of method of payment.
Big
Rs. 1,500m
100m
Rs. 2,000m
Small
Rs. 200m
10m
Rs. 40m
(b)
(c)
Expected earnings of Rs. 2,040m, minus the loss of interest (net of tax) which
would have been obtained from the investment of the Rs. 400m in cash
which was given up to acquire Small
How to obtain the cash is a gearing decision which has been covered in Part B of
this Study Text.
Note. You may be asked in the exam about the consequences of using different
finance sources to support a cash offer. Exam questions may ask you to evaluate
whether a cash bid or a paper bid is more appropriate.
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CA Sri Lanka
(b)
To raise cash on the stock market, which will then be used to buy the target
company's shares. To the target company shareholders, this is a cash bid.
Sometimes, a company might acquire another in a share exchange, but the shares
are then sold immediately on a stock market to raise cash for the seller.
Whatever the detailed arrangements of a takeover with paper, the end result will
be an increase in the issued share capital of the predator company.
3.3.1 Example: Purchase by share exchange (1)
ACL Co has agreed to acquire all the ordinary shares in M Co and has also agreed a
share-for-share exchange as the form of consideration. The following information
is available.
ACL Co
M Co
Rs Mn
Rs Mn
Operating profit
100
20
Net profit before taxation
80
14
Net profit after taxation
60
10
Share capital Rs. 0.50 ordinary shares
Rs. 20m
Rs. 5m
Price-earnings ratio
10
12
The agreed share price for M Co will result in its shareholders receiving a
premium of 25% on the current share price.
Required
Calculate the number of new shares ACL Co must issue to purchase the shares in
M Co.
Solution
Market value ACL Co (10 Rs. 60m) = Rs. 600m
Value per share (Rs. 600m/40m) = Rs. 15 per share
Market value M Co (12 Rs. 10m) = Rs. 120m
Value of bid (Rs. 120m 1.25) = Rs. 150m
Number of shares issued (Rs. 150m/Rs. 15) = 10 million shares
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495
=
=
6m 1/3 = 2 million
20m + 2m = 22 million
=
=
Rs. 2 million
Rs. 200m + 18m + 12m 2m
=
=
Share value
Cash
Value of 3,000 shares before take over (3,000 Rs. 3)
496
Rs
10,364
1,000
11,364
9,000
2,364
CA Sri Lanka
X plc
Rs. 4m
Rs. 2.75m
10m
12
Y plc
Rs. 3.5m
Rs. 2.4m
5m
10
X has made an offer to acquire all the share capital of Y. The offer price is 5 new
shares in X for every 3 shares in Y.
Required
Calculate the premium in % in the price offered to the shareholders of Y.
Solution
EPS, X = (Rs. 2.75 million/10 million shares) = Rs. 0.275
Share price, X = Rs. 0.275 12 = Rs. 3.30
EPS, Y = (Rs. 2.4 million/5 million shares) = Rs. 0.48
Share price, Y = Rs. 0.48 10 = Rs. 4.80
Offer = 5 shares in X, value 5 Rs. 3.30, Rs. 16.50, for 3 shares in Y
Current market value of 3 shares in Y = 3 Rs. 4.80 = Rs. 14.40
The premium in the offer price is therefore (Rs. 16.50 Rs. 14.40)/Rs. 14.40 =
14.6%
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497
Rs '000
1,000
300
700
200
60
140
560
498
Dilution of EPS
Cost to the
company
CA Sri Lanka
Control
Authorised share
capital increase
Borrowing limits
increase
Taxation
Income
CA Sri Lanka
(a)
(b)
Are unsecured (that is, 'junior' debt, low in the priority list for repayment in
the event of liquidation of the borrower)
499
(c)
Because they are unsecured, attract a much higher rate of interest than
secured debt (typically 4% or 5% above LIBOR)
(d)
Often, give the lender the option to exchange the loan for shares after the
takeover
(b)
(c)
The total of the initial and guaranteed deferred consideration amounts may be
based on an assets based approach to valuation, or on an earnings basis, using,
for example, the average level of expected profits over a given future period.
The additional amount of deferred consideration might be payable if the
acquired company's average profits or revenues over the next three years
exceed a certain amount.
This method would only be appropriate if the acquired company was to be run
independently of the buyer's company, at least for the period on which the
contingent consideration is based. If the acquired business were to be
immediately integrated within the buyer's, it would be difficult to identify
separately the relevant sales or profits.
Under these types of arrangement, then, the overall valuation of the business will
have a variable element. The buyer will need to estimate the minimum,
500
CA Sri Lanka
maximum and expected total amounts they may have to pay, with corresponding
probabilities relating to the likelihood of the business reaching the specified
targets. In particular, they will have to ensure that they could, if necessary, afford
to pay the maximum amount, regardless of how unlikely that is to arise.
Note. In the exam, you could well get a question where the cash vs shares decision
is finely balanced, and financing the cash offer may be the critical issue.
CA Sri Lanka
If the target company's shares are bought at a higher P/E ratio than the
predator company's shares, the predator company's shareholders will
suffer a fall in EPS.
501
(b)
If the target company's shares are valued at a lower P/E ratio, the
predator company's shareholders will benefit from a rise in EPS.
Annual earnings
Rs. 560,000
Rs. 50,000
EPS
20c
50c
P/E ratio
20
By offering two shares in Big Co worth Rs. 4 each for one share in Little Co, the
valuation placed on each Little Co share is Rs. 8, and with Little Co's EPS of 50c,
this implies that Little Co would be acquired on a P/E ratio of 16. This is lower
than the P/E ratio of Big Co, which is 20.
If the acquisition produces no synergy, and there is no growth in the earnings of
either Big Co or its new subsidiary Little Co, then the EPS of Big Co would still be
higher than before, because Little Co was bought on a lower P/E ratio. The
combined group's results would be as follows.
Big Co group
Number of shares (2,800,000 + 200,000)
3,000,000
Annual earnings (560,000 + 50,000)
610,000
EPS
20.33c
If the P/E ratio is still 20, the market value per share would be Rs. 4.07, which is 7c
more than the pre-takeover price.
The process of buying a company in order to boost your own P/E is known as
bootstrapping. Whether the stock market is fooled by this process is debatable.
The P/E ratio is likely to fall after the takeover in the absence of synergistic or
other gains.
4.2.2 Example: Mergers and takeovers (2)
RW Co agrees to acquire the shares of HHH Co in a share exchange arrangement.
The agreed P/E ratio for HHH Co's shares is 15.
RW Co
HHH Co
Number of shares
3,000,000
100,000
Market price per share
Rs. 2
Earnings
Rs. 600,000
Rs. 120,000
P/E ratio
10
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CA Sri Lanka
The EPS of HHH Co is Rs. 1.20, and so the agreed price per share will be Rs. 1.20
15 = Rs. 18. In a share exchange agreement, RW Co would have to issue nine new
shares (valued at Rs. 2 each) to acquire each share in HHH Co, and so a total of
900,000 new shares must be issued to complete the takeover.
After the takeover, the enlarged company would have 3,900,000 shares in issue
and, assuming no earnings growth, total earnings of Rs. 720,000. This would give
an EPS of:
Rs. 720,000
= 18.5c
3,900,900
The pre-takeover EPS of RW Co was 20c, and so the EPS would fall. This is because
HHH Co has been bought on a higher P/E ratio (15 compared with RW Co's 10).
ST Co
5,000,000
Rs. 6
BB Co
3,000,000
Rs. 4
Rs. 2,000,000
Rs. 2,200,000
40c
15
Rs. 600,000
Rs. 950,000
20c
20
CA Sri Lanka
ST Co group
7,000,000
EPS would have been
37.24c
EPS will be 45c
503
4.4 Further points to consider: net assets per share and the
quality of earnings
You might think that dilution of earnings must be avoided at all cost. However,
there are three cases where a dilution of earnings might be accepted on an
acquisition if there were other advantages to be gained.
(a)
(b)
(c)
A trading company with high earnings, but with few assets, may want to
increase its assets base by acquiring a company which is strong in assets but
weak in earnings so that assets and earnings get more into line with each
other. In this case, dilution in earnings is compensated for by an increase
in net asset backing.
504
Rs. 1,500,000
= 75c
2,000,000
Rs. 2,500,000
= Rs. 1.25
2,000,000
CA Sri Lanka
(b)
G Co's EPS figure is 40c (Rs. 400,000 1,000,000), and the company is being
bought on a multiple of 10 at Rs. 4 per share. As the takeover consideration
is being satisfied by shares, IT Co's earnings will be diluted because IT Co is
valuing G Co on a higher multiple of earnings than itself. IT Co will have to
issue 666,667 shares valued at Rs. 6 each (earnings of 75c per share at a
multiple of 8) to satisfy the Rs. 4,000,000 consideration. The results for IT Co
will be as follows.
EPS =
Rs. 1,900,000
= 71.25c (3.75c lower than the previous 75c)
2,666,667
APS =
Rs. 6,000,000
= Rs. 2.25 (Re. 1 higher than the previous Rs. 1.25)
2,666,667
If IT Co is still valued on the stock market on a P/E ratio of 8, the share price
should fall by approximately 30c (8 3.75c, the fall in EPS) but because the
asset backing has been increased substantially, the company will probably
now be valued on a higher P/E ratio than 8.
The shareholders in G Co would receive 666,667 shares in IT Co in exchange for
their current 1,000,000 shares; that is, two shares in IT Co for every three shares
currently held.
(a)
Earnings
Three shares in G Co earn (3 40c)
Two shares in IT Co will earn (2 71.25c)
Increase in earnings, per three shares held in G Co
(b)
Rs
1.200
1.425
0.225
Assets
Three shares in G Co have an asset backing of (3 Rs. 3.5)
Two shares in IT Co will have an asset backing of (2 Rs. 2.25)
Loss in asset backing, per three shares held in G Co
Rs
10.50
4.50
6.00
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505
QUESTION
Bid terms
506
CA Sri Lanka
MM Co
Rs Mn
117
45
162
6
156
50
106
156
The ordinary share capital of UVW Co consists of Rs. 0.50 shares and the ordinary
share capital of MM Co consists of Re. 1 shares. The board of directors of UVW Co
believes there is a strong synergy between the two businesses which will lead to
an increase in after-tax profits of Rs. 15m per year following acquisition.
Share prices for each company in recent years have been as follows.
Year ended 31 May
20X6
20X7
20X8
UVW Co
MM Co
Rs
3.50
2.40
Rs
4.80
3.20
Rs
6.90
3.40
20X9
(ie present)
Rs
9.30
2.90
A shareholder in MM Co has expressed concern over the bid. He points out that,
following acquisition, the annual dividends are likely to be lower, as UVW Co
normally pays small dividends. As the shareholder relies on dividend income to
cover his living expenses, he is concerned that he will be worse off following
acquisition of MM Co. He also believes that the price offered for the shares of MM
Co is too low.
CA Sri Lanka
507
Required
(a)
Calculate:
(i)
(ii)
(iii) The share price of UVW Co following the takeover, assuming the priceearnings ratio of the company is maintained and the synergy achieved
(b)
ANSWER
(a)
(i)
(ii)
Rs Mn
After-tax profits:
UVW Co
MM Co
Increase due to synergy
Earnings of combined group
127
28
15
170
300,000,000
16,666,667
316,666,667
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CA Sri Lanka
currently valued at (3 Rs. 2.90) Rs. 8.70. The offer price represents a
premium to the current market price of MM Co shares of just Rs. 0.60 per
Rs. 8.70 of shares, which is about 5%. This bid premium seems very low.
The current share price of UVW Co is Rs. 9.30, having risen from Rs. 6.90
last year. The possibility that the share price will remain at this level (a P/E
ratio of 22), or might even rise after the takeover, should be questioned. A
fall in the UVW Co share price of about 5% or more (to less than Rs. 8.70)
would mean that MM Co shareholders would suffer a loss by agreeing to the
takeover offer.
In contrast, the current EPS of MM Co is (Rs. 28 million/50 million shares)
56c and the P/E ratio is therefore just 5.2 (Rs. 2.90/56c). There is a very
large difference between the P/E ratios at which the two companies are
currently valued, adding weight to the concern that either UVW Co shares
are currently overvalued or MM Co shares are undervalued by the market.
On the other hand, MM Co shareholders might take the view that shares in
UVW Co are likely to rise still further in value after the takeover. Accepting
the offer from UVW Co would therefore enable them to make a further
capital gain after the takeover has occurred.
MM Co shareholders might want to invest in a company with a high
dividend payout policy, and so would not want to hold on to their UVW Co
shares after a takeover. If so, they should sell their UVW Co shares and invest
in a different company. Concerns about dividend policy should not affect the
response of MM Co shareholders to the takeover offer.
QUESTION
Post-merger valuation
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509
TK Co
Rs Mn
28.6
8.2
36.8
3.1
33.7
12.0
21.7
33.7
14
DEF Co has offered the shareholders of TK Co four shares in DEF Co for every
three shares held. After-tax savings in overheads of Rs. 1.5m per annum are
expected from the acquisition of TK Co.
Required
(a)
Calculate:
(i)
(ii)
The earnings per share for DEF Co following the successful takeover of
TK Co
(iii) The share price of DEF Co following the takeover, assuming that the
price-earnings ratio is maintained and the savings achieved
(b)
DEF Co
TK Co
510
CA Sri Lanka
ANSWER
(a)
Workings
DEF Co current EPS =
Total earnings
Rs. 4.2 million
=
= 10.5c
Number of shares
40 million
P/E ratio = 18
Current market price of DEF Co shares = 18 10.5c = 189c.
TK Co current EPS =
P/E ratio = 14
Current price of TK Co shares = 14 25c = 350c.
(i)
(ii)
Rs Mn
4.2
3.0
1.5
8.7
56m
EPS following the takeover: Rs. 8.7 million/56 million = Rs. 0.155, ie
15.5c.
(iii) Share price of DEF Co after the takeover, assuming a P/E ratio of 18:
15.5c 18 = Rs. 2.79
(b)
CA Sri Lanka
Rs
5,670
8,370
2,700
511
Rs
10,500
11,160
660
The takeover would increase the total value of the equity shares of the
companies, on the assumption that a P/E ratio of 18 can be maintained.
There are two reasons for this increase in value.
(i)
(ii)
There will be savings of Rs. 1.5 million, adding ( 18) Rs. 27 million to
equity values.
Under the terms of the current bid, DEF Co shareholders would enjoy an
increase in the value of their investment by (Rs. 2,700/Rs. 5,670) almost
50%. TK Co shareholders would also expect some increase in the value of
their investment but only by (Rs. 660/Rs. 10,500) about 6%. Most of the
increase in the equity valuation arising from the acquisition would therefore
be enjoyed by the DEF Co shareholders.
The estimated increase in the equity valuation is dependent on the
assumption of savings of Rs. 1.5 million and the assumption that a P/E ratio
of 18 will be maintained. If these assumptions turn out to be overoptimistic, the value of DEF Co shares after the takeover will be lower than
Rs. 2.79, and there would be a serious risk that the value of the investment of
TK Co shareholders would fall as a result of the takeover.
The offer from DEF Co is therefore too low, and the directors of TK Co would
recommend rejection of the bid on these grounds.
5 Regulation of takeovers
During an acquisition a company must be careful to comply with regulations and
legislation. This section looks at the types of regulation to be aware of.
CA Sri Lanka
seeks to ensure equal treatment of all shareholders of the same class in the
company sought to be taken over. The rules of the Code are aimed at ensuring
dissemination of sufficient information and advice with adequate time to the
shareholders of the target company in order for them to arrive at an informed
decision relating to the takeover.
The SEC ensures that persons adhere to the provisions of the Takeovers and
Mergers Code in respect of the acquisition of listed companies. Approvals are
granted to market announcements, offer documents and independent valuation
reports in the takeover process of public listed companies in terms of the
Takeovers and Mergers Code.
The Code deals with three types of offers, namely voluntary offers, partial offers
and mandatory offers.
5.1.1 The Code: general principles
The Code stipulates detailed rules which must be observed by persons involved in
a merger or takeover transaction. Detailed knowledge is not required for the
exam. The general principles include the following.
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(a)
(b)
(c)
(d)
(e)
(f)
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6 Post-acquisition integration
Many takeovers fail to achieve their full potential because of lack of attention paid
to what happens after the takeover. In this section we look at what problems
occur and how they can be addressed.
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Rule 2
The acquiring company must ensure it can Add value to the target
(that is, ensure targets are set, communicated to customers and
synergies are realised).
Rule 3
Rule 4
Rule 5
Step 2
Step 3
Resource audit
Both physical and human assets are examined in order to get a clear
picture. This includes examining the roles of each of the main
stakeholders (staff, customers and suppliers) and evaluating the
products sold.
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Step 4
Step 5
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(a)
(b)
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beneficial for the merger of companies with very different products, markets
and cultures.
In the circumstances of a complete absorption, the two companies will become
one, and thus a common operational system must be developed. The acquiring
company's management should not impose immediately their own systems on the
target company's operations, assuming them to be superior. This is likely to
alienate acquired employees.
It is probably best to use the system already in place, in the acquired company,
initially supplemented by requests for additional reports felt to be immediately
necessary for adequate information and control flows between the two
management bodies. As the integration process proceeds, the best aspects of each
of the companies' systems will be identified and a common system developed.
Where the two companies are to operate independently, it is likely that some
changes will be needed to financial control procedures to get the two group
companies in line. Essentially, however, the target company's management may
continue with their own cultures, operations and systems.
Note. Any discussion of post-merger value enhancing strategies must involve
more than just a list of bullet points and must be relevant to the entities involved.
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(a)
(b)
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(b)
(c)
(d)
(e)
Other employees
Commonly, the economy of scale cost savings anticipated in a merger will be
largely achieved by the loss of jobs, as duplicated service operations are
eliminated and loss-making divisions closed down. However, in some
instances, the increased competitive strength of the newly enlarged
enterprise can led to expansion of operations and the need for an increased
workforce.
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(f)
Financial institutions
These are perhaps the outright winners. The more complex the deal, the
longer the battle, and the more legal and financial problems encountered, the
greater their fee income, regardless of the end result.
8 Exit strategies
An exit strategy is a way to terminate ownership of a company or the operation of
part of the company. You need to be able to discuss the types of exit strategy that
are available and their implications.
8.1 Divestment
A divestment is disposal of part of its activities by an entity.
Mergers and takeovers are not inevitably good strategy for a business. In some
circumstances, strategies of internal growth, no growth or even some form of
divestment might be preferable.
Businesses must though have regard for the impact on:
The performance of the company
Workforce morale and performance
Stock market reaction the market dislikes uncertainty so must be given as
much information as soon as possible
8.2 Demergers
A demerger is the opposite of a merger. It is the splitting up of a corporate body
into two or more separate and independent bodies. For example, the ABC
Group might demerge by splitting into two independently operating companies
AB and C. Existing shareholders are given a stake in each of the new separate
companies.
Demerging, in its strictest sense, stops short of selling out, but is an attempt to
ensure that share prices reflect the true value of the underlying operations. In
large diversified conglomerates, so many different businesses are combined into
one organisation that it becomes difficult for analysts to understand them fully.
In addition, a management running ten businesses instead of two could be seen to
lose some focus.
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Economies of scale may be lost, where the demerged parts of the business
had operations in common to which economies of scale applied.
(b)
The smaller companies which result from the demerger will have lower
revenue, profits and status than the group before the demerger.
(c)
(d)
The ability to raise extra finance, especially debt finance, to support new
investments and expansion may be reduced.
(e)
8.3 Sell-offs
A sell-off is a form of divestment involving the sale of part of a company to a
third party, usually another company. Generally, cash will be received in exchange.
A company may carry out a sell-off for one of the following reasons.
(a)
(b)
It wishes to sell off a part of its business which makes losses, and so to
improve the company's future reported consolidated profit performance.
This may be in the form of a management buyout (MBO) see below.
(c)
In order to protect the rest of the business from takeover, it may choose
to sell a part of the business which is particularly attractive to a buyer.
(d)
(e)
A subsidiary with high risk in its operating cash flows could be sold, so as to
reduce the business risk of the group as a whole.
(f)
A sell-off may however disrupt the rest of the organisation, especially if key
players within the organisation disappear as a result.
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8.4 Liquidations
The extreme form of a sell-off is where the entire business is sold off in a
liquidation. In a voluntary dissolution, the shareholders might decide to close the
whole business, sell off all the assets and distribute net funds raised to
shareholders.
8.5 Spin-offs
In a spin-off, a new company is created whose shares are owned by the
shareholders of the original company which is making the distribution of assets.
There is no change in the ownership of assets, as the shareholders own the same
proportion of shares in the new company as they did in the old company. Assets of
the part of the business to be separated off are transferred into the new company,
which will usually have different management from the old company. In more
complex cases, a spin-off may involve the original company being split into a
number of separate companies.
For a number of possible reasons such as those set out below, a spin-off appears
generally to meet with favour from stock market investors.
(a)
The change may make a merger or takeover of some part of the business
easier in the future, or may protect parts of the business from predators.
(b)
(c)
It may be easier to see the value of the separated parts of the business
now that they are no longer hidden within a conglomerate.
(d)
(e)
CASE STUDY
In April 2012 Chesapeake Energy, the second largest US natural gas producer,
filed details of its plan to spin off its oilfield services division via an IPO with an
estimated value of USD 862.5m. This is part of a plan to bolster Chesapeake's
finances and to reduce its debt levels.
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(b)
(c)
(d)
(e)
CASE STUDY
The San Francisco Business Times reported that several companies were
considering going private, particularly young companies with shares under
pressure in public markets. Tighter scrutiny of public company finances, together
with new federal disclosure laws, had added to the cost of financing through
public equity markets. Going private would allow greater flexibility to restructure
operations, and a potential increase in value for those companies whose cash at
bank or non-current assets were worth far more than the depressed stock market
value.
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(a)
(b)
To the group, the buyout would be a method of divestment, selling off the
subsidiary as a going concern.
(b)
(c)
(d)
The subsidiary may be part of a group that has just been taken over and
the new parent company may wish to sell off parts of the group that it has
just acquired.
(e)
The best offer price might come from a small management group wanting
to arrange a buyout.
(f)
When a group has taken the decision to sell a subsidiary, it will probably get
better co-operation from the management and employees of the subsidiary
if the sale is a management buyout.
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(a)
(b)
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(c)
Financial backers of the buyout team, who will usually want an equity stake
in the bought-out business, because of the venture capital risk they are
taking. Often, several financial backers provide the venture capital for a
single buyout.
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However, many management buyouts, once they occur, begin with some
redundancies to cut running costs.
An institutional investor (such as a venture capitalist) should evaluate a buyout
before deciding whether or not to finance. Aspects of any buyout that ought to be
checked are as follows.
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(a)
Does the management team have the full range of management skills that
are needed (for example, a technical expert and a finance director)? Does it
have the right blend of experience? Does it have the commitment?
(b)
Why is the company for sale? The possible reasons for buyouts have
already been listed. If the reason is that the parent company wants to get rid
of a loss-making subsidiary, what evidence is there to suggest that the
company can be made profitable after a buyout?
(c)
What are the projected profits and cash flows of the business? The
prospective returns must justify the risks involved.
(d)
What is being bought? The buyout team might be buying the shares of the
company, or only selected assets of the company. Are the assets that are
being acquired sufficient for the task? Will more assets have to be bought?
When will the existing assets need replacing? How much extra finance would
be needed for these asset purchases? Can the company be operated
profitably?
(e)
(f)
(g)
What are the exit routes and when might they be taken?
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(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
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CHAPTER ROUNDUP
In this chapter we explained what is meant by the terms mergers, takeovers and
acquisitions and the reasons why they happen.
We also looked at what can happen when a takeover is announced. The target
company may resist the takeover, and we discuss possible defensive tactics.
We examined how an acquisition can be financed and discussed the factors that
will influence the choice of method of payment.
Many takeovers fail to achieve their full potential because of lack of attention paid
to what happens after the takeover. We looked at what problems occur and how
they can be addressed.
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PROGRESS TEST
A smaller company takes over a larger one, so that the smaller company must
increase its voting equity by over 100% to complete the takeover. What is this
process called?
What is the name of the arrangement where part of the purchase consideration is
only paid when the target company reaches certain performance targets?
If the target company's shares are valued at a lower P/E ratio, the predator
company's shareholders will suffer a fall in EPS.
True
False
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MMM has 30 million shares in issue and a current share price of Rs. 6.90 before
any public announcement of the planned takeover. MMM is forecasting growth in
earnings of 6% a year for the foreseeable future.
JJJ has 5 million shares in issue and a current share price of Rs. 12.84. It is
forecasting growth in earnings of 9% a year for the foreseeable future.
The directors of MMM are considering two alternative bid offers:
Bid offer A share based bid of 2 MMM shares for each JJJ share.
Bid offer B cash offer of Rs. 13.50 per JJJ share.
10
Assuming synergistic benefits are realised, evaluate bid offer A and bid offer B
from the viewpoint of MMM's existing shareholders.
11
Evaluate bid offer A and bid offer B from the viewpoint of JJJ's shareholders, again
assuming synergistic benefits are realised.
12
Advise the directors of MMM on the potential impact on the shareholders of both
MMM and JJJ of not successfully realising the potential synergistic benefits after
the takeover.
13
Advise the directors of MMM on the steps that could be taken to minimise the risk
of failing to realise the potential synergistic benefits arising from the adoption of
JJJ's information technology and information system.
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A takeover
An anti-takeover device
A reverse takeover
An earn-out arrangement
(1)
(2)
(3)
(4)
Acquiring company should provide top management with relevant skills for
managing the acquired company within one year
(5)
False. The predator company's shareholders will benefit from a rise in earnings
per share.
(a)
(b)
(c)
(d)
(a)
(b)
(c)
(d)
10 & 11
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MMM
JJJ
Total
Before offer
Total value (Rs Mn)
207.0
64.2
271.2
The above figures show that if the synergistic benefits are not realised, then only
JJJ's shareholders will benefit from the takeover, regardless of the type of bid.
They will still receive an immediate gain of Rs. 3.3m if the cash offer is accepted
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which has no risk attached. The theoretical gain of Rs. 3.6m from the share offer
will depend on whether the market reacts positively to the takeover (in the form
of a higher share price for MMM). It is also subject to the risk of having a
shareholding in a company that has lower growth prospects than JJJ.
MMM's shareholders will not benefit from the takeover if the synergistic benefits
are not realised. They will lose Rs. 3.6m from the share offer and Rs. 3.3m from
the cash offer. The bid will only be attractive to MMM's shareholders if the
additional benefits from JJJ's IT and IS systems are realised or if MMM experiences
higher than expected growth through the combined business.
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CHAPTER
INTRODUCTION
Not all businesses achieve their goals successfully, and it is important that managers can identify
situations where there is a risk of corporate failure so that they can take action to try to prevent
that failure from happening.
The chapter discusses measures that you should apply to assess whether a business is
underperforming and then provides an assessment of these measures or models for their
usefulness. The third section of the chapter covers the identification and discussion of
performance improvement strategies that can be marshalled to prevent corporate failure.
In the next section, we look at how products have life cycles. This means companies need to
identify stages and plan their product mix so that products are growing in revenue at the same
time as others are declining.
Then we look at how performance management systems may need to be amended to support the
changes and initiatives which are required to improve an organisation's performance.
Finally, in this chapter we discuss financial restructuring in companies. Financial restructuring
and other means of corporate re-shaping can take place when companies are in difficulties or
seeking to change their focus.
Knowledge Component
5
Corporate Growth Strategy
5.2
Business valuation,
merger, acquisition and
divestment and other
corporate growth
strategies
5.2.7
5.2.8
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CHAPTER CONTENTS
LEARNING
OUTCOME
5.2.7
5.2.7
5.2.8
5.2.7
5.2.8
6 Reconstruction schemes
5.2.8
7 Financial reconstructions
5.2.8
5.2.8
5.2.8
(b)
How do corporations 'go bad' and what can be done to turn them round?
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more generally. However, not all companies follow the conventional life cycle
pattern, since companies can be revitalised or transformed at any time.
So, instead of simply looking at decline in the terms of life cycle overall, it will be
useful to look for more specific reasons. The reasons for declining demand might
include:
Technological advances leading to the growth of substitute products, often of
lower cost and higher quality
Rising costs of inputs of complementary products
Regulatory changes or changes in legislation
Shrinking customer groups (caused, for example, by demographic changes)
Changes in lifestyle, buyers' needs, tastes or trends
Customers are in financial difficulty (for example, due to economic hardship
in a recession)
In her article Strategies for Declining Industries, Kathryn Harrigan (a student of
Michael Porter) suggested that there are two types of industrial decline:
(a)
(b)
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(a)
In endgame conditions, firms which had not competed with each other were
drawn into price wars.
(b)
The characteristics of declining industries differ (eg some have high exit
barriers, some are concentrated, others are fragmented), so different
strategies are appropriate.
(c)
(d)
Forecasting techniques can help firms identify the type of competitor that
will leave the industry and the types most likely to remain.
(e)
(f)
Unless a company has the lowest costs, a strong distribution system relative
to competitors, or a loyal niche of customers, it might be worth selling the
business to a competitor who can make better use of it.
(h)
These are all observable externally. Internally, however, there may be a severe
crisis, whose severity for the long term depends on the behaviour of managers.
Slatter identified four stages in the crisis.
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(a)
(b)
Inaction or hidden crisis. When the signs of crisis appear, managers explain
them away, or say that there is nothing they can do.
(c)
Faulty action or disintegration. Managers decide that things are amiss and
act to do something about them too little, usually. Moreover, management
becomes more autocratic, reducing alternative sources of information.
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(d)
Crisis and collapse (or dissolution). Slatter says that, in the end, action is
impossible. An expectation of failure increases, the most able managers
leave, and there are power struggles.
A more recent survey by Marius Pretorius (2008) also reviewed the evidence on
business failure, and classified the causes of business failure into four main
categories. These are similar to Slatter's symptoms.
(a)
(b)
Internal and external causes. Firms often fail due to internal causes rather
than external ones. Internal factors can include human resources issues
such as a lack of appropriate management action and discipline, but internal
factors may also include high operating expenses, a lack of cash control, a
lack of capital, or an inappropriate marketing strategy. External factors
exist in the firm's operating environment.
(c)
(d)
Financial causes. Pretorius suggests weak cash flow is not a cause of failure
but suggests it arises from business-related causes. Working capital may
suffer if customers fail to pay on time or inventories lie unsold.
CASE STUDY
An example of corporate failure comes from the demise of Lehman Brothers in the
US in late 2008. The following excerpt is from The Times, September 16 2008.
'An aggressive chief executive and ineffective board have brought a bank to
bankruptcy; but the crisis reveals wider weaknesses in the financial system.' The
article goes on to describe Dick Fuld, the chief executive of Lehman Brothers as
'imperious', not good at 'straight-listening' and 'deluded' about the ability of the
bank to cope with the financial crisis that arose in late 2007 in the US. The
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Lehman's board are described in the article as 'compliant' and having 'wholly
unrealistic expectations of the genuine value of the bank'.
The article goes on to analyse the collapse of the bank looking at its business
model and what was going on in its competitive environment at the time.
Lehman's business model relied on property prices rising, as it held assets of
around $40 billion in US real estate. These are the same type of mortgage-backed
securities that had undermined Bear Stearns earlier. Even after the onset of the
credit crisis, the bank invested more rather than withdrawing from this market.
The article remarks 'Lehman did this in the hope of emulating the profitability of
the big players in investment banking: Goldman Sachs, Morgan Stanley and Merrill
Lynch'.
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(a)
(b)
(c)
(d)
(e)
(f)
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(b)
(c)
(d)
The interplay of these factors leads to decline, usually along one of four
trajectories.
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(a)
(b)
Builders become imperialists. Acquisitive, growth-driven companies overexpand into areas they cannot manage properly.
(c)
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(d)
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only 15% of companies have characteristics which are more indicative of failed
companies than the company under review. The lower the H score, the weaker the
company's financial health can be judged to be.
Overall, these quantitative techniques have proved 'generally impressive' in
predicting failure, but they must be tailored to the sample under consideration.
Whether additional funds could be lent to the company with reasonable safety
Whether the company would fail without additional funds
1.7 Z-scores
Business failure can be predicted by Z-scores, using a number of financial
variables, or by a model such as Argenti's model, which emphasises defects,
mistakes and symptoms. These two models show how quantitative and
qualitative measures of performance can both be used to predict business failure.
In the late 1960s, Edward Altman researched the extent to which analysis of
different financial ratios could be used to predict business failure and
bankruptcy.
Altman analysed 22 accounting and non-accounting variables in relation to a
selection of failed and non-failed firms in the US. From this analysis, he identified
five key indicators of the likely failure or non-failure of businesses:
(a)
(b)
(c)
(d)
(e)
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Liquidity
Profitability
Activity/efficiency
Leverage
Solvency
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These five indicators were then used to derive a Z-score. The Z-score represents a
combination of different ratios, weighted by coefficients (derived from Altman's
analysis of firms which had declared bankruptcy compared to firms in similar
industries and of a similar size which had survived).
The Z-score is calculated as follows.
FORMULA TO LEARN
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
Where:
X1 = working capital/total assets (to measure liquidity)
X2 = retained earnings/total assets (to measure cumulative profitability)
X3 = earnings before interest and tax/total assets (to measure activity/efficiency,
by looking at the productivity of assets
X4 = market value of equity/book value of total debt (a form of gearing ratio, to
measure leverage)
X5 = sales/total assets (to measure solvency, by looking at revenue-generating
capacity)
The Z-score model suggests that firms with a Z-score of 3.0 or more are likely to
be financially sound and relatively safe, so they should be expected to survive,
based on the financial data.
(However, there is still a danger that mismanagement, fraud, a major economic
downturn, or other unexpected factors could cause an organisation's performance
to decline, and could lead to it failing.)
At the other end of the scale, the Z-score model suggests that firms with a Z-score
of 1.8 or less are likely to fail and are headed for bankruptcy. It is very rare for a
firm with financial conditions generating a score below 1.8 to recover. The lower a
firm's score, the greater likelihood there is of it going bankrupt.
Obviously, however, these scoring predictions leave a 'grey area' between 1.8 and
3.0 where the eventual failure or non-failure of an organisation could not be
predicted with certainty. Further investigation is likely to be required to assess
whether the firm is financially sound or in danger of failing.
For firms whose Z-scores are between 2.7 and 3.0, it is probably safe to predict
survival, even though they are in the grey area and so fall below the threshold of
relative safety (ie 3.0).
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However, firms whose Z-scores fall within the range 1.8-2.7 are at risk of going
bankrupt unless dramatic action is taken to ensure their survival. But, if the
necessary action is taken, there is a chance that these firms will survive.
Mistakes
Symptoms
Deteriorating ratios
Creative accounting signs of window-dressing
Declining morale and declining quality
The model uses a management-scoring approach that explicitly seeks to rate the
risks of poor management causing corporate failure. The model takes the
qualitative problems associated with management and assigns a score for each
problem area. These scores are judgemental, but aim to provide a means of
comparing the situation with the possible worse-case scenario.
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Source of
problem
Observed variable
Group A
Management defects
Group B
Group C
Score
8
4
2
2
2
1
Accounting defects
Management mistakes
High leverage
Symptoms of trouble
Creative accounting
3
3
3
15
= 43
15
15
15
= 45
4
4
4
= 12
The maximum score allotted is 100 (being 43 from Group A, 45 from Group B and
12 from Group C).
The criteria require that, for a firm to be cleared as healthy, it meets certain
standards.
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Category of score
Group A
Group B
Group C
Total score
Maximum permitted
10
15
0
25
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(b)
(c)
(d)
(e)
(f)
1.9.2 Information in the chairman's report, the directors' report and the
audit report
The report of the chairman or chief executive that accompanies the published
accounts might be very revealing. Although this report is not audited, and will no
doubt try to paint a rosy picture of the company's affairs, any difficulties the
company has had and not yet overcome will probably be discussed in it. There
might also be warnings of problems to come in the future. The audit report itself
may indicate difficulties.
1.9.3 Information in the press
Newspapers and financial journals are a source of information about companies,
and the difficulties or successes they are having and the markets in which they
operate. There may be reports of strikes, redundancies and closures.
1.9.4 Credit ratings
Ratings from specialist agencies or banks may be useful.
1.9.5 Published information about environmental or external matters
There will also be published information about matters that will have a direct
influence on a company's future, although the connection may not be obvious.
Examples of external matters that may affect a company adversely are:
(a)
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(b)
(c)
(d)
(e)
Significant events can take place between the end of the financial year and
the publication of the accounts.
(b)
(c)
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The financial ratios of firms which fail can be seen in retrospect to have
deteriorated significantly prior to failure, and to be worse than the ratios
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No fully accepted model for predicting future business failures has yet been
established, although some form of Z-score analysis would appear to be the
most promising avenue for progress. In the UK, several Z-score type failure
prediction models exist.
(c)
(d)
(e)
(f)
(g)
Nonetheless, Z-score models are used widely by banks and financial institutions
for assessing the credit risk of companies who are seeking funding. The models
are also used by accountancy firms, management consultants, and by companies
wanting to acquire other companies. (The companies looking to make the
acquisition use the models to assess the financial health of their target
companies.)
Importantly, though, while a Z-score can indicate the likelihood of financial
distress, and possible corporate failure, it does not provide any suggestions or
solutions as to how a firm could try to overcome its financial distress.
Moreover, Altman found that while the Z-score model proved an accurate
forecaster of failure up to two years prior to distress, its accuracy diminished
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substantially as the lead time increased beyond that. Therefore, in 1977 Altman
and two colleagues (Haldeman and Narayanan) developed the Z-score model
further into the ZETA score model, which demonstrated higher accuracy over a
longer period of time (up to five years prior to distress).
The ZETA score model included the five original variables of the Z-score model,
but also added 'stability of earnings' and 'size' (measured by a firm's total assets)
to them.
2.2.1 Other quantitative models
While Altman's Z-score model, and the later ZETA score model, are important
quantitative models to help predict business failure, they are by no means the only
such models which have been developed. In fact, there have been a large number
of quantitative models developed.
We noted a few of these in Section 1.4 earlier, but an additional type of model to
be aware of is that which looks specifically at the probability of a company failing.
These models again look at different performance indicators, but instead of
producing a 'score', they calculate a probability of failure.
(b)
The best predictor of failure (sometimes called Beaver's ratio) is the ratio of
cash flow from operations to total debt (operating cash flow/total debt),
where total debt includes both long-term and short-term debt.
This ratio indicates the length of time it will take an organisation to repay its
debt, assuming all the cash flow from operations is devoted to repaying the
debt. The lower the ratio, the less ability an organisation has to service the
principal (debt) and the related interest payments. Consequently, the lower
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the ratio, the more likely it is that problems will arise for the organisation in
the future.
All the organisations in Beaver's study with a ratio below 0.2 subsequently
failed within five years, while all the organisations he studied which had a
ratio above 0.4 did not fail in the next five years.
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embarked on once the new executive knows how the firm really works,
including its informal organisation).
(b)
(c)
(d)
Poor marketing. The marketing mix can be redeployed. Slatter believes that
the sales force of a crisis-ridden firm is likely to be particularly demotivated.
(e)
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(f)
(g)
Financial policy. Firms might suffer because of high gearing. Arguably many
of the firms subject to management buyouts financed by interest-bearing
loans are acutely vulnerable. Converting debt to equity and selling assets are
ways of dealing with this.
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CASE STUDY
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Mr Elop maintained that Nokia had some brilliant sources of innovation, but they
are simply not bringing them to market fast enough, and are not collaborating
internally.
Source based on: Nokia in crisis says CEO Stephen Elop. The Telegraph,
9 February 2011. www.telegraph.co.uk
Companies that recovered did so largely because of the way in which the recovery
strategy was implemented.
(a)
(b)
(c)
Turning a company around requires an able top management, with the right mix
of skills and experience, to stand outside of the culture of the organisation.
Substantial changes at the top may be needed, and one of the most important
symbols of a new order is the change of personnel. The development of an
effective top management team depends on three things.
(a)
What resources does the team have to work with, in the context of the
industry and of the firm?
(b)
What is the ideal management team, given the nature of the crises facing
the organisation? For example, a firm with poor financial controls may
require a team with a financial or systems bias, whereas a firm whose
problem was lacklustre products may need a team with a marketing bias.
(c)
Against this ideal team, how does the current team shape up? New
expertise may need to be imported, or a plan may be needed to enhance the
capability of the existing team.
(b)
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(a)
(b)
The chief executive officer has direct responsibility for the operations of the
company.
(b)
(c)
(d)
The chief executive manages the executive team such as the heads of
department.
(b)
Poor financial planning. Starting out with too little capital or money, failing
to control cash flow effectively, failing to balance liquidity and profitability,
and failing to take financial responsibility.
(c)
(d)
Poor management. Leaders not recognising their own failings and not
seeking any help or advice (or ignoring help and advice they are given);
having insufficient relevant business experience, delegating poorly, and
hiring the wrong people.
(Note the link here back to Argenti's A score model, which highlighted
'Management defects' as one of its key headings.)
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The product life cycle is the period, which begins with the initial product
specification, and ends with the withdrawal from the market of both the product
and its support. It is characterised by defined stages including introduction,
growth, maturity, decline and senility.
Figure 17.1
Sales and
profits
Sales
Introduction
Growth
Maturity
Decline
Senility
Time
Profit
4.1.1 Introduction
(a)
(b)
The product for the time being is a loss-maker, and has negative cash flows.
(c)
The product is high risk because it is new and has not yet been accepted by
the market.
(d)
The product has few, if any, competitors (because they are not willing to take
similar risks).
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If the new product gains market acceptance, sales will eventually rise more
sharply and the product will start to make profits.
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(b)
(c)
Competitors are attracted with similar products, but as sales and production
rise, unit costs fall (eg due to economies of scale).
(d)
(e)
(f)
4.1.3 Maturity
The rate of sales growth slows down and the product reaches a period of maturity,
which is probably the longest period of a successful product's life. Most products
on the market will be at the mature stage of their life. Profits are good.
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(a)
Total sales growth in the market slows down significantly. Purchases are
now based on repeat or replacement purchases, rather than new customers.
(b)
(c)
(d)
Many products on the market will be at the mature stage of their life cycle.
(e)
Profits remain good, and levels of investment are low, meaning cash flow is
also positive.
(f)
(g)
(h)
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(i)
(j)
4.1.4 Decline
Eventually, products are superseded by technically superior substitutes. Sales
begin to decline and there is over-capacity of production in the industry. Prices
are lowered in order to try to attract business. Severe competition occurs, profits
fall and some producers leave the market. The remaining producers try to
prolong the product life by modifying it and searching for new (niche) market
segments. Investment is kept to a minimum. Although some producers are
reluctant to leave the market if they have not found alternative industries to move
into, many inevitably do because of falling profits.
Growth
Financial
High business risk High business
characteristics Negative net cash risk
flow
Neutral net
DCF evaluation for cash flow
Maturity
Decline
Medium
Low risk
business risk NeutralPositive cash positive cash
flow
flow
overall
investment
Critical
success
factors
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Information
needs
Introduction
Growth
Market research
into demand
Market
Comparative
growth/share competitor
costs
Diminishing
returns
Competitor
marketing
strategies
DCF
Market share
Physical
evaluation
Marketing
objectives
Maturity
Limiting
factors
Decline
Rate of
decline
Best time to
leave
Reliable sale
values of
assets
ROI
Free cash
Profit margin flow (for
Maintaining investment
market share elsewhere)
Mainly nonfinancial
measures owing
to volatility (eg
rate of take up by
consumers)
Growth
Maturity
Decline
Cash
Net user
Net user
Generator
Generator
Return on
capital
Not important
Not important
Important
Important
Growth
Vital
Vital
Grow with
new uses
Negative growth
Profit
Not expected
Important
Important
Very important
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New products at the introduction and growth stages which, when mature,
will generate cash.
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(b)
Mature products, which generate cash for new investment. Mature products
generate most of the profits and cash.
(c)
A product portfolio should also contain products with life cycles of different
lengths.
The BCG matrix is also closely linked to the idea of the product life cycle, and
highlights the importance of businesses having a balance of products (or strategic
business units) at different stages in their life cycles.
The BCG matrix highlights that, in order to ensure long-term success, a business
needs to combine high-growth products which need cash inputs (stars and
question marks) and low-growth products which generate cash (cash cows). In
effect, we could suggest that the products in the BCG matrix align to the stages of
the product life as follows:
The best way to achieve a stable revenue in the long term is by having cash cows
in a portfolio (products which command a large market share in mature markets).
However, as the BCG matrix indicates, to maintain the presence of cash cows in its
portfolio over the long term, a business also needs to have 'star' products in its
current portfolio. In time, the current 'stars' will become 'cash cows' and will then
be able to replace the current cash cows when they decline and become 'dogs'.
Managers should look at three criteria when reviewing product or business unit
portfolios:
(1)
(2)
(3)
A product's life cycle can be 'extended' by the use of technology. Demand for
recorded music has been met over the years by vinyl, CD, DVD and internet
downloads via MP3, different technological solutions to the same customer need.
Although technology can be used to extend an individual product's life cycle,
overall the pace of technological developments in recent years has led to their
shortening. The short product life cycles associated with fast-moving technology
have become both a problem and an opportunity for manufacturers.
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The 'problem' for manufacturers is that the rapid rate of changes translates into a
critical need to stay at the leading edge of technology. If they fail to do so, their
products will quickly become obsolete, and they will lose market share. By
contrast, the 'opportunity' is that if a manufacturer can develop a new technology
in advance of their competitors, this might enable them to increase market share.
5.1 Turnaround
When a business is in terminal decline and faces closure or takeover, there is a
need for rapid and extensive change in order to achieve cost reduction and
revenue generation. This change could be achieved through a turnaround
strategy. We can identify seven elements of such a strategy.
5.1.1 Crisis stabilisation
The emphasis is on reducing costs and increasing revenues. An emphasis on
reducing direct costs and improving productivity is more likely to be effective
than efforts to reduce overheads.
(a)
(b)
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The old management allowed the situation to deteriorate and may be held
responsible by key stakeholders.
(b)
(c)
Managers brought in from outside will not be prisoners of the old culture
and ways of working within the organisation (which had led to the
turnaround situation), so they will be able to identify fresh approaches and
strategies.
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5.2.2 Accountability
Establishing a culture of accountability could also be an important part of a
performance improvement strategy; encouraging everyone in an organisation to
take ownership for results.
However, this does not mean that employees should be held accountable for
results they cannot influence. For example, expecting a mechanic in a factory to
influence 'profit' is a meaningless target. Instead, individual staff should set
specific objectives and targets for their functional areas (for example, for the
mechanic, these might relate to productivity, wastage and quality).
In addition, employees could be empowered to take action to influence the targets
they have set. This combination of target setting and empowerment should
encourage employees to be more accountable for results.
5.2.3 Employee rewards
We looked at some of the issues surrounding performance management and
employee reward systems in Chapter 1. One of the key messages from that is of
the need to integrate human resource management processes (recruitment,
retention or reduction of staff) with the strategic direction and control of an
organisation.
These issues are particularly important in the context of performance
improvement strategies. Management should consider what goals are chosen for
employees and how performance is measured and rewarded in a performance
management system. The goals must align with the overall objectives of the
organisation as it seeks to improve its performance.
Clearly, an organisation in crisis working hard to survive will have some
demanding goals and targets to attain. These may well be set for a short period of
time with the recognition that once the business recovers, new goals will be
drawn up. Rewards could be deferred until the business has recovered, to provide
incentives to perform even where the immediate reward is not available.
6 Reconstruction schemes
Reconstruction schemes are undertaken when companies have got into
difficulties or as part of a strategy to enhance the value of the firm for its owners.
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(b)
However, a company might be on the brink of going into liquidation, but hold out
good promise of profits in the future. In such a situation, the company might be
able to attract fresh capital and to persuade its creditors to accept some securities
in the company as 'payment', and achieve a capital reconstruction which allows
the company to carry on in business.
(b)
(c)
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(b)
(c)
Step 2
Step 3
Design the reconstruction. Often, the question will give you details of
how to do it.
Step 4
Calculate and assess the new position, and also how each group has
fared, and compare with the Step 1 position.
Step 5
In addition, you should remember the following points when designing the
reconstruction.
(a)
(b)
The actual reconstruction might involve the creation of new share capital
of a different nominal value than existing share capital, or the cancellation
of existing share capital.
It can also involve the conversion of equity to debt, debt to equity, and debt
of one type to debt of another.
(c)
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7 Financial reconstructions
There are many possible reasons why management would wish to restructure a
company's finances. A reconstruction scheme might be agreed when a company is
in danger of being put into liquidation, owing debts that it cannot repay, and so
the creditors of the company agree to accept securities in the company, perhaps
including equity shares, in settlement of their debts. On the other hand, a company
may be willing to undergo some financial restructuring to better position itself for
long-term success.
A financial reconstruction scheme is a scheme whereby a company reorganises
its capital structure, including leveraged buyouts, leveraged recapitalisations and
debt for equity swaps.
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the swap takes place, the preceding asset class is cancelled for the newly acquired
asset class.
One possible reason that the company may engage in debt/equity swaps is
because the company must meet certain contractual obligations, such as
maintaining a debt:equity ratio below a certain number. Also a company may issue
equity to avoid making coupon and face value payments because they feel they
will be unable to do so in the future. The contractual obligations mentioned can be
a result of financing requirements imposed by a lending institution, such as a
bank, or may be self-imposed by the company, as detailed in the company's
prospectus. A company may self-impose certain valuation requirements to entice
investors to purchase its stock. Debt/equity swaps may also be carried out to
rebalance a firm's weighted average cost of capital (WACC).
QUESTION
Reconstruction
For illustration, assume there is an investor who owns a total of Rs. 2,000 in ABC
Co stock. ABC has offered all shareholders the option to swap their stock for debt
at a rate of 1.5.
Required
Calculate the amount that the investor will receive.
ANSWER
The investor would receive, if they elected to take the swap, Rs. 3,000 (1.5
Rs. 2,000) worth of debt, gaining Rs. 1,000 for switching asset classes. However,
the investor would lose all rights as a shareholder, such as voting rights, if they
swapped their equity for debt.
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(b)
(c)
(d)
(e)
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CHAPTER ROUNDUP
Corporate decline arises from the decline in the industry and from poor
management. It is still possible to make money in declining industries, just as it is
possible to 'turn round' declining companies.
Models of business failure fall broadly into those that emphasise a number of
financial variables, or by those that emphasise qualitative measures. A model is
only as good as the quality of information it uses. It is likely that there will be
limitations to the data collected. There will also be limitations on the
application of the model and care needs to be taken when adopting a 'one size
fits all' approach.
The organisation needs to plan its product range so that there is an optimum mix
of products coming on stream, generating cash, or being run down. You should
understand by now that organisational survival depends on organisations
planning ahead.
Assuming the life cycle pattern applies, in order to survive and prosper, firms need
new products to take the place of declining ones. Different control measures are
appropriate at different stages. The life cycle can be determined by technology or
customer demand.
One specific way in which an organisation could respond to the threat of failure or
closure is through a turnaround strategy.
There are many possible reasons why management would wish to restructure a
company's finances. A reconstruction scheme might be agreed when a company is
in danger of being put into liquidation, owing debts that it cannot repay, and so
the creditors of the company agree to accept securities in the company, perhaps
including equity shares, in settlement of their debts. On the other hand, a company
may be willing to undergo some financial restructuring to better position itself for
long-term success.
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PROGRESS TEST
Introduction
Growth
Maturity
Decline
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Revenue
Operating costs
20X8
Rs Mn
1,460
1,153
20X9
Rs Mn
1,560
1,279
20Y0
Rs Mn
1,915
1,724
Operating profit
Interest
307
35
281
74
191
95
272
87
207
66
96
31
185
141
65
20X8
Rs Mn
20X9
Rs Mn
20Y0
Rs Mn
Assets
Non-current assets
Current assets
1,120
235
1,778
285
2,115
341
Total assets
1,355
2,063
2,456
230
204
465
456
230
344
991
498
230
410
1,261
555
1,355
2,063
2,456
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20X8
1.56
450
702
WC/TA
RE/TA
PBIT/TA
MVE/Total long-term debt
Revenue/TA
Z
0.163
0.151
0.227
1.510
1.077
2.746
0.103
0.167
0.136
0.758
0.756
1.770
0.087
0.167
0.078
0.478
0.780
1.452
107%
173%
197%
X1
X2
X3
X4
X5
Gearing (debt/equity)
20X9
1.67
450
752
20Y0
1.34
450
603
Discuss the strengths and weaknesses of quantitative and qualitative models for
predicting corporate failure.
10
11
Identify the qualitative problems that are apparent in the company's structure and
performance, and explain why these are relevant to possible failure.
12
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Poor financial controls; high cost structure; a big project and high gearing
We have given more than one example of each but you are only asked for one.
FACTORS IN ARGENTI'S MODEL
Defects
Mistakes
Symptoms
Deteriorating ratios
Creative accounting signs of window-dressing
Declining morale and declining quality
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Because of the use of X4: market value of equity/book value of debt, Z-score
models cannot be used for unquoted companies which lack a market value of
equity.
The answer is C. The fact that the market is no longer growing means the product
has to be in either the mature or decline phases of its life cycle. The focus on
retention rates indicates the importance of capturing (and retaining) market share
from competitors, which is an important feature of mature markets.
(a)
(b)
(c)
(d)
(e)
(a)
(b)
(c)
(d)
(e)
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11
12
Assess the results of analysis in questions 10 and 11, and state what
additional data should be obtained to assess the company's financial health
The company is still profitable, making Rs. 65m of profits in 20Y0. Its revenues are
still growing (from Rs. 1,560m to Rs. 1,915m over the past year) but operating
costs have increased by 50% from 20X8 to 20Y0 and interest charges have gone
up by Rs. 60m over that period. Thus margins have suffered (falling from 21% to
10% operating margin over the period). It is likely at the early stage of the project
that costs will be high and revenues low. So a longer-term view needs to be taken
before concluding that the company is definitely failing.
However, the decline in the margin needs further explanation looking at costs in
detail and how these are being controlled.
Finally, it would be useful to compare the fall in the share price with the
movement in the market to assess whether this is a general trend or reflecting
sentiment over RMB's prospects.
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CHAPTER
INTRODUCTION
We start by considering the significant risks organisations face, and we shall look at these in more
detail later.
You need to understand straightaway that the risks organisations face are not just those that relate
to the financial statements organisational risks cover the whole range of activities. A common
complaint of examiners is that students often don't consider a sufficiently wide range of risks. One
important distinction is between strategic risks (integral, long-term risks that the board is likely
to be most concerned with) and operational risks (largely the concern of line management).
The essentials to remember are not just a list of the major risks, but also:
Knowledge Component
6
Corporate Risk Identification and Management
6.1
6.2
Corporate risk
identification
Corporate risk
management
6.1.1
Discuss various types of risks such as credit risk, interest rate risk,
liquidity risk, foreign exchange risk, price risk, operational risk and
reputational risk.
6.1.2
6.1.3
Discuss value at risk as a risk measurement tool and control tool and
its limitations.
6.1.4
6.2.1
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CHAPTER CONTENTS
LEARNING
OUTCOME
6.1.1
6.1.1, 6.1.2
3 Financial risks
6.1.1, 6.1.2
6.1.3, 6.1.4
6.2.1
QUESTION
Risks
ANSWER
Make your own list, specific to the organisations that you are familiar with. Here is
a list extracted from an article by Tom Jones (Risk Management, Administrator,
April 1993).
Fire, flood, storm, impact, explosion, subsidence and other hazards
Accidents and the use of faulty products
Error: loss through damage or malfunction caused by mistaken operation of
equipment or wrong operation of an industrial programme
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Most risks must be managed to some extent, and some should be sought to be
eliminated as being outside the scope of the remit of the management of a
business. For example, a business in a high-tech industry, such as computing,
which evolves rapidly within ever-changing markets and technologies, has to
accept high risks in its research and development activities; but should it also be
speculating on interest and exchange rates within its treasury activities?
Risk management under this view is an integral part of strategy, and involves
analysing what the key value drivers are in the organisation's activities, and the
risks tied up with those value drivers. In its Risk Management Standard, the
Institute of Risk Management linked in key value drivers with major risk
categories.
CASE STUDY
Since risk and return are linked, one consequence of focusing on achieving or
maintaining high profit levels may mean that the organisation bears a large
amount of risk. The decision to bear these risk levels may not be conscious, and
may go well beyond what is considered desirable by shareholders and other
stakeholders.
This is illustrated by the experience of the National Bank of Australia, which
announced it had lost hundreds of millions of pounds on foreign exchange trading,
resulting in share price instability and the resignation of both the chairman and
chief executive. In the end, the ultimate loss of A$360 million was 110 times its
official foreign exchange trading cap of A$ 3.25 million.
The bank had become increasingly reliant on speculation and high-risk investment
activity to maintain profitability. Traders had breached trading limits on 800
occasions, and at one stage had unhedged foreign exchange exposures of more
than A$2 billion. These breaches were reported internally, as were unusual
patterns in trading (very large daily gains) but senior managers took no action.
For three years, the currency options team had been the most profitable team in
Australia, and had been rewarded by bonuses greater than their annual salaries.
Eventually, however, the team made large losses, and entered false transactions to
hide their deficits.
The stock market, however, was unimpressed by the efforts of the bank to make
members of the team scapegoats, and market pressure forced changes at the top
of the organisation, a general restructuring and a more prudent attitude to risk.
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For example, the legal risk of breaching laws in day-to-day activities (for
example, an organisation's drivers exceeding the speed limit) would be
classed as an operational risk. However, the legal risk of stricter health
and safety legislation forcing an organisation to make changes to its
production processes would be classed as a strategic risk, as it is a longterm risk impacting seriously on the way the business produces its goods.
(b)
3 Financial risks
In this section we review the main risks connected with sources of finance and
international activity that businesses face.
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(b)
592
(a)
(b)
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The gathering of advance fees, made up of supposed legal fees, registration fees
and sales tax, is the actual objective of the scam.
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therefore have no market value. Arguably also in slow markets use of market
values underestimates long-term asset values.
3.6.4 Systems risks
Accounting fairly for risks may require investment in new systems, and there may
be an increased risk of systems problems, as systems have to cope with linking
of assets with derivatives, accommodating changes in hedge allocations and
measuring hedge effectiveness.
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The method requires that changes in each key variable are isolated.
However, management is more interested in the combination of the effects
of changes in two or more key variables.
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(b)
(c)
Sensitivity analysis does not examine the probability that any particular
variation in costs or revenues might occur.
(d)
(e)
0
1
2
3
Cash flow
Rs
(9,000)
7,000
5,000
5,000
Discount
factor
10%
1.000
0.909
0.826
0.751
Present
value (PV)
Rs
(9,000)
6,363
4,130
3,755
NPV +5,248
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Solution
The risk-adjusted NPV of the project is as follows.
Year
0
1
2
3
Cash flow
Rs
(9,000)
4,900
3,000
2,500
PV factor
1.000
0.909
0.826
0.751
PV
Rs
(9,000)
4,454
2,478
1,878
NPV = 190
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Step 2
(b)
(c)
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Figure 18.1
Normal distribution curve
Frequency
(%)
50% of
occurences
50% of
occurences
Profit/loss
(a)
The area of 95% certainty is the 50% > mean (all the profitable
outcomes) + 45% < mean (the smallest loss outcomes) = 95%
Look for the figure of .4500 in the area under the normal curve
table towards the back of this text.
The closest figure to .4500 is .4505
This represents a figure of 1.65
Step 2
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(b)
The area of 99% certainty is the 50% > mean (all the profitable
outcomes) + 49% < mean (the smallest loss outcomes) = 99%
Look for the figures of .4900 in the area under the normal curve
table at the end of this text.
The closest figure to .4900 is .4901
This represents a figure of 2.33
Step 2
Value at risk may be calculated over varying lengths of time, although you will
often see it calculated daily. It depends on the holding period and the confidence
level. Although it gives a basis for calculating some numbers, it assumes a normal
distribution (which may not be the case), involves estimates of impact and
probability, and is potentially overly simplistic (for example, consequential
impacts are difficult to measure).
4.6 Scenarios
Scenario building is the process of identifying alternative futures, ie constructing
a number of distinct possible futures permitting deductions to be made about
future developments of markets, products and technology.
Scenarios are used in several situations.
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They cannot assess how likely the spillage is to occur in practice. Scenario analysis
can also highlight flaws in risk management or contingency planning.
4.6.2 As a prediction technique
A series of alternative pictures of a future operating environment are developed
which are consistent with current trends and consistent within themselves. The
impact of each different scenario on the business is assessed, and specific risks
highlighted. Contingency plans are drawn up to implement in the event of a given
scenario becoming true, or to implement now to give protection against the
scenario. However, it may not be easy to assess different scenarios, and
specification of scenarios is subjective.
Failure and effects analysis. This involves breaking a system down into
components, and analysing the effect of failure of each component, and the
impact on the rest of the system.
(b)
Fault and event analysis. Logic diagrams are used to analyse courses and
consequences.
(c)
Root cause analysis. This traces risks back to originating causes or events.
(d)
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(a)
A maximum payback period can be set to reflect the fact that risk increases
the longer the time period under consideration.
(b)
A high discounting rate can be used so that a cash flow which occurs quite
some time in the future will have less effect on the decision.
(c)
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(e)
To ensure that future events are no worse than predicted, prudence, slack
and overly pessimistic estimates can be applied.
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Controls over financial risk can be classified under the three main headers:
Input: expert management of risk by a treasurer or treasury function
Process: hedging exposures over a certain size
Output: monitoring risk levels through, for example, value at risk calculations
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internal funds for business, the management of currencies and cash flows, and the
complex strategies, policies and procedures of corporate finance'.
Larger companies have specialist treasury departments to handle financial risks.
The most important risks affecting the treasury function are as follows.
Business activities have to be curtailed due to lack of funds
Hedging results in losses over time
Exposures are not communicated to the board
There will be risks associated with the degree of centralisation of the treasury
function:
(a)
(b)
Decentralising the treasury function may mean that the local operations
may not have the resources available to employ staff with the expertise
necessary to handle complex treasury issues. There may be inefficiencies
caused by duplication of staff and lack of centralisation of balances leading to
unnecessary hedging. It may be more difficult to exercise control over
geographically-dispersed activities.
In a cost centre, managers have an incentive only to keep the costs of the
department within budgeted spending targets. The cost centre approach
implies that the treasury is there to perform a service of a certain standard
to other departments in the enterprise. The treasury is treated much like any
other service department.
(b)
Treating the treasury department as a profit centre recognises the fact that
treasury activities such as speculation may earn revenues for the company,
and may as a result make treasury staff more motivated. It also means that
treasury departments have to operate with a greater degree of commercial
awareness, in for example the management of working capital. However,
there may be a greater risk of large losses if staff pursue profits recklessly.
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Competence of staff
Local managers may not have sufficient expertise in the area of treasury
management to carry out speculative treasury operations competently.
Mistakes in this specialised field may be costly. It may only be appropriate to
operate a larger centralised treasury function as a profit centre, and
additional specialist staff may need to be recruited.
(b)
Controls
Adequate controls must be in place to prevent costly errors and
overexposure to risks such as foreign exchange risks. It is possible to enter
into a very large foreign exchange deal over the telephone.
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(c)
Information
A treasury team which trades in futures and options or in currencies is
competing with other traders employed by major financial institutions who
may have better knowledge of the market because of the large number of
customers they deal with. In order to compete effectively, the team needs to
have detailed and up-to-date market information.
(d)
Attitudes to risk
The more aggressive approach to risk taking which is characteristic of
treasury professionals may be difficult to reconcile with a more measured
approach to risk within the board of directors. The recognition of treasury
operations as profit-making activities may not fit well with the main
business operations of the company.
(e)
Internal charges
If the department is to be a true profit centre, then market prices should be
charged for its services to other departments. It may be difficult to put
realistic prices on some services, such as arrangement of finance or general
financial advice.
(f)
Performance evaluation
Even with a profit centre approach, it may be difficult to measure the success
of a treasury team for the reason that successful treasury activities
sometimes involve avoiding costs, for example when a currency devalues.
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607
Different countries are often at different stages of the trade cycle at any
one time.
(b)
(c)
(d)
(e)
However, there are a number of factors that may limit the potential for
international diversification.
608
(a)
(b)
(c)
(d)
(e)
Some types of investor may have a parochial home bias for domestic
investment.
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609
610
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CHAPTER ROUNDUP
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611
PROGRESS TEST
Give three examples of ways that risk can be measured in probability analysis.
Expected values can help an accountant evaluate the range of possible net present
value outcomes.
True
False
Risk-averse businesses always seek to minimise the levels of risk that they face.
True
False
10
11
612
The risk that a new product will fail to find a large enough market
The risk that a senior manager with lots of experience will be recruited by a
competitor
The risk of resource depletion meaning that new sources of raw materials
will have to be found
12
List three business risks that are associated with the internet.
13
14
The level of reputation risk depends significantly on the level of other risks.
True
False
15
Identify the different risks facing the HOOD Company, placing the risks into
suitable categories.
17
Evaluate the potential effect of each risk on the company, recommending how the
impact of that risk can be minimised.
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613
614
False. Sensitivity analysis assesses the effect of changes in variables, not the
probability of occurrence.
The certainty equivalent approach is where expected cash flows are converted
to riskless equivalent amounts.
False
Risk hedging is reducing the impact of one risk by incurring a risk in the opposite
direction.
Pure risks relate to harmful outcomes; speculative risks relate to positive and
harmful outcomes.
Speculative risks are risks from which good or harm may result.
10
The answer is C. Loss of a senior manager would be an operational risk. The other
risks are strategic risks.
11
12
13
14
True. Although the threat to reputation also depends on how likely it is that the
organisation will suffer bad publicity if risks in other areas materialise.
15
Economic risks arise from the effect of exchange rate movements on the
international competitiveness of the organisation.
16
Risk can be defined as the possibility that events or results will turn out differently
from is expected. The risks facing the HOOD Company are outlined below.
Identification/assessment methodology
Tolerable/unacceptable risks
Management guidelines
Reporting guidelines
CA Sri Lanka
Operational risks
These are risks relating to the business' day-to-day operations.
(a)
Accounting irregularities
The unexplained fall in gross profit in some stores may be indicative of fraud
or other accounting irregularities. Low gross profit in itself may be caused
by incorrect inventory values or loss of sale income. Incorrect stock levels
in turn can be caused by incorrect inventory counting or actual stealing
of inventory by employees. Similarly, loss of sales income could result
from accounting errors or employees fraudulently removing cash from
the business rather than recording it as a sale.
(b)
(c)
Event
HOOD may be vulnerable to losses in a warehouse fire.
Strategic risks
These risks relate to factors affecting Hood's ability to trade in the longer term.
(a)
Production
The possibility of sunlight making some of HOOD Company's products
potentially dangerous may give rise to loss of sales, also inventory recall.
(b)
Corporate reputation
Risks in this category relate to the overall perception of HOOD in the
marketplace as a supplier of (hopefully) good-quality clothing. However,
this reputation could be damaged by problems with the manufacturing
process and a consequent high level of returns.
(c)
Macro-economic risk
The company is dependent on one market sector and vulnerable to
competition in that sector.
(d)
Product demand
The most important social change is probably a change in fashion. HOOD
has not changed its product designs for four years, indicating some lack of
investment in this area. Given that fashions tend to change more frequently
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615
than every four years, HOOD may experience falling sales as customers seek
new designs for their outdoor clothing. HOOD may also be vulnerable to
seasonal variations in demand.
17
The potential effects of the risks on HOOD and methods of overcoming those risks
are explained below.
Operational risks
(a)
Accounting irregularities
The potential effect on HOOD is loss of income either from stock not being
available for sale or cash not being recorded. The overall amount is unlikely
to be significant, as employees would be concerned about being caught
stealing.
The risk can be minimised by introducing additional controls including the
necessity of producing a receipt for each sale and the agreement of cash
received to the till roll by the shop manager. Loss of stock may be identified
by more frequent stock checks in the stores or closed-circuit television.
(b)
(c)
Event
The main effects of a warehouse fire will be a loss of inventory and the
incurring of costs to replace it. There will also be a loss of sales as the
inventory is not there to fulfil customer demand, and perhaps also a loss of
subsequent sales as customers continue to shop elsewhere.
Potential losses of sales could be avoided by holding contingency
inventory elsewhere, and losses from the fire could be reduced by
insurance.
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Strategic risks
(a)
Production
The effect on HOOD is the possibility of having to reimburse customers and
the loss of income from the product until the problems are resolved.
The risk can be minimised by HOOD taking the claim seriously and
investigating its validity, rather than ignoring it. For the future,
guarantees should be obtained from suppliers to confirm that products are
safe and insurance taken out against possible claims from customers for
damage or distress.
(b)
Corporate reputation
As well as immediate losses of contribution from products that have
been returned, HOOD faces the consequence of loss of future sales from
customers who believe their products no longer offer quality. Other clothing
retailers have found this to be very serious; a reputation for quality, once
lost, undoubtedly cannot easily be regained. The potential effect of a drop
in overall corporate reputation will be falling sales for HOOD, resulting
eventually in a going concern problem.
HOOD can guard against this loss of reputation by enhanced quality
control procedures, and introducing processes such as total quality
management.
(c)
Macro-economic risk
The potential effect on HOOD largely depends on HOOD's ability to provide
an appropriate selection of clothes. It is unlikely that demand for coats etc
will fall to zero, so some sales will be expected. However, an increase in
competition may result in falling sales, and without some diversification,
this will automatically affect the overall sales of HOOD.
HOOD can minimise the risk in two ways: by diversifying into other areas.
Given that the company sells outdoor clothes, then commencing sales of
other outdoor goods such as camping equipment may be one way of
diversifying risk. It can also look to reduce operational gearing, fixed cost
as a proportion of turnover.
(d)
Product demand
Again, the risk of loss of demand and business to competitors may
undermine HOOD's ability to continue in business.
This risk can be minimised by having a broad strategy to maintain and
develop the brand of HOOD. Not updating the product range would appear
to be a mistake in this context, as the brand may be devalued as products
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617
may not meet changing tastes of customers. The board must therefore
allocate appropriate investment funds to updating the products and
introduce new products to maintain the company's image.
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CHAPTER
INTRODUCTION
This chapter focuses on how currency derivatives can be used to manage
transaction risk. Any company engaged in international trade will be exposed to
such risk where movements in exchange rates can have a significant effect on
the value of transactions. There are numerous ways in which a company can
hedge against transaction risk both internal and external methods are
available. It is important to know the characteristics of the various techniques
and also the best strategy to adopt in particular scenarios.
Knowledge Component
6
Corporate Risk Identification and Management
6.1
6.2
Corporate risk
identification
Corporate risk
management
6.1.1
Discuss various types of risks such as credit risk, interest rate risk,
liquidity risk, foreign exchange risk, price risk, operational risk and
reputational risk.
6.1.2
6.2.1
6.2.2
6.2.3
6.2.4
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LEARNING OUTCOME
CHAPTER CONTENTS
1 Translation, transaction and economic risk
6.1.1, 6.1.2
2 Exchange rates
6.1.1, 6.1.2
6.2.1
7 Currency futures
8 Currency options
9 Currency swaps
6.2.3
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621
rupee gain on the payable. In essence, these two accounts hedged each other from
translation exposure to exchange rate changes.
CASE STUDY
622
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2 Exchange rates
2.1 Exchange rates
Currency rates can be quoted as direct quotes or indirect quotes.
The spot rate is the rate at which currencies can be exchanged now. The forward
rate is the rate at which currencies will be exchanged on a set future date.
An exchange rate is the rate at which a currency can be traded in exchange for
another currency.
The spot exchange rate is the rate at which currencies can be bought or sold for
immediate delivery.
The forward rate is an exchange rate set for currencies to be exchanged at a
future date.
Every traded currency in fact has many exchange rates. There is an exchange rate
with every other traded currency on the foreign exchange markets. Foreign
exchange dealers make their profit by buying currency for less than they sell it,
and so there are really two exchange rates: a selling rate and a buying rate.
623
In order to pay the bill, the company must obtain (buy) $10,000 from the
bank. In other words, the bank will sell $10,000 to the company.
(b)
When the bank agrees to sell US$10,000 to the company, it will tell the
company what the spot rate of exchange will be for the transaction. If the
bank's selling rate (known as the 'offer', or 'ask' price) is, say, $0.0077 for
the currency, the bank will charge the company:
$10,000
= Rs.1,298,701
$0.0077 per Re.1
If a Sri Lankan exporting company receives $10,000 from a customer, the
company will want to sell the dollars to obtain SL rupees (its home currency). The
bank will therefore buy the dollars at a quoted bid price. If the bank quotes a bid
price of, say, $0.0079, for the currency the bank will pay the exporter:
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CA Sri Lanka
$10,000
= Rs.1,265,823
$0.0079 per Re.1
Note that the bank buys the dollars for less than it sells them; in other words it
makes a net profit on the transactions. In this case, the net profit is Rs. 32,878. If
you are undecided between which price is the bid price and which is the offer
price, remember that the bank's customer will always be offered the worse rate.
An exporter will pay a high price for the foreign currency and an importer will
receive a low price. Just think what happens when you buy currency for a holiday
and then sell it back when you come home (ignoring commission).
If you come back to Sri Lanka from a holiday in America with spare dollars, and
you are told the spread of rates is $0.00770.0079/Rs, will you have to pay the
bank $0.0077 or $0.0079 to obtain Re. 1? Answer: you will have to pay the higher
price, $0.0079.
The rule is that banks buy (currency) low and sell high.
QUESTION
Bid-offer
Calculate how many dollars an exporter would receive or how many dollars an
importer would pay, ignoring the bank's commission, in each of the following
situations, if they were to exchange currency at the spot rate.
(a)
(b)
A US importer buys goods from a Japanese supplier and pays 1 million yen.
203.650
ANSWER
(a)
The bank is being asked to buy the Danish kroners and will give the
exporter:
150,000
= $15,726.57 in exchange
9.5380
(b)
The bank is being asked to sell the yen to the importer and will charge for
the currency:
1,000,000
= $4,910.39
203.650
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625
2.4 Spread
The difference between the bid price and the offer price is known as the spread.
One of the easiest ways to find the closing (end of day) exchange rates is to use the
financial press.
The difference between the bid price and the offer price, covering dealers' costs
and profit, is called the spread. The spread can be quoted in different ways.
Rs. 0.6500/$. +/- 0.0005 or Rs. 0.6495 0.6505/$.
QUESTION
Exchange rates
PTA Inc, a US-based company, is engaged in both import and export activities.
During a particular month, PTA sells goods to GH plc, a Sri Lankan company, and
receives Rs. 5 million. In the same month, PTA imports goods from a Sri Lankan
supplier, which cost Rs. 5 million.
Required
Calculate the dollar values of the Rupee receipt and payment if the exchange rates
were Rs. 130.22/$ +/- 1.3.
ANSWER
(a)
As an exporter, PTA will pay a high rate to buy dollars (sell rupees) that is,
they will be quoted a rate of 130.22 + 1.3 = 131.52. PTA will therefore
receive:
Rs. 5 million/131.52 = $38,017.
(b)
As an importer, PTA will receive a low rate to sell dollars (buy rupees) that
is, a rate of 130.22 1.3 = 128.92. PTA will therefore pay
Rs. 5 million/128.92 = $38,784.
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(b)
If the dollar was to depreciate against the SL rupee by 2% in the next month
and by a further 1% in the second month, how would W Inc's strategy
probably change and what would the resulting benefit be?
Solution
(a)
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627
(b)
(b)
Although either the exporter or the importer avoids transaction risk, the other
party to the transaction will bear the full risk. Who ultimately bears the risk may
depend on bargaining strength or the exporter's competitive position (it is
unlikely to insist on payment in its own currency if it faces strong competition).
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3.4 Netting
Netting is a process in which credit balances are netted off against debit balances
so that only the reduced net amounts remain due to be paid by actual currency
flows.
Unlike matching, netting is not technically a method of managing transaction risk.
The objective is simply to save transactions costs by netting off inter-company
balances before arranging payment. Many multinational groups of companies
engage in intra-group trading. Where related companies located in different
countries trade with each other, there is likely to be inter-company indebtedness
denominated in different currencies.
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629
(a)
(b)
Subsidiary companies can lend the equivalent of the dividend to the parent
company.
(c)
(d)
Increase the transfer prices paid by the subsidiary to the parent company.
(e)
Foreign governments may put measures in place to stop the above methods being
used.
(b)
(c)
(d)
For performance (delivery of the currency and payment for it) at a future
time which is agreed when making the contract (this future time will be
either a specified date, or any time between two specified dates)
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How much local currency they will receive (if they are selling foreign currency
to the bank)
How much local currency they must pay (if they are buying foreign currency
from the bank)
The current spot price is irrelevant to the outcome of a forward contract.
(a)
(b)
(i)
2,000
At the spot rate, now, for Rs. 277,778
0.0072
(ii)
2,000
In three months' time, under a forward contract, for Rs. 259,740
0.0077
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2,000
At the spot rate, now, for Rs. 273,973
0.0073
631
(ii)
2,000
0.0079
In both cases, the quoted currency (Swiss franc) would be worth less against the
SL rupee in a forward contract than at the current spot rate. This is because it is
quoted forward 'at a discount', against the SL rupee.
If the forward rate is thus higher than the spot rate, then it is 'at a discount' to the
spot rate.
The forward rate can be calculated today without making any estimates of future
exchange rates. Future exchange rates depend largely on future events and will
often turn out to be very different from the forward rate. However, the forward
rate is probably an unbiased predictor of the expected value of the future
exchange rate, based on the information available today. It is also likely that the
spot rate will move in the direction indicated by the forward rate.
4.2.2 The rule for adding or subtracting discounts and premiums
Forward rates as adjustments to spot rates
Forward rate cheaper
Quoted at discount
Quoted at premium
or
1 = $1.3510 0.0015
As with the spot rate, a company will always be offered the worst rate by the bank.
For example, if the company is selling (that is, the bank is buying and paying $)
in three months' time, the bank will offer $1.3495. If the company is buying (that
is, the bank is buying $ and paying ) in three months' time, the bank will require
$1.3525 for every it sells.
4.3.1 Example: Forward contracts
It is now 31 March 20X1. Washington Inc, a US company, has purchased goods
from AB plc, a Sri Lankan importer and exporter. Washington is due to pay Rs. 5m
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to AB in three months' time, and wants to hedge the foreign currency payment to
reduce transaction risk.
The $/Rs spot rates on 31 March 20X1 are $1 = Rs. 130.22 Rs. 130.72.
The 3-month forward rates have been quoted as $1 = Rs. 128.32 Rs. 129.10.
Calculate the amount in $ that Washington will have to pay if the company hedges
the payment using a forward contract.
Solution
Washington will want to buy Rs (sell $) in three months' time, which means that
the bank will be selling Rs and buying $. Washington will be offered the 'worst'
rate; that is, the bank will pay Rs. 128.32 for each $ received from Washington.
The $ cost of the payment to AB plc will be:
Rs. 5m/128.32 = $38,965
QUESTION
Forward rates
Using the information in the example above, calculate how much in Rs AB would
have to pay Washington if, in three months' time, a payment of $5m is due.
ANSWER
AB will be selling Rs (buying $), which means that the bank will be selling $. The
bank will want to sell $ at a high rate, and therefore will offer AB $1 for every
Rs. 129.10 the company pays. The total cost of the payment in three months' time
will be:
$5m Rs. 129.10 = Rs. 645.5m
633
(a)
(ii)
(iii) The supplier is late with the delivery, and so the importer does not
have to pay for the goods until later than expected.
(b)
An exporter might find the same types of situation, but in reverse, so that
they do not receive any payment at all, or they receive more or less than
originally expected, or they receive the expected amount, but only after some
delay.
(b)
If the customer has arranged for the bank to buy currency but then cannot
deliver the currency for the bank to buy, the bank will:
(i)
Sell currency to the customer at the spot rate (when the contract falls
due for performance)
(ii)
Buy the currency back, under the terms of the forward exchange
contract
If the customer has contracted for the bank to sell them currency, the bank
will:
(i)
(ii)
Thus, the bank arranges for the customer to perform their part of the forward
exchange contract by either selling or buying the 'missing' currency at the spot
rate. These arrangements are known as closing out a forward exchange contract.
CA Sri Lanka
In the exam, a tabular approach may be helpful. Starting at (1), which is where the
Sri Lankan company needs to be, work backwards to what must be done now.
Now
Three
months
CA Sri Lanka
Importer
SL Rs
USA $s
4 withdraw funds from SL account 3 put money into US account
(1 + borrowing rate )*
(1 + deposit )*
5 to compare to a forward
1 pay $ invoice from supplier
2 pay off with $ deposit
635
*Remember to take the interest rate quoted and multiply by 3/12 if you have a
three-month loan.
What the tabular approach means is that the transaction determines whether you
are paying or receiving. This is the loan repayment which determines how much
money you have to place on deposit in the US$ account (the size of the loan),
which in turn determines the payment in Rs.
The effect is exactly the same as using a forward contract, and will usually cost
almost exactly the same amount. If the results from a money market hedge were
very different from a forward hedge, speculators could make money without
taking a risk. Therefore market forces ensure that the two hedges produce very
similar results.
5.2.1 Example: Money market hedge (1)
A Sri Lankan company owes a Danish supplier Kr3,500,000 in three months' time.
The spot exchange rate is Re. 1 = Kr0.0044 0.0045. The company can borrow in
Rs for three months at 8.60% per annum, and can deposit kroner for three months
at 10% per annum.
Required
Calculate the cost in SL rupees with a money market hedge.
Solution
The interest rates for three months are 2.15% to borrow in rupees and 2.5% to
deposit in kroner. The company needs to deposit enough kroner now so that the
total including interest will be Kr3,500,000 in three months' time. This means
depositing:
Kr3,500,000/(1 + 0.025) = Kr3,414,634.
These kroner will cost Rs. 776,053,181 (spot rate 0.0044 remember the
company will always receive the worst rate). The company must borrow this
amount and, with three months' interest of 2.15%, will have to repay:
Rs. 776,053,181 (1 + 0.0215) = Rs. 792,738,324.
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Three
months
SL Rs.
4 withdraw funds from SL
account
Kr3,414,634/0.0044 =
Rs. 776,053,181
8.6% 3/12 = 2.15% (ie
1.0215)
5 to compare to a forward
Rs. 776,053,181 1.0215 =
Rs. 792,738,324
Danish Kr
3 put money into Kr account
Kr3,500,000/1.025 =
Kr3,414,634
10% 3/12 = 2.5% (ie 1.025)
1 pay Kr invoice from supplier
3,500,000
2 pay off with Kr deposit
(3,500,000)
Borrow
Kr
Deposit
Kr
QUESTION
(1+2)
Investing
Borrowing
New
Zealand
%
2.5
3.0
Thailand
%
4.5
5.2
Required
Calculate the cost to the Thai company of using a money market hedge.
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637
ANSWER
Importer
Now
Three
months
Thai Bt
4 withdraw funds from Thai
account $2,981,366 19.0500
= Bt56,795,022
5.2% 3/12 = 1.3% (ie 1.013)
5 to compare to a forward
Bt56,795,022 1.013 =
Bt57,533,357
New Zealand $s
3 put money into NZ account
$3,000,000/1.00625 =
$2,981,366
2.5% 3/12 = 0.625 (ie 1.00625)
1 pay $ invoice from supplier
3,000,000
2 pay off with $ deposit
(3,000,000)
This can be shown in tabular form as follows (using an example of a Sri Lankan
exporter receiving $ from a US customer).
Exporter
Now
Three
months
SL Rs.
4 pay $ loan into SL bank account
(1 + deposit rate)
5 to compare to a forward
US $
3 take out $ loan
(1 + borrowing rate)
1 receive $ from export
2 pay off $ loan with export
revenue
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CA Sri Lanka
three months at 7% per annum. What is the receipt in dollars with a money
market hedge and what effective forward rate would this represent?
Solution
Exporter
Now
Three
months
US $
4 pay SFr loan into US account
SFr2,457,002/2.2510 =
$1,091,516
Swiss Fr
3 take out SFr loan
SFr2,500,000/1.0175 =
SFr2,457,002
QUESTION
Investing
Borrowing
Australia
%
4.5
6.0
Japan
%
2.7
3.3
Required
Calculate the amount the Australian company will receive if it uses a money
market hedge.
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639
ANSWER
Exporter
Now
Four
months
Australian $
4 pay loan into Australian
account
14,836,795/62.8000 =
Aus$236,255
Japanese
3 take out loan
15,000,000/1.011 =
14,836,795
The Australian company will receive Aus$239,799 from the money market hedge.
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1 month
3 months
US dollar
Deposit
Borrowing
rate
rate
%
%
7
10.25
7
10.75
Spot
1 month forward
3 months forward
Deposit
rate
%
10.75
11.00
Borrowing
rate
%
14.00
14.25
1 = $
1.8625 1.8635
1.8565 1.8577
1.8445 1.8460
Required
Calculate the cheapest method for T Co. Ignore commission costs.
Solutions
The three choices must be compared on a similar basis, which means working out
the cost of each to T Co either now or in three months' time. Here the cost to T
Co in three months' time will be determined.
Choice 1: The forward exchange market
T Co must buy dollars in order to pay the US supplier. The exchange rate in a
forward exchange contract to buy $4,000,000 in three months' time (bank sells) is
1 = $1.8445.
The cost of the $4,000,000 to T Co in three months' time will be:
$4,000,000
1.8445 = 2,168,609.38
This is the cost in three months.
Choice 2: The money markets
Using the money markets involves lending (depositing) in the foreign currency, as
T Co will eventually pay the currency.
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641
Importer
Now
Three
months
Rs
4 withdraw funds from SL
account
$3,931,304/1.8625 =
2,110,767
14.25 3/12 = 3.5625%
(ie 1.035625)
5 to compare to a forward
2,110,767 1.035625 =
2,185,963
USA $s
3 put money into US account
$4,000,000/1.0175 =
$3,931,204
7% 3/12 = 1.75% (ie 1.0175)
1 pay $ invoice from supplier
$4,000,000
2 pay off with $ deposit
($4,000,000)
2,168,609
2,185,867
2,206,711
The cheapest method for T Co is the forward exchange contract, therefore the
company should use this hedging technique to hedge against transaction risk for
this transaction.
QUESTION
Hedging techniques
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Method 1
Borrow 750,000 for three months, convert the loan into rupees and repay the
loan out of eventual receipts. The interest payable on the loan will be purchased in
the forward exchange market.
Method 2
Enter into a three-month forward exchange contract with the company's bank to
sell 750,000.
The spot rate of exchange is US$1 = 1.6006.
The three-month forward rate of exchange is US$1 = 1.5935.
Annual interest rates for three months' borrowing and lending are: euro 3%,
rupees 5%.
Required
(a)
Identify which of the two methods is the most financially advantageous for
W Co.
(b)
Discuss the other factors to consider before deciding whether to hedge the
risk using the foreign currency markets.
ANSWER
(a)
Method 1
W Co borrows 750,000.
Exporter
Now
Three
months
Rs
4 pay loan into Sri Lankan
bank account
744,417/1.6006 =
US$465,086
5% 3/12 = 1.25%
(ie 1.0125)
5 to compare to a forward
US$465,086 1.0125 =
US$470,900
3% 3/12 = 0.75%
(ie 1.0075)
1 receive from export
750,000
2 pay off loan with export
revenue (750,000)
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Conclusion
On the basis of the above calculations, Method 1 gives a slightly higher
receipt. However, the difference is quite small, and banker's commission has
been excluded from the calculation.
(b)
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CA Sri Lanka
Offsetting
Before using any technique to hedge foreign currency transactions, receipts
and payments in the same currency at the same date should be offset. This
technique is known as matching. For example, if the company is expecting to
receive 750,000 on 31 March and to pay 600,000 at about the same time,
only the net receipt of 150,000 needs to be considered as a currency
exposure.
Matching can be applied to receipts and payments which do not take place
on exactly the same day by simply hedging the period and amount of the
difference between the receipt and payment, or even by using a currency
bank account. A company that has many receipts and payments in a single
currency such as the euro should consider matching assets with liabilities
in the same currency.
7 Currency futures
A currency future is a standardised contract to buy or sell a fixed amount of
currency at a fixed rate at a fixed future date:
Buying the futures contract means receiving the contract currency
Selling the futures contract means supplying the contract currency
645
Futures contracts are assumed to mature at the end of March, June, September or
December. One of their limitations is that currencies can only be bought or sold on
exchanges for US dollars.
7.1.1 Ticks
The price of a currency future moves in 'ticks'. A tick is the smallest movement
in the exchange rate and is normally four decimal places.
Tick value = size of futures contract tick size
For example, if a futures contract is for 62,500 and the tick size is $0.0001, the
tick value is $6.25. (Note that the tick size and tick value are always quoted in US
dollars.)
What this means is that for every $0.0001 movement in the price, the company
will make a profit or loss of $6.25. If the exchange rate moves by $0.004 in the
company's favour which is 40 ticks (0.004/0.0001) the profit made will be 40
$6.25 = $250 per contract.
Examples of futures contract specifications including tick size and tick value
are given below.
Currency
British pound
Contract
size
Price
quotation
Tick size
Tick value
per contract
62,500
US$/1
$0.0001
$6.25
Canadian dollar
C$100,000
US$/C$1
$0.0001
$10.00
Euro
125,000
US$/1
$0.0001
$12.50
Japanese yen
12,500,000
US$/100
$0.000001
$12.50
Swiss franc
SFr125,000
US$/SFr1
$0.0001
$12.50
Australian dollar
A$100,000
US$/A$1
$0.0001
$12.50
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CA Sri Lanka
basis will not decrease in this predictable way (which will create an imperfect
hedge). There is no basis risk when a contract is held to maturity.
In order to manage basis risk, it is important to choose a currency future with the
closest maturity date to the actual transaction. This reduces the unexpired
basis when the transaction is closed out.
(b)
The second reason is basis risk as discussed above. The actions of speculators
may increase basis risk.
A measure of hedge efficiency compares the profit made on the futures market
with the loss made on the cash or commodity market, or vice versa.
7.2.1 Example: Hedge efficiency
You are given the following details about the results of a hedge by an American
company for a payment of SFr 650,000 in 30 days' time under two scenarios. In
each case, compute the hedge efficiency. Assume today's spot rate is SFr1 =
$0.5803. Contract size is SFr125,000, and tick size is $12.50.
Number of contracts = 650,000/125,000 = 5.2, round to 5.
Scenario 1
$/SFr
$
Futures hedge (5 contracts)
0.5725
Today: buy 5 at
0.6030
In 30 days: sell 5 at
305
Gain/(loss) per contract in ticks
Total gain/(loss) on 5 contracts:
19,063
5 $12.50 no. of ticks
Cash transaction
In 30 days: SFr 650,000 are
actually bought at
Net cost of the Swiss francs
CA Sri Lanka
0.6112
(397,280)
(378,217)
Scenario 2
$/SFr
0.5725
0.5610
(115)
(7,187)
0.5680
(369,200)
(376,387)
647
Solutions
The futures hedge gives slightly more or less than the target payment of $377,195
(SFr 650,000 0.5803) because of hedge inefficiency. To compute the hedge
efficiency in each case, compute gain/loss as a percentage. In scenario 1 the gain
comes from the futures market. In scenario 2 the gain comes from the cash
market.
Hedge efficiency
Target payment (650,000 0.5803)
Actual cash payment
Gain/(loss) on spot market
$
377,195
397,280
(20,085)
Futures gain/(loss)
19,063
Hedge efficiency
94.9%
$
377,195
369,200
7,995
(7,187)
111.2%
305 5
= 94.9%
309 5.2
In scenario 2, the spot market gained 123 ticks on 5.2 contracts. The futures price
lost 115 ticks on 5 contracts.
Hedge efficiency =
123 5.2
= 111.2%
115 5
An alternative measure of the hedge efficiency on the futures market might be its
success measured against the results of using a forward contract.
7.2.2 Margins and marking to market
There are two types of margin initial margin and variation margin.
An initial margin is similar to a deposit. When a currency future is set up, the
trader would be required to deposit some cash (the initial margin) with the
futures exchange in a margin account this acts as security against the trader
defaulting on their trading obligations. This money will remain in the margin
account as long as the currency future remains 'open'.
We mentioned above the process of calculating the profit or loss on a contract
when there is movement in the exchange rate. This profit or loss is received into
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or paid from the margin account on a daily basis rather than in one large amount
when the contract matures. This procedure is known as marking to market.
The futures exchange monitors the margin account on a daily basis. If the trader is
making significant losses, the futures exchange may require additional margin
payments known as variation margins. This practice creates uncertainty, as the
trader will not know in advance the extent (if any) of such margin payments.
Step 2
Figure 19.1
Futures
market
Action:
NOW
LATER
Buy
Futures
Sell
futures
No
Action
Buy the
currency
Foreign
currency
Action:
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649
Step 2
Figure 19.2
NOW
LATER
Sell
futures
Buy
futures
No
action
Buy the
currency
Futures
market
Action:
Foreign
currency
Action:
Step 2
Buy the same number of home currency futures contracts on the date
that you buy the US$
Figure 19.3
NOW
LATER
Sell
futures
Buy
futures
No
action
Buy
dollars
Futures
market
Action:
Dollars
Action:
CA Sri Lanka
Step 1
Step 2
Sell the same number of home currency futures contracts on the date
that you sell the US$
Figure 19.4
NOW
LATER
Buy
futures
Sell
futures
No
action
Sell
dollars
Futures
market
Action:
Dollars
Action:
(b)
(c)
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651
Step 2
Step 3
Hedge outcome
(a)
(b)
The gain or loss on the future will accrue during the contract. For exam
purposes, you will take this gain or loss when the contract is
terminated.
7.4.1 Example: Hedging
A US company buys goods worth 720,000 from a German company, payable in
30 days. The US company wants to hedge against the strengthening against the
dollar.
Current spot is 1 = $0.9215 0.9221 and the futures rate is 0.9245.
The standard size of a three-month futures contract is 125,000.
In 30 days' time, the spot is 0.9345 0.9351. Closing futures price will be 0.9367.
Required
Evaluate the hedge.
Solution
Step 1
Setup
(a)
Which contract?
We assume that the three-month contract is the best available.
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(b)
Type of contract
We need to buy or sell $. As the futures contract is in , we need
to buy futures.
(c)
Number of contracts
720,000
= 5.76, say 6 contracts
125,000
Step 2
Step 3
Hedge outcome
(a)
Net outcome
$
673,272
(9,150)
664,122
In this instance, the risk feared was the risk that the payment
would go up in $ terms, as you needed more $ to buy each that
you needed to pay the European supplier.
The risk has materialised, as in the end you need to pay $0.9351
to buy each rather than $0.9221.
Buying the futures has mitigated this loss because at the end
you can sell them for more than you paid, as have become more
valuable.
CA Sri Lanka
Transaction on
future date
Now
On future date
Receive
currency
Sell
currency futures
Buy
currency futures
Pay
currency
Buy
currency futures
Sell
currency futures
653
Transaction on
future date
Now
On future date
Receive
Buy
currency futures
Sell
currency futures
Pay
Sell
currency futures
Buy
currency futures
(b)
The exact date of receipt or payment of the currency does not have to be
known, because the futures contract does not have to be closed out until the
actual cash receipt or payment is made. In other words, the futures hedge
gives the equivalent of an 'option forward' contract, limited only by the
expiry date of the contract.
(c)
654
(a)
(b)
(c)
(d)
(e)
Using the market will involve various costs, including brokers' fees.
In general, the disadvantages of futures mean that the market is much smaller
than the currency forward market.
QUESTION
Futures
AB plc, a company based in the UK, imports and exports to the US. On 1 May it
signs three agreements, all of which are to be settled on 31 October:
(a)
(b)
(c)
On 1 June the spot rate is 1 = 1.5500 1.5520 $ and the October forward rate is
at a premium of 4.00 3.95 cents per pound. Sterling futures contracts are trading
at the following prices:
Sterling futures (IMM) Contract size 62,500
Contract settlement date
Jun
Sep
Dec
(b)
Demonstrate how a futures hedge could be set up, and calculate the result
of the futures hedge if, by 31 October, the spot market price for dollars has
moved to 1.5800 1.5820 and the sterling futures price has moved to
1.5650.
ANSWER
(a)
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655
Using a forward contract, the sterling cost of the dollar payment will be
669,500/1.5100 = 443,377. The net cash received on October 31 will
therefore be 550,000 443,377 = 106,623.
(b)
Step 1
Setup
(a)
Which contract?
December contracts
(b)
Type of contract
Sell sterling futures in May; we sell the sterling to buy the $
we need.
(c)
Number of contracts
Here we need to convert the dollar payment to , as
contracts are in .
Using December futures price
669,500
= 447,228
1.4970
No of contracts =
Step 2
447,228
= 7.16 contracts (round to 7)
62,500
Step 3
$
1.4970 Sell
1.5650 Buy
0.0680 Loss
Net outcome
Spot market payment
Futures market loss
Translated at closing spot rate
The bank sells low hence we use the
rate of 1.5800
656
$
(669,500)
(29,750)
(699,250)
1.5800
442,563
CA Sri Lanka
8 Currency options
Currency options protect against adverse exchange rate movements while
allowing the investor to take advantage of favourable exchange rate movements.
They are particularly useful in situations where the cash flow is not certain to
occur (eg when tendering for overseas contracts).
8.1 Introduction
A currency option is an agreement involving a right, but not an obligation, to buy
or sell a certain amount of currency at a stated rate of exchange (the exercise
price) at some time in the future.
A forward exchange contract is an agreement to buy or sell a given quantity of
foreign exchange, which must be carried out because it is a binding contract.
However, some exporters might be uncertain about the amount of currency they
will earn in several months' time.
An alternative method of obtaining foreign exchange cover, which overcomes
much of this problem, is the currency option. A currency option does not have
to be exercised. Instead, when the date for exercising the option arrives, the
importer or exporter can either exercise the option or let the option lapse.
The exercise price for the option may be the same as the current spot rate, or it
may be more favourable or less favourable to the option holder than the current
spot rate.
As with other types of option, buying a currency option involves paying a
premium, which is the most the buyer of the option can lose. The level of option
premiums depends on the following factors:
CA Sri Lanka
657
terms, as this will help you to interpret questions and make decisions regarding
different types of options.
Call option the right to buy (the contract currency)
Put option the right to sell (the contract currency)
A call option gives the buyer of the option the right to buy the underlying
currency at a fixed rate of exchange (and the seller of the option would be
required to sell the underlying currency at that rate).
A put option gives the buyer of the option the right to sell the underlying
currency at a fixed rate of exchange (and the seller of the option would be
required to buy the underlying currency at that rate).
Exercise price the price at which the future transaction will take place.
The exercise price is also known as the strike price. It is the price with which the
prevailing spot rate should be compared in order to determine whether the option
should be exercised or not.
In the money where the option strike price is more favourable than the current
spot rate.
At the money where the option strike price is equal to the current spot rate.
Out of the money where the option strike price is less favourable than the
current spot rate.
For example, if a German company holds a call option to purchase Rs with a strike
price of 1 = Rs. 0.9174 and the current spot rate is 1 = Rs. 0.9200, the option is
'out of the money', as the current spot rate is more favourable than the option
strike price.
A European option can only be exercised at the date of expiry.
An American option can be exercised at any date up to and including the date of
expiry.
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CA Sri Lanka
(b)
Solutions
(a)
The spot rate is better than the option rate, therefore the spot rate is used.
This will give a value of $9,230,769 or $9,080,769 after the premium (which
is paid up front).
(b)
The option rate is better than the spot rate, therefore the option will be
exercised. This will give a value of $8,333,333 (or $8,183,333 after the
premium).
(c)
CA Sri Lanka
659
(PHLX). The schedule of prices for /$ options is set out in tables such as the one
shown below.
Philadelphia SE /$ options 31,250 (cents per pound)
Strike price
1.5750
1.5800
1.5900
1.6000
1.6100
1.6200
Aug
2.58
2.14
1.23
0.50
0.15
Calls
Sep
3.13
2.77
2.17
1.61
1.16
0.81
Oct
3.24
2.64
2.16
1.71
1.33
Aug
0.05
0.32
0.93
1.79
Puts
Sep
0.67
0.81
1.06
1.50
2.05
2.65
Oct
1.32
1.71
2.18
2.69
3.30
(b)
(c)
(d)
(e)
Why is a call option exercisable in September more expensive than a call option
exercisable in August but with the same strike price?
This is because there is a longer period until the exercise date and it is
therefore more likely that exercising the option will be beneficial. The
difference also reflects the market's view of the direction in which the
exchange rate is likely to move between the two dates.
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Traded options are standard sizes and are thus 'tradable', which means they
can be sold on to other parties if not required. OTC options are designed for a
specific purpose and are therefore unlikely to be suitable for another party.
(b)
Traded options are more flexible, in that they cover a period of time
(American options), whereas OTC options are fixed date (European options).
OTC options can be agreed for a longer period than the standard two-year
maximum offered by traded options. This gives greater flexibility and
protection from currency movements in the longer term, should the
transaction require it.
(b)
(b)
(c)
(d)
The following table will be helpful to remember when answering exam questions
on currency options.
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661
Transaction on future
date
Now
Option on future
date
Receive
currency
Buy
currency put
Sell
currency
Pay
currency
Buy
currency call
Buy
currency
Receive
Buy
currency call
Buy
currency
Pay
Buy
currency put
Sell
currency
Note that this table only applies to traded options. It would be possible to
purchase a dollar put or call option over the counter.
8.6 Closing out when traded options still have time to run
In practice, most traded options are closed out, like futures contracts, because the
date when the cash is required does not match the option expiry date.
The position with options is equivalent to the position with futures; the expiry
date of options must be on or after the date of the key event. Thus if you were told
a company was receiving a payment on 10 September, and you were given a
choice of using June, September or December options:
You could most likely choose September, as that expires soonest after 10
September (on 30 September)
You could choose December
You would not choose June (as June options expire before 10 September, the
date on which you will receive the payment)
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Step 1
Step 2
(b)
(c)
(d)
(e)
Step 3
(b)
Net outcome
Puts
Strike price
June
July
August
June
July
August
1.4750
6.34
6.37
6.54
0.07
0.19
0.50
1.5000
3.86
4.22
4.59
0.08
0.53
1.03
1.5250
1.58
2.50
2.97
0.18
1.25
1.89
Show how traded currency options can be used to hedge the risk at a strike price
of 1.525. Calculate the sterling cost of the transaction if the spot rate in July is:
(a)
(b)
CA Sri Lanka
1.461.4620
1.611.6120
663
Solutions
Step 1
(b)
(c)
(d)
2,000,0001.525
41.97, say 42 contracts
31,250
(e)
Premium
= 0.0125 31,250 42
= $16,406 1.5350 (to obtain premium in )
= 10,688
Step 3
Outcome
(a)
1.5250
1.46
Yes
1,312,500
1.5250
1.61
No
664
$
2,001,563
2,000,000
1,563
1,563
= 1,071
1.46
CA Sri Lanka
(b)
Net outcome
QUESTION
(1,312,500)
1,071
(10,688)
(1,322,117)
(1,242,236)
(10,688)
(1,252,924)
1 = $1.4600
1 = $1.5000
ANSWER
As the option is an over-the-counter option, it is possible to have a dollar call
option and to cover the exact amount.
(a)
If the exchange rate is 1.4600, the option will be exercised and the cost will
be:
2,000,000
= 1,351,351
1.4800
(b)
If the exchange rate is 1.5000, the option will not be exercised, and the cost
will be:
2,000,000
= 1,333,333
1.5000
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665
QUESTION
Puts
July
August
September
July
August
September
2.55
3.57
4.01
1.25
2.31
2.90
0.7500
0.8000
ANSWER
Step 1
(b)
(c)
(d)
600,000
= 60
10,000
(e)
Step 2
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CA Sri Lanka
Step 3
Outcome
(a)
(b)
0.77
0.75
Yes
600,000
0.77
0.80
No
-
$
(750,000)
Net outcome
Spot market outcome translated at
closing spot rate (600,000/0.80)
Options position (600,000/0.77)
Premium
(779,221)
(21,420)
(800,641)
(21,420)
(771,420)
(b)
9 Currency swaps
Currency swaps effectively involve the exchange of debt from one currency to
another. Currency swaps can provide a hedge against exchange rate movements
for longer periods than the forward market and can be a means of obtaining
finance from new countries.
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667
In a currency swap, the parties agree to swap equivalent amounts of currency for
a period. This effectively involves the exchange of debt from one currency to
another. Liability on the main debt (the principal) is not transferred and the
parties are liable to counterparty risk: if the other party defaults on the
agreement to pay interest, the original borrower remains liable to the lender. In
practice, most currency swaps are conducted between banks and their customers.
An agreement may only be necessary if the swap were for longer than, say, one
year.
9.1.1 Example: Swapping currencies
Consider a US company X with a subsidiary Y in France which owns vineyards.
Assume a spot rate of $1 = 0.7062. Suppose the parent company X wishes to
raise a loan of 1.6 million for the purpose of buying another French wine
company. At the same time, the French subsidiary Y wishes to raise $1 million to
pay for new up-to-date capital equipment imported from the US. The US parent
company X could borrow the $1 million and the French subsidiary Y could borrow
the 1.6 million, each effectively borrowing on the other's behalf. They would then
swap currencies.
Figure 19.5
US
Bank
1 US Co borrows
$1m in US
French
Bank
1 French Co borrows
1.6m in France
US Co
French
Co
Flexibility
Swaps are easy to arrange and are flexible, since they can be arranged in any
size and are reversible.
(b)
Cost
Transaction costs are low, only amounting to legal fees, since there is no
commission or premium to be paid.
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CA Sri Lanka
(c)
Market avoidance
The parties can obtain the currency they require without subjecting
themselves to the uncertainties of the foreign exchange markets.
(d)
Access to finance
The company can gain access to debt finance in another country and
currency where it is little known, and consequently has a poorer credit
rating, than in its home country. It can therefore take advantage of lower
interest rates than it could obtain if it arranged the currency loan itself.
(e)
Financial restructuring
Currency swaps may be used to restructure the currency base of the
company's liabilities. This may be important where the company is trading
overseas and receiving revenues in foreign currencies, but its borrowings
are denominated in the currency of its home country. Currency swaps
therefore provide a means of reducing exchange rate exposure.
(f)
(g)
Liquidity improvement
A currency swap could be used to absorb excess liquidity in one currency
which is not needed immediately, to create funds in another where there is a
need.
(b)
(c)
Sovereign risk
There may be a risk of political disturbances or exchange controls in the
country whose currency is being used for a swap.
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669
(d)
Arrangement fees
Swaps have arrangement fees payable to third parties. Although these may
appear to be cheap, this is because the intermediary accepts no liability for
the swap. (The third party does however suffer some spread risk, as they
warehouse one side of the swap until it is matched with the other, and then
undertake a temporary hedge on the futures market.)
Step 2
Step 3
(a)
(b)
(c)
(d)
At the end of the useful life of the investment, the original payments are
reversed with ET Co paying back the 1 million it originally received and
receiving back from ZRS Co the Rs. 200 million. ET Co uses this
Rs. 200 million to repay the loan it originally received from its UK lender.
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CA Sri Lanka
Given the wide range of financial instruments (both internal and external)
available to companies that are exposed to foreign currency risk, how can an
appropriate strategy be devised that will achieve the objective of reduced
exposure while at the same time keeping costs at an acceptable level and not
damaging the company's relationship with its customers and suppliers?
The following example will give you an idea of how to put together a suitable
strategy while justifying your choice of doing so.
1 month forward
(mid rate)
1.5601
3 months forward
(mid rate)
1.5655
Calls
October
December
2.02
3.00
1.32
n/a
0.84
2.12
Puts
October
December
1.00
2.16
n/a
n/a
2.18
3.14
The treasurer is considering two methods of hedging the risk, forward or option
contracts. Market expectations, based on current published economic forecasts,
are that sterling will appreciate against the US$ over the next three months. The
treasurer thinks the might weaken or at least remain stable against the $. The
treasurer suggests that if options are to be used, one-month options should be
bought at a strike price of 1.57 and three-month options at a strike price of 1.58.
Ignore transaction costs.
Required
(a)
CA Sri Lanka
Recommend, with reasons, the most appropriate method for IOU Inc to
hedge its foreign exchange risk on the two interest payments due in one and
three months' time. Your answer should include appropriate calculations,
using the figures in the question, to support your recommendation and a
671
Assume you are a financial manager with the nationally-owned postal and
telecommunications company in Zorro, a country in Asia. In organisations
such as this, periodic settlements are made between local and foreign
operators. Net receipts or payments are in US$.
Explain the main types of foreign exchange risk exposure that are likely to
affect the organisation, and advise the company on policies it could consider
to reduce exposure to these risks.
Solutions
(a)
(ii)
725,000
= 23.2 contracts. Say, 23 contracts hedging 31,250 23.
31,250
= 718,750, leaving 6,250 to be hedged on forward market.
(v)
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CA Sri Lanka
Outcome
Option will be exercised if dollar weakens to more than $1.57 in .
Exercise 23 contracts @ $1.57
Option outcome 1.57 23 31,250
Option premium
Unhedged amount covered by forward contract 6,250 1.5601
$
1,128,438
9,488
9,751
1,147,677
(ii)
530,000
31,250
(v)
Outcome
Option will be exercised if dollar weakens to more than $1.58 in .
Option outcome 1.58 17 31,250
Option premium
Forward contract receipt 1,250 1.5655
Net payment
$
839,375
11,263
(1,957)
848,681
Recommendation
Options should only be used if it is thought to be a good chance that the
pound will weaken (but protection is still required against its
strengthening). If, as the market believes, the pound is likely to strengthen,
forward contracts will offer better value.
(b)
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673
Economic exposure
This is the risk of an adverse change in the present value of the
organisation's future cash flows as a result of longer-term exchange rate
movements.
Netting off
The Zorro postal and telecommunications company will receive domestic
income in its local currency but will make settlements (net receipts or
payments) with foreign operators in US dollars. It may appear that most of
the currency risk is hedged because dollar payments are balanced against
dollar receipts before settlement. However, although this is a good way of
reducing currency transaction costs, it does not remove currency risk.
Residual risk
Although the foreign transactions are denominated in dollars, the exchange
risk involves all the currencies of the countries with which the company
deals. For example, if money is owed to Germany and the euro has
strengthened against the dollar, then the dollar cost of the transaction has
increased. Also, although all of these transactions are short term, their
combined effect is to expose the company to continuous exchange risk on
many currencies. The company needs a strategy to manage this form of
economic exposure.
Management of currency risk
One way to manage currency risk in this situation is to attempt to match
assets and liabilities in each currency as follows.
(i)
The company needs to examine each country with which it deals and,
having selected those with which it has a material volume of
transactions, determine in each case whether there is a net receipt
or net payment with that country and the average amount of this net
receipt/payment.
(ii)
If for a given country there is normally a net receipt, currency risk can
be hedged by borrowing an amount in that currency equal to the
expected net receipt for the period for which hedging is required, and
converting this amount to the home currency.
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675
CHAPTER ROUNDUP
The spot rate is the rate at which currencies can be exchanged now.
The forward rate is the rate at which currencies will be exchanged on a set future
date.
676
If the forward rate is higher than the spot rate, the currency is quoted at a
discount; if forward rate is lower than the spot rate, the currency is quoted at a
premium.
You may be asked to compare different hedging methods in the exam and
recommend the most appropriate course of action.
Currency swaps effectively involve the exchange of debt from one currency to
another. Currency swaps can provide a hedge against exchange rate movements
for longer periods than the forward market and can be a means of obtaining
finance from new countries.
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677
PROGRESS TEST
Fill in the boxes in the diagram with (A) to (E), to indicate which factors are linked
by which theory.
(A)
(B)
(C)
(D)
(E)
Difference in
interest rates
(1)
(2)
(3)
(4)
(5)
Expected change
in spot rate
Difference between
forward/spot
rates
(b)
678
Difference in
expected inflation
Now
On future date
Receive
currency
currency futures
currency futures
Pay
currency
currency futures
currency futures
Receive
currency futures
currency futures
Pay
currency futures
currency futures
CA Sri Lanka
Now
Receive
currency
currency put
currency
Pay
currency
currency call
currency
Receive
currency call
currency
Pay
currency put
currency
What are the main factors affecting the level of option premiums?
10
11
12
TB Co, an American company, plans to use a money market hedge to hedge its
payment of 4,000,000 for Spanish goods in one year. The US interest rate is 6%
and the euro interest rate is 4%. The spot exchange rate is US$1 = 1.46, while the
one year forward rate is US$1 = 1.46. Determine the amount of US$ needed if a
money market hedge is used.
13
CA Sri Lanka
Buy forward
Buy futures
Buy call
679
0.007985
0.008250
Illustrate how KYT might hedge its foreign exchange risk using currency futures.
15
Explain the meaning of basis risk and show what basis risk is involved in the
proposed hedge.
16
Assuming the spot exchange rate is 120 yen/$ on 1 September and that basis risk
decreases steadily in a linear manner, calculate what the result of the hedge is
expected to be. Briefly discuss why this result might not occur. Margin
requirements and taxation may be ignored.
17 The KYT business plan for the next five years shows a significant increase in
business with Japan. The general manager tells you that the operations director is
presenting the business case for setting up a wholly owned subsidiary in Japan. To
that end, he has asked you to prepare a paper, to be presented at the board
meeting, explaining the foreign exchange exposure risks which would result from
such an investment.
In particular, he tells you he would like to explain transaction and translation
exposure, as he has heard that translation exposure risk is only a book entry and
not a 'real cost' and so can be ignored.
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CA Sri Lanka
The bank is buying the currency, therefore the bid price of HK$7.7425 is relevant
(remember than the exporter will always pay the higher price). The exporter will
receive:
HK$400,000/7.7425 = $51,662.90
(a)
(b)
(c)
(d)
(e)
(f)
Market sentiment
Speculation
Government policy
(1)
(2)
(3)
(4)
(5)
C
E
D
A
B
(a)
(b)
Fisher effect
Interest rate parity
International Fisher effect
Purchasing power parity
Expectations theory
5
Transaction on future
date
Now
On future date
Receive
currency
Sell
currency futures
Buy
currency futures
Pay
currency
Buy
currency futures
Sell
currency futures
Receive
Buy
currency futures
Sell
currency futures
Pay
Sell
currency futures
Buy
currency futures
CA Sri Lanka
Transaction on future
date
Now
Receive
currency
Buy
currency put
Sell
currency
Pay
currency
Buy
currency call
Buy
currency
Receive
Buy
currency call
Buy
currency
Pay
Buy
currency put
Sell
currency
681
A settlement date is the date when trading on a futures contract stops and all
accounts are settled.
10
11
True
12
Exercise price
Maturity of option
Volatility of exchange/interest rates
Interest rate differentials
4,000,000
= 3,846,154
1+0.04
The most appropriate strategy is to buy a call option which will expire in three
months. If the bid is successful, T Co can use the option to purchase the euros
needed. Even if the bid is not accepted, it will still exercise the option if the euro
spot rate exceeds the exercise price and sell the euros in the open market.
14
15
Basis risk arises from the fact that the price of a futures contract may not move as
expected in relation to the value of the instrument being hedged. Basis changes do
occur and thus represent potential profits/losses to investors. Typically, this risk
is much smaller than the risk of remaining unhedged.
Basis risk is the difference between the spot and futures prices.
Spot price = 1/128.15
= 0.007803
Basis = 0.007803 0.007985 = 182 ticks with 3 months to expiry
Basis with one month to expiry, assuming uniform reduction = 1/3 182 = 61 ticks
Spot price on 1 Sept = 1/120 = 0.008333
Therefore predicted futures price = 0.008333 + 0.000061 = 0.008394
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CA Sri Lanka
16
Outcome
Futures market
Opening futures price
Closing futures price
Movement in ticks
0.007985
0.008394
409 ticks
$
(1,166,667)
56,238
(1,110,429)
Hedge efficiency
56,238
= 76%
74,197
This hedge is not perfect because there is not an exact match between the
exposure and the number of contracts, and because the spot price has moved
more than the futures price due to the reduction in basis. The actual outcome is
likely to differ since basis risk does not decline uniformly in the real world.
17
Transaction risk
This is the risk of adverse exchange rate movements occurring in the course
of normal trading transactions. This would typically arise as a result of
exchange rate fluctuations between the date when the price is agreed and
the date when the cash is paid.
This form of exposure can give rise to real cash flow gains and losses. It
would be necessary to set up a treasury management function whose role
would be to assess and manage this risk through various hedging techniques.
(ii)
Translation risk
This arises from fluctuations in the exchange rate used to convert any
foreign denominated assets or liabilities, or foreign denominated income or
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683
expenses when reporting back to the head office and thereby impacting on
the investment performance.
This type of risk has no direct cash flow implications, as they typically arise
when the results of the subsidiary denominated in a foreign currency are
translated into the home currency for consolidation purposes. Although
there is no direct impact on cash flows, it could influence investors' and
lenders' attitudes to the financial worth and creditworthiness of the
company. Given that translation risk is effectively an accounting measure
and not reflected in actual cash flows, normal hedging techniques are not
normally relevant. However, given the possible impact the translated results
have on the overall group's performance and the possible influence on any
potential investment decision-making process, it is imperative that such
risks are reduced by balancing assets and liabilities as far as possible.
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CHAPTER
INTRODUCTION
This chapter continues our discussion and application of derivatives this time focusing on
interest rate hedging. In times of volatile interest rates, companies borrowing large sums of
money may wish to hedge against adverse movements in interest rates that could have a
significant effect on the level of interest payments. Similarly, companies lending large sums of
money may wish to hedge against interest rates falling, which will have an adverse effect on
interest received.
In this chapter we focus on the different types of interest rate derivatives, their characteristics
and how they work. It is important to know how to apply these instruments in particular
scenarios and also to recommend the best instrument for that scenario. Make sure you are
familiar with the advantages and disadvantages of the different instruments for evaluation
purposes.
Knowledge Component
6
Corporate Risk Identification and Management
6.1
Corporate risk
identification
6.2
Corporate risk
management
6.1.1
6.1.2
Discuss various types of risks such as credit risk, interest rate risk, liquidity
risk, foreign exchange risk, price risk, operational risk and reputational risk.
Discuss factors contributing towards each of the above risks.
6.2.1
6.2.2
6.2.3
6.2.4
685
LEARNING OUTCOME
CHAPTER CONTENTS
1 Interest rate risk
6.1.1, 6.1.2
6.2.2
6.2.1
(b)
Minimise any inherent risks, notably invested foreign exchange risk, in the
debts the company owes and is owed
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CA Sri Lanka
Finance term (the longer the term, the more difficult interest rates are
to predict)
(ii)
(b)
Currency of debt
A company can face higher costs if it borrows in a currency for which
exchange rates move adversely against the company's domestic currency.
The treasurer should seek to match the currency of the loan with the
currency of the underlying operations/assets that generate revenue to
pay interest/repay the loans.
(c)
Term of loan
A company can be exposed by having to repay a loan earlier than it can
afford to, resulting in a need to re-borrow, perhaps at a higher rate of
interest.
(d)
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687
(e)
QUESTION
Hedging
ANSWER
Hedging is a means of reducing risk.
Hedging involves coming to an agreement with another party who is prepared to
take on the risk that you would otherwise bear. The other party may be willing to
take on that risk because they would otherwise bear an opposing risk which may
be 'matched' with your risk; alternatively, the other party may be a speculator
who is willing to bear the risk in return for the prospect of making a profit.
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CA Sri Lanka
In the case of interest rates, a company with a variable rate loan clearly faces the
risk that the rate of interest will increase in the future as the result of changing
market conditions which cannot now be predicted.
Many financial instruments have been introduced in recent years to help
corporate treasurers to hedge the risks of interest rate movements. These
instruments include forward rate agreements, financial futures, interest rate
swaps and options.
CASE STUDY
Tate and Lyle noted in its 2011 annual report that: 'The Group has an exposure to
interest rate risk arising principally from changes in US dollar, sterling and euro
interest rates.
'This risk is managed by fixing or capping portions of debt using interest rate
derivatives to achieve a target level of fixed/floating rate net debt, which aims to
optimise net finance expense and reduce volatility in reported earnings.
'The Group's policy is that between 30% and 75% of Group net debt (excluding
the Group's share of joint-venture net debt) is fixed or capped (excluding out-ofthe-money caps) for more than one year and that no interest rate fixings are
undertaken for more than 12 years.
'At 31 March 2011, the longest term of any fixed rate debt held by the Group was
until November 2019. The proportion of net debt at 31 March 2011 that was fixed
or capped for more than one year was 85%.'
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1.4.1 Pooling
Pooling means asking the bank to pool the amounts of all its subsidiaries when
considering interest levels and overdraft limits. It should reduce the interest
payable, stop overdraft limits being breached and allow greater control by the
treasury department. It also gives the company the potential to take advantage of
better rates of interest on larger cash deposits.
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CA Sri Lanka
Important dates
Trade date
The date on which the contract begins (or when the contract
is 'dealt').
Spot date
Fixing date
Settlement date
Maturity date
5%
9%
Solution
(a)
Rs
(50,000)
(250,000)
(300,000)
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691
(b)
At 9% because interest rates have risen, the bank will pay L Co:
FRA receipt Rs. 10 million (9% 6%) 6/12
Payment on underlying loan at market rate 9% Rs. 10 million 6/12
Rs
150,000
(450,000)
(300,000)
Protection provided
An FRA would protect the borrower from adverse interest rate
movements above the rate negotiated.
(b)
Flexibility
FRAs are flexible; they can in theory be arranged for any amounts and any
duration.
(c)
Cost
Forward rate agreements cost little to arrange.
Rate available
The rate the bank will set for the forward rate agreement will reflect
expectations of future interest rate movements. If interest rates are
expected to rise, the bank may set a higher rate than the rate currently
available.
(b)
(c)
Term of FRA
The FRA will terminate on a fixed date.
(d)
Binding agreement
FRAs are binding agreements so are less easy to sell to other parties.
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QUESTION
4%
3%
ANSWER
(a)
The actual base rate is above the FRA rate, therefore the bank will pay the
difference as compensation to ABC that is, 0.25%.
ABC will borrow at the best available rate, which is base rate + 1%, that is
5% (4 + 1).
Net cost to ABC = 5% 0.25% = 4.75%
(b)
As the actual base rate is below the FRA rate, ABC will pay compensation of
0.75% to the bank.
ABC will borrow at the best available rate that is 4% (3 + 1).
Net cost to ABC = 4% + 0.75% = 4.75%
This amounts to 0.0475 3/12 Rs. 4m = Rs. 47,500.
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The futures price is likely to vary with changes in interest rates. This acts as
a hedge against adverse interest rate movements. We will illustrate this in an
example shortly.
(b)
The outlay to buy futures is much less than for buying the financial
instrument itself.
Lenders will wish to hedge against the possibility of falling interest rates by:
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The basis risk can be calculated as the difference between the futures price and
the current price ('cash market' price) of the underlying security.
3.4.1 Example: Basis and basis risk
To give an example, if three-month SLIBOR (the Sri Lankan Inter-Bank Offered
Rate) is 7% and the September price of the three-month sterling future is 92.70
now (at the end of March, say) then the basis is:
SLIBOR (100-7)
Futures
93.00
92.70
0.30 %
Or 30 basis points
1 basis point = 0.01%
= 10m 6/3
1m
Contract size Length of contract
= 20 contracts
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CA Sri Lanka
Closing price
(a)
Futures outcome
At opening rate:
0.91 sell
At closing rate:
0.8850 buy
0.0250 receipt
Futures outcome:
Receipt Size of contract Number of contracts
Length of contract
One year
Net outcome
Rs
(550,000)
125,000
(425,000)
425,000
12/6 = 8.5%
10,000,000
Cost
Amount hedged
Inflexibility of terms
Traded interest rate futures are for fixed periods and cover begins in
March, June, September or December. Contracts are for fixed, large
amounts, so may not entirely match the amount being hedged.
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697
(b)
Basis risk
The company may be liable to the risk that the price of the futures contract
may not move in the expected direction.
(c)
Daily settlement
The company will have to settle daily profits or losses on the contract.
QUESTION
96.00
96.10
96.20
Contracts are assumed to expire at the end of the quoted months. SLIBOR remains
at 3.5% and ABC Co can still borrow at a rate of approximately SLIBOR + 1%.
Required
Assuming that ABC Co takes out a loan at a fixed rate of SLIBOR + 1% at the start
of the loan, assess the outcome of the futures contract if SLIBOR is:
(a)
(b)
ANSWER
The solution to this question takes a slightly different approach from the example
above. Rather than converting into monetary terms at each stage, we leave the
answers in % and convert into money at the end. Either approach is acceptable.
Set up
(a)
(b)
What type? Sell (as ABC is borrowing and rates are expected to rise)
(c)
Loan period
Exposure
(3/3) = 4 contracts
(d)
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CA Sri Lanka
Outcome
Net rate
(a)
(5.00)
(b)
(4.00)
(3.90)
4.10
Profit
0.20
(4.80)
Note the fixed
outcome
(3.90)
3.10
Loss
(0.80)
(4.80)
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(b)
SC Co wishes to borrow Rs. 4 million fixed rate in June for nine months and wishes
to protect itself against rates rising above 6.75%. It is 11 May and the spot rate is
currently 6%. The data is as follows.
Rs. 1,000,000 points of 100%
Effective
interest rate
%
6.75
6.50
6.25
June
0.16
0.05
0.01
Calls
Sept
0.03
0.01
0.01
Dec
0.03
0.01
0.01
June
0.14
0.28
0.49
Puts
Sept
0.92
1.15
1.39
Dec
1.62
1.85
2.10
SC Co negotiates the loan with the bank on 12 June (when the Rs. 4m loan rate is
fixed for the full nine months) and closes out the hedge.
What will be the outcome of the hedge and the effective loan rate if prices on
12 June have moved to:
(a)
(b)
700
7.4%
5.1%
CA Sri Lanka
Solution
Set up
(a)
(b)
What type?
(c)
Strike price
93.25
(d)
How many?
Rs. 4m 9
/3 = 12 contracts
Rs. 1m
(e)
Premium
Contracts premium
Step 2
Step 3
(100 6.75)
Size of contract
12 months
Length of contract
= 12 0.0014
1,000,000
= Rs. 4,200
12
3
Closing prices
(a)
7.4%
(b)
5.1%
Outcome
Options market
outcome
Right to pay interest at
Closing rate
Exercise?
Net position
(a)
(b)
6.75
7.40
Yes
6.75
5.10
No
Rs
Spot (Rs. 4m 9/12
5.1%)
Option (Rs. 4m 9/12
6.75%)
Option premium
Net outcome
Effective interest rate
Rs
153,000
202,500
4,200
206,700
(a)
(206,700/4,000,000)
(12/9)
= 6.89%
4,200
157,200
(b)
(157,200/4,000,000)
(12/9)
= 5.24%
Make sure you read the question carefully to determine whether you have been
told which strike price to use. If you have not been told, you can choose the
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701
exercise price closest to the interest rate for example, if the interest rate is 3%,
then you would choose an exercise price of 97.00.
QUESTION
96000
96250
96500
March
0.120
0.015
0
Calls
June
0.195
0.075
0.085
September
0.270
0.155
0.085
March
0.020
0.165
0.400
Puts
June
0.085
0.255
0.480
September
0.180
0.335
0.555
Required
Assess an option hedge at 3.75%, assuming that the loan is taken out at SLIBOR +
1% and SLIBOR is:
(a) 4%
(b) 3%
ANSWER
Again this solution takes the approach of leaving everything in % and converting
to Rs at the end.
Set up
(a)
Which contract?
June
(b)
What type?
(c)
Strike price
(d)
How many?
Loan period
Exposure
(e)
Premium
Size of contract
12 months
Length of contract
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CA Sri Lanka
Outcome
Options market outcome
Right to pay interest at
Profit/loss on option
Opening position put
Closing position future
(see calculation in
Section 3 Question
'Interest rate futures')
Net outcome
In Rs.
(a)
5.00%
(b)
4.00%
3.75%
4.10%
3.75%
3.10%
0.35% (profit)
Do not exercise
option
4.00 + 0.255
= 4.255%
0.04255 Rs. 4m 3/12
Rs. 42,550
(a)
Upside risk the company has the choice not to exercise the option and will
therefore be able to take advantage of falling interest rates.
(b)
Over the counter options these are tailored to the specific needs of the
company and are therefore more flexible than exchange traded options for a
more exact hedge.
(c)
4.5.2 Disadvantages
(a)
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703
(b)
Collar if the company has a collar, this will limit its ability to take
advantage of lower interest rates to the lower limit set by the cap.
(c)
(d)
704
(a)
A company which has debt at a fixed rate of interest can make a swap so
that it ends up paying interest at a variable rate.
(b)
CA Sri Lanka
COMPANY
B
BANK 1
Loan
at 8.5%
fixed
BANK 2
In this example, company A can use a swap to change from paying interest at a
floating rate of SLIBOR + 1% to one of paying fixed interest of (8.5% + 1%) = 9.5%.
A swap may be arranged with a bank, or a counterparty may be found through a
bank or other financial intermediary. Fees will be payable if a bank is used.
However, a bank may be able to find a counterparty more easily, and may have
access to more counterparties in more markets than if the company seeking
the swap tried to find the counterparty itself.
Swaps are generally terminated by agreeing a settlement interest rate, generally
the current market rate.
Note. A useful approach to adopt in an exam for a swap organised by a bank is to
assume unless told otherwise that the variable interest rate payment is at
SLIBOR.
5.1.1 Example: Interest rate swap
Goodcredit has been given a high credit rating. It can borrow at a fixed rate of
11%, or at a variable interest rate equal to SLIBOR, which also happens to be 11%
at the moment. It would like to borrow at a variable rate.
Secondtier is a company with a lower credit rating, which can borrow at a fixed
rate of 12.5% or at a variable rate of SLIBOR plus 0.5%. It would like to borrow at
a fixed rate.
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705
Solution
Goodcredit
Secondtier
Company wants
Variable
Fixed
(SLIBOR)
(12.5%)
(SLIBOR + 12.5%)
(11%)
(SLIBOR + 0.5%)
(SLIBOR + 11.5%)
Could pay
Potential gain
Split evenly
Expected outcome
Sum total
1%
0.5%
0.5%
(SLIBOR 0.5%)
(12%)
(SLIBOR + 11.5%)
(11%)
(SLIBOR + 0.5%)
(SLIBOR + 11.5%)
(SLIBOR + 0.5%)
SLIBOR + 0.5%
12%
(12%)
(SLIBOR 0.5%)
(12%)
(SLIBOR + 11.5%)
(SLIBOR)
(12.5%)
(SLIBOR + 12.5%)
0.5%
0.5%
1%
Swap terms
12.5 11.5
= 12%
2
The starting point, the 12.5%, is what Secondtier would pay without the swap. The
[(12.5 11.5)/2] is half the gain, half the difference between what Secondtier
would pay and could pay.
The results of the swap are that Goodcredit ends up paying variable rate interest,
but at a lower cost than it could get from a bank, and Secondtier ends up paying
fixed rate interest, also at a lower cost than it could get from investors or a bank.
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Goodcredit
Secondtier
11%
SLIBOR
12.5%
SLIBOR +
0.5%
Difference
%
1.5
0.5
1.0
Goodcredit has a better credit rating than Secondtier in both types of loan market,
but its advantage is comparatively higher in the fixed interest market. The 1%
differential between Goodcredit's advantage in the two types of loan may
represent a market imperfection. Whatever the reason, it represents a potential
gain which can be made out of a swap arrangement. For a gain to happen:
(a)
Each company must borrow in the loan market in which it has comparative
advantage. Goodcredit has the greatest advantage when it borrows fixed
interest. Secondtier has the least disadvantage when it borrows floating rate.
(b)
The parties must actually want interest of the opposite type to that in which
they have comparative advantage. Goodcredit wants floating and Secondtier
wants fixed.
Once the target interest rate for each company has been established, there is an
infinite number of swap arrangements which will produce the same net result.
The example illustrated above is only one of them.
QUESTION
We illustrated above one way in which the swap could work. (Swap fixed 12%,
swap floating SLIBOR + 0.5%).
Required
Identify an alternative arrangement for the swap, based on swapping fixed
interest at 11%.
Goodcredit
Secondtier
Could pay
Swap floating
Swap fixed
Net interest cost
CA Sri Lanka
(11%)
(SLIBOR + 0.5%)
(SLIBOR 0.5%)
(12%)
707
ANSWER
Could pay
Swap floating (Working)
Swap fixed
Net interest cost
Working
Goodcredit
(11%)
(SLIBOR 0.5%)
11%
(SLIBOR 0.5%)
Secondtier
(SLIBOR + 0.5%)
SLIBOR 0.5%
(11%)
(12%)
Given that the gains are split equally, the floating interest swap can be calculated
as:
SLIBOR
12.5 11.5
= SLIBOR 0.5%
2
The starting point, the SLIBOR, is what Goodcredit would pay without the swap.
The 12.5 11.5 is half the gain, half the difference between what Goodcredit
2
would pay and could pay.
(a)
Swaps are flexible, since they can be arranged in any size, and they can be
reversed if necessary. Transaction costs are low, particularly if no
intermediary is used, and are potentially much lower than the costs of
terminating one loan and taking out another.
(b)
Credit ratings
Companies with different credit ratings can borrow in the market that
offers each the best deal and then swap this benefit to reduce the mutual
borrowing costs. This is an example of the principle of comparative
advantage.
(c)
Capital structure
Risk management
Swaps can be used to manage interest rate risk by swapping floating for
fixed rate debt if rates are expected to rise. Swaps can also be used to swap a
variable rate for a fixed rate investment if interest rates are expected to fall.
(e)
Convenience
CA Sri Lanka
(f)
If a company's future cash flows are uncertain, it can use a swap to ensure it
has predictable fixed rate commitments.
5.3.2 Disadvantages
(a)
Additional risk
The swap is subject to counterparty risk; the risk that the other party will
default leaving the first company to bear its obligations. This risk can be
avoided by using an intermediary.
(b)
Lack of liquidity
QUESTION
SM Co wishes to borrow 300 million euros for five years at a floating rate to
finance an investment project in Germany. The cheapest rate at which it can raise
such a loan is euro LIBOR + 0.75%.
The company's bankers have suggested that one of their client companies, Q Co,
would be interested in a swap arrangement. This company needs a fixed interest
loan at 300 million. The cheapest rate at which it can arrange the loan is 10.5%
per annum. It could, however, borrow in euros at the floating rate of euro LIBOR +
1.5%.
SM Co can issue a fixed interest five-year bond at 9% per annum interest. The
banker would charge a swap arrangement fee of 0.15% per year to both parties.
Required
Propose a swap by which both parties can benefit.
CA Sri Lanka
709
ANSWER
Company wants
Would pay (no swap)
Could pay
Commission
Potential gain
(difference between would pay
and could pay commission)
split evenly
Expected outcome
(would pay + potential gain)
Swap terms
Could pay
Swap floating
Swap fixed (Step 4)
Commission
Net paid
Would pay
Gain
SM Co
Floating
(SLIBOR +
0.75%)
(9%)
Q Co
Fixed
(10.5%)
Sum total
(SLIBOR +
11.25%)
(SLIBOR +
10.5%)
(0.3%)
0.45%
(0.15%)
(SLIBOR +
1.5%)
(0.15%)
0.225%
0.225%
(SLIBOR +
0.525%)
(10.275%)
(SLIBOR +
10.8%)
(9%)
(SLIBOR +
1.5%)
SLIBOR +
1.5%
(10.125%)
(0.15%)
(10.275%)
(SLIBOR +
10.5%)
(SLIBOR +
1.5%)
10.125%
(0.15%)
(SLIBOR +
0.525%)
(SLIBOR +
0.75%)
0.225%
(10.5%)
0.225%
(0.3%)
(SLIBOR +
10.8%)
(SLIBOR +
11.25%)
0.45%
Both companies make a net gain of 0.225%. The swap proceeds as follows.
Step 1
Step 2
Step 3
Step 4
Each year, each company pays its own loan interest and swaps the
interest to the counterparty and receives the interest swap from the
counterparty. As shown above, the exact payments between the two
companies will depend on how the gains are to be split.
Here the floating swap is the floating interest Q Co. The fixed interest
swap can be calculated as:
10.5% 11.25 10.5 = 10.125%
2
710
CA Sri Lanka
Step 5
At the end of five years, the loan principals are swapped back and the
companies repay their original loans.
It is 31 December. Octavo needs to borrow Rs. 6 million in three months' time for
a period of six months. For the type of loan finance which Octavo would use, the
rate of interest is currently 13% per year and the corporate treasurer is unwilling
to pay a higher rate.
The treasurer is concerned about possible future fluctuations in interest rates, and
is considering the following possibilities.
(a)
(b)
(c)
Required
Explain briefly how each of these three alternatives might be useful to Octavo.
Solution
Forward rate agreements (FRAs)
Entering into an FRA with a bank will allow the treasurer of Octavo to effectively
lock in an interest rate for the six months of the loan.
This agreement is independent of the loan itself, on which the prevailing rate will
be paid. If the FRA were negotiated to be at a rate of 13%, and the actual interest
rate paid on the loan were higher than this, the bank will pay the difference
between the rate paid and 13% to Octavo.
CA Sri Lanka
711
Conversely, if the interest paid by Octavo turned out to be lower than 13%, they
would have to pay the difference to the bank. Thus the cost to Octavo will be 13%
regardless of movements in actual interest rates.
Interest rate futures
Interest rate futures have the same effect as FRAs, in effectively locking in an
interest rate, but they are standardised in terms of size, duration and terms.
They can be traded on an exchange, and they will generally be closed out
before the maturity date, yielding a profit or loss that is offset against the loss or
profit on the money transaction that is being hedged. So, for example, as Octavo is
concerned about rises in interest rates, the treasurer can sell future contracts
now; if that rate does rise, their value will fall, and they can then be bought at a
lower price, yielding a profit which will compensate for the increase in Octavo's
loan interest cost. If interest rates fall, the lower interest cost of the loan will be
offset by a loss on their futures contracts.
There may not be an exact match between the loan and the future contract
(100% hedge), due to the standardised nature of the contracts, and margin
payments may be required while the futures are still held. Basis risk can also
cause hedge inefficiency.
Interest rate options
Short-term interest rate options give Octavo the opportunity to benefit from
favourable interest rate movements as well as protecting them from the effects
of adverse movements.
They give the holder the right but not the obligation to deal at an agreed interest
rate at a future maturity date. This means that if interest rates rise, the treasurer
would exercise the option, and 'lock in' to the predetermined borrowing rate. If,
however, interest rates fall, then the option would simply lapse, and Octavo would
feel the benefit of lower interest rates.
The main disadvantage of options is that a premium will be payable to the seller of
the option, whether or not it is exercised. This will therefore add to the interest
cost. The treasurer of Octavo will need to consider whether this cost, which can be
quite expensive, is justified by the potential benefits to be gained from favourable
interest rate movements.
712
CA Sri Lanka
Speculation. Derivatives are used for speculation when they are used on
their own and not in conjunction with the underlying instrument. For
example, a long position in a futures contract is a bet that the price of the
underlying instrument will move in a certain direction by a certain date.
Similarly, the writer of a call option bets that the price will not move above a
certain range over a period of time. In both cases, the derivatives position
can result in losses if the price does not move in the anticipated direction.
(b)
Hedging. When derivatives are used for hedging they are always used in
combination with the underlying transaction. The principle of hedging is
that any profits or losses in the cash position will be offset by losses or
profits in the derivatives position. We have seen this in the examples
involving derivatives in this chapter and the previous chapter.
The empirical evidence on the use of derivatives by corporations shows that firms
primarily use derivatives for hedging rather than speculation.
One unresolved issue is why companies need to hedge their risks since investors
can themselves diversify away all risks by including the shares of the company in a
portfolio. Here we review the arguments that have been put forward to explain
the use of hedging. The main arguments are:
CA Sri Lanka
(a)
(b)
(c)
(ii)
713
which have higher priority than equity creates incentives for the firm's
equity holders to under-invest. Hedging reduces the incentive to
under-invest since hedging reduces uncertainty and the risk of loss.
Because firms with more valuable growth opportunities and higher
leverage are more likely to be affected by the underinvestment
problem, these firms are also more likely to hedge.
714
CA Sri Lanka
CHAPTER ROUNDUP
Factors influencing interest rate risk include: fixed rate versus floating rate debt,
and the term of the loan.
Forward rate agreements hedge risk by fixing the interest rate on future
borrowing.
Interest rate futures can be used to hedge against interest rate changes between
the current date and the date at which the interest rate on the lending or
borrowing is set. Borrowers sell futures to hedge against interest rate rises.
Lenders buy futures to hedge against interest rate falls.
CA Sri Lanka
715
PROGRESS TEST
Identify three aspects of a debt in which a company may be exposed to risk from
interest rate movements.
What happens if one party to a interest rate swap defaults on the arrangements to
pay interest?
Under the terms of a swap arrangement, L Co has paid interest at 10%, Dewie at
SLIBOR + 1%.
The parties have swapped floating rate interest at SLIBOR + 1%. What amount of
fixed rate interest do they need to swap for L Co to end up paying net interest of
SLIBOR 0.5%?
Discuss the advantages of hedging with interest rate caps and collars.
The following information relates to questions 8 and 9.
Current futures prices suggest that interest rates are expected to fall during the
next few months. AB Co expects to have Rs. 400 million available for short-term
investment for a period of five months commencing in late October. The company
wishes to protect this short-term investment from a fall in interest rates, but is
concerned about the premium levels of interest rate options. It would also like to
benefit if interest rates were to increase rather than fall. The company's advisers
have suggested the use of a collar option.
Short sterling options (Rs. 500,000), points of 100%
Strike price
95250
95500
95750
Sept
0.040
0.000
0.000
Calls
Dec
0.445
0.280
0.165
Sept
0.040
0.250
0.500
Puts
Dec
0.085
0.170
0.305
SLIBOR is currently 5% and the company can invest short-term at SLIBOR minus
25 basis points.
716
CA Sri Lanka
Assume that it is now early September. The company wishes to receive more than
Rs. 6,750,000 in interest from its investment after paying any option premium.
Illustrate how a collar hedge may be used to achieve this. (Note. It is not necessary
to estimate the number of contracts for this illustration.)
Estimate the maximum interest that could be received with your selected hedge.
The following information relates to questions 10, 11 and 12.
Alecto Co, a large listed company based in Sri Lanka, is expecting to borrow
Rs. 22,000,000 in four months' time on 1 May 2012. It expects to make a full
repayment of the borrowed amount nine months from now. Currently, there is
some uncertainty in the markets, with higher than normal rates of inflation, but an
expectation that the inflation level may soon come down. This has led some
economists to predict a rise in interest rates and others suggesting an unchanged
outlook or maybe even a small fall in interest rates over the next six months.
Although Alecto Co is of the opinion that it is equally likely that interest rates
could increase or fall by 0.5% in four months, it wishes to protect itself from
interest rate fluctuations by using derivatives. The company can borrow at
SLIBOR plus 80 basis points, and SLIBOR is currently 3.3%. The company is
considering using interest rate futures, options on interest rate futures or interest
rate collars as possible hedging choices.
The following information and quotes from an appropriate exchange are provided
on euro futures and options. Margin requirements may be ignored.
Three-month rupee futures, Rs. 1,000,000 contract, tick size 0.01% and tick value
Rs. 25.
March
June
September
96.27
96.16
95.90
Options on three-month Rupee futures, Rs. 1,000,000 contract, tick size 0.01% and
tick value Rs. 25. Option premiums are in annual %.
March
0.279
0.012
Calls
June
0.391
0.090
Strike
September
0.446
0.263
96.00
96.50
March
0.006
0.196
Puts
June
0.163
0.581
September
0.276
0.754
It can be assumed that settlement for both the futures and options contracts is at
the end of the month. It can also be assumed that basis diminishes to zero at
contract maturity at a constant rate and that time intervals can be counted in
months.
10
CA Sri Lanka
Briefly discuss the main advantage and disadvantage of hedging interest rate risk
using an interest rate collar instead of options.
717
718
11
Based on the three hedging choices Alecto Co is considering and assuming that the
company does not face any basis risk, recommend a hedging strategy for the
Rs. 22,000,000 loan. Support your recommendation with appropriate comments
and relevant calculations in Rs.
12
Explain what is meant by basis risk and how it would affect the recommendation
made in Question 11 above.
CA Sri Lanka
Advantages of caps
(i)
(ii)
If interest rates fall, the purchaser of the cap will not exercise the option and
will thus take advantage of the lower interest rates.
Advantages of collars
(i)
CA Sri Lanka
Using a collar, a borrower can buy an interest rate cap (put option) and
sell an interest rate floor (call option) at a lower strike rate. The main
advantage compared with a pure cap is that the cost will be lower, since the
borrower will receive a premium for selling a call option. However, this
advantage is tempered by the borrowing company foregoing the benefit
of movements in interest rates below the floor.
719
(ii)
A collar for a lender would be buying an interest rate floor (call option)
and selling an interest rate cap (put option). The cost again would be
lower than for a one-way option, and the lender would receive a
guaranteed minimum rate of interest. However, the lender would not be
able to enjoy the benefit of receiving interest above the level at which the cap
is set.
To earn Rs. 6.75 million, annual interest rate after premium costs would have to
be:
$6.75million 12
= 4.05%
$400 million 5
Call strike
price
95750
95750
95500
Put strike
price
95500
95250
95250
Interest
rate
%
4.25
4.25
4.50
Less
0.25%
%
(0.25)
(0.25)
(0.25)
Less
call
premium
%
(0.165)
(0.165)
(0.280)
Add
put
premium
%
0.170
0.085
0.085
Net
receipt
%
4.005
3.920
4.055
Of the three, the only combination that guarantees an interest rate above 4.05% is
buying a call option at 95500 and selling a put option at 95250. The minimum
return will be:
Rs. 400,000,000
9
5
4.055% = Rs. 6,758,333
12
The maximum interest rate that is possible under the selected hedge is 4.75%,
equivalent to the put option exercise price of 95250. AB Co will not have exercised
its option, but taken advantage of the rate being above 4.5%.
Net return = 4.75 0.25 0.280 + 0.085 = 4.305%.
Maximum return = Rs. 400,000,000
10
5
4.305% = Rs. 7,175,000.
12
An interest rate collar involves the purchase of a put option and the
simultaneous selling of a call option at different exercise prices. The main
advantage is that it is cheaper than just purchasing the put option. This is because
the premium received from selling the call option reduces the higher premium
payable for the put option.
The main disadvantage is that the benefit from any upside movement in interest
rates is capped by the sale of the call option. With just the put option, the full
upside benefit would be realised.
720
CA Sri Lanka
11
Futures
Cost of borrowing
Expected futures
price
Gain/loss on futures
market
Net cost
Effective interest
rate
The difference in interest rates comes from the rounding of the contracts.
Using options on futures
As Alecto is looking to protect against a rise in interest rates, it needs to buy June
put options. As before, 37 contracts are needed.
Interest rates
Put option exercise price
June futures price
Exercise option?
Gain
Increase to 3.8%
4%
3.5%
3.98%
3.98%
No
Yes
0.48%
Decrease to 2.8%
4%
3.5%
2.98%
2.98%
No
No
-
%
(4.60)
(0.16)
(4.76)
%
(3.60)
(0.16)
(3.76)
%
(4.60)
0.48
(0.58)
(4.70)
%
(3.60)
(0.58)
(4.18)
Using a collar
Buy June put at 96.00 for 0.163 and sell June call at 96.50 for 0.090. Net premium
payable = 0.073. As before, 37 contracts are required.
CA Sri Lanka
721
Buy put
4%
3.98%
No
Sell call
3.5%
3.98%
No
%
(4.60)
(0.07)
(4.67)
Buy put
4%
2.98%
No
Sell call
3.5%
2.98%
Yes
%
(3.60)
(0.52)
(0.07)
(4.19)
If the interest rate futures market is used, the interest cost will be fixed at 4.47%,
but if options on futures or an interest rate collar is used, the cost will change. If
interest rates were to fall, then the options hedge gives the more favourable rates.
However, if interest rates rise, then the futures hedge gives the lowest interest
cost and the options hedge has the highest cost. If Alecto wants to fix its interest
rate irrespective of the circumstances, then the futures hedge should be selected.
This recommendation does not include margin payments or other transaction
costs, which should be considered in full before a final decision is made.
12
722
Basis risk arises from the fact the price of a futures contract may not move as
expected in relation to the value of the instrument being hedged. Basis changes do
occur and thus represent potential profits/losses to investors. Basis risk is the
difference between the spot and futures prices and so there is no basis risk
where a futures contract is held until maturity. In this case, however, the June
contracts are closed two months before expiry and there is no guarantee that the
price of the futures contract will be the same as the predicted price calculated by
basis at that date. It is assumed that the unexpired basis above is 0.18 but it could
be either more or less.
CA Sri Lanka
This creates a problem in that the futures contract, which in theory gives a fixed
interest cost, may vary and therefore the amount of interest is not fixed or
predictable. Typically, this risk is much smaller than the risk of remaining
unhedged and therefore the impact of this risk is smaller and preferable to not
hedging at all.
CA Sri Lanka
723
724
CA Sri Lanka
Appendix
726
CA Sri Lanka
Appendix
(x )
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
2.0
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
3.0
3.1
3.2
3.3
CA Sri Lanka
0.00
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
0.09
.0000
.0398
.0793
.1179
.1554
.1915
.2257
.2580
.2881
.3159
.3413
.3643
.3849
.4032
.4192
.4332
.4452
.4554
.4641
.4713
.4772
.4821
.4861
.4893
.4918
.4938
.4953
.4965
.4974
.4981
.4987
.4990
.4993
.4995
.0040
.0438
.0832
.1217
.1591
.1950
.2291
.2611
.2910
.3186
.3438
.3665
.3869
.4049
.4207
.4345
.4463
.4564
.4649
.4719
.4778
.4826
.4864
.4896
.4920
.4940
.4955
.4966
.4975
.4982
.4987
.4991
.4993
.4995
.0080
.0478
.0871
.1255
.1628
.1985
.2324
.2642
.2939
.3212
.3461
.3686
.3888
.4066
.4222
.4357
.4474
.4573
.4656
.4726
.4783
.4830
.4868
.4898
.4922
.4941
.4956
.4967
.4976
.4982
.4987
.4991
.4994
.4995
.0120
.0517
.0910
.1293
.1664
.2019
.2357
.2673
.2967
.3238
.3485
.3708
.3907
.4082
.4236
.4370
.4484
.4582
.4664
.4732
.4788
.4834
.4871
.4901
.4925
.4943
.4957
.4968
.4977
.4983
.4988
.4991
.4994
.4996
.0160
.0557
.0948
.1331
.1700
.2054
.2389
.2704
.2995
.3264
.3508
.3729
.3925
.4099
.4251
.4382
.4495
.4591
.4671
.4738
.4793
.4838
.4875
.4904
.4927
.4945
.4959
.4969
.4977
.4984
.4988
.4992
.4994
.4996
.0199
.0596
.0987
.1368
.1736
.2088
.2422
.2734
.3023
.3289
.3531
.3749
.3944
.4115
.4265
.4394
.4505
.4599
.4678
.4744
.4798
.4842
.4878
.4906
.4929
.4946
.4960
.4970
.4978
.4984
.4989
.4992
.4994
.4996
.0239
.0636
.1026
.1406
.1772
.2123
.2454
.2764
.3051
.3315
.3554
.3770
.3962
.4131
.4279
.4406
.4515
.4608
.4686
.4750
.4803
.4846
.4881
.4909
.4931
.4948
.4961
.4971
.4979
.4985
.4989
.4992
.4994
.4996
.0279
.0675
.1064
.1443
.1808
.2157
.2486
.2794
.3078
.3340
.3577
.3790
.3980
.4147
.4292
.4418
.4525
.4616
.4693
.4756
.4808
.4850
.4884
.4911
.4932
.4949
.4962
.4972
.4979
.4985
.4989
.4992
.4995
.4996
.0319
.0714
.1103
.1480
.1844
.2190
.2517
.2823
.3106
.3365
.3599
.3810
.3997
.4162
.4306
.4429
.4535
.4625
.4699
.4761
.4812
.4854
.4887
.4913
.4934
.4951
.4963
.4973
.4980
.4986
.4990
.4993
.4995
.4996
.0359
.0753
.1141
.1517
.1879
.2224
.2549
.2852
.3133
.3389
.3621
.3830
.4015
.4177
.4319
.4441
.4545
.4633
.4706
.4767
.4817
.4857
.4890
.4916
.4936
.4952
.4964
.4974
.4981
.4986
.4990
.4993
.4995
.4997
727
Appendix
3.4
3.5
.4997 .4997 .4997 .4997 .4997 .4997 .4997 .4997 .4997 .4998
.4998
This table can be used to calculate N(d1), the cumulative normal distribution
functions needed for the Black-Scholes model of option pricing. If d1>0, add 0.5 to
the relevant number above. If d1<0, subtract the relevant number above from 0.5.
728
CA Sri Lanka
Index
730
CA Sri Lanka
Index
A
A score, 545, 551
Abandon, 411
Abandonment option, 411, 413
Accelerating payments, 627
Accounting rate of return (ARR), 328
Accounting rate of return (ARR)
method of share valuation, 448
Accounting risks, 594
Acid test, 67
Acquisition, 487
Acquisition using bonds, 498
Actuarial method, 198
Adjusted payback, 359
Adjusted present value (APV), 414
Advance fee fraud, 593
Advantages of a stock market listing,
146
Agency costs, 261
Agency problem, 18
Agency theory, 18, 31
Aggressive, 103
Aggressive working capital
management, 103
Allocative efficiency, 309
Alpha value, 236
Altman, 543
American option, 658
Annualised cost, 407
Appreciating, 384
Arbitrage, 270
Argenti, 543, 545, 551
Argenti's A score, 545
Ask price, 624
Assessing creditworthiness, 116
Assessment of investment, 360
Asset replacement, 408
Asset turnover, 66
Asset valuation bases, 439
At the money, 658
Average inventory, 109
B
Bad debt risk, 124
CA Sri Lanka
C
C S Jones, 515
Calculated intangible value, 474, 475
Call, 661, 700
Call option, 658, 700
Capital asset pricing model (CAPM),
230
Capital investment appraisal, 327
Capital market participants, 145
Capital markets, 144
Capital rationing, 400, 406
Capital structure, 260, 466
Capital structure decision, 260
Capital structure in the real world,
273
731
Index
Conservative, 103
Conservative working capital
management, 103
Constraints on financial strategy, 30
Consumer Affairs Authority, 514
Consumer Affairs Authority Act, 514
Consumer Affairs Council, 514
Contesting an offer, 492
Contingency funding, 92
Contingency planning, 600
Controlling phase, 327
Conversion premium, 181
Conversion value, 181
Convertible bonds, 181, 497
Convertible debt, 181
Corporate decline, 536
Corporate governance, 19, 32
Corporate memory, 541
Cost centre, 605
Cost of capital, 222, 330, 453
Cost of debt, 238
Cost of equity, 224, 225
Cost of ordinary share capital, 224
Cost of preference shares, 229
Counter currency, 624
Counter-bid, 493
Counterparty risk, 668
Counterpurchase, 378
Countertrade, 131, 378
Country risks, 380
Coupon, 173
Coupon swaps, 704
Covariance, 598
Credit control, 115
Credit default swaps, 610
Credit enhancement, 610
Credit guarantees, 610
Credit insurance, 125
Credit rating, 31, 117
Credit risks, 591
Credit triggers, 610
Credit utilisation report, 117
Credit-linked notes, 610
Creditors, 132
Creditworthiness, 116, 173
Crisis, 539
Crisis stabilisation, 563
CA Sri Lanka
Index
D
Debenture, 174
Debt and gearing, 66
Debt capacity, 420
Debt capital and taxation, 241
Debt collection policy, 121
Debt portfolio, 686
Debt ratio, 66
Debt:equity, 66
Debt-equity swaps, 569
Decentralised cash management, 51
Decision trees, 357
Decline, 560
Declining companies, 538
Declining industries, 536
Deep discount bond, 175
Defects, 545
Defensive tactics, 492
Defining phase, 324
Degearing betas, 276
Delaying payments, 627
Delphi method, 601
Demerger, 519
Depreciating currencies, 384
Derivative, 645
Design and development, 326
Devising a foreign currency hedging
strategy, 670
Dilution, 153, 504
Direct benefits, 323
Direct financial distress costs, 261
Direct quote, 623
Disadvantages of a stock market
listing, 146
Disadvantages of debt, 261
CA Sri Lanka
E
Early settlement discounts, 122
Earnings growth, 446
Earnings per share (EPS), 68
Earnings valuation bases, 442
Earnings yield, 69, 447
Earnings yield valuation, 447
Earn-out arrangement, 500
Economic constraints, 36
Economic exposure, 622
Economic order quantity (EOQ),
106
Economic risk, 592, 622
Economic value added, 457
Edward Altman, 543
Efficient market hypothesis, 309
733
Index
Endgame, 537
Environmental analysis, 552
EPS before and after a takeover, 501
Equity, 306
Equity share capital, 306
Equivalent annual annuity, 410
Equivalent annual cost, 407
Eurobond, 186, 187
Eurocredits, 187
Eurocurrency, 186
Eurodollars, 186
Euromarkets, 186
European option, 658
EVA, 457
Ex div, 224
Ex rights, 156
Excess return, 475
Exchange controls, 629
Exchange rate, 43, 623
Exchange-traded options, 659, 700
Exercise price, 658
Exit strategies, 519
Expectations, 41
Expectations of inflation, 342
Expectations of interest rate
movements, 687
Expected cash flows, 354, 598
Expected value, 597
Export credit insurance, 131
Exporting, 378
Extracting profits, 376
F
Factoring, 126
Factors influencing dividend policy,
292
Failure and effects analysis, 601
Failure of mergers and takeovers, 517
Failure to satisfy a forward contract,
633
Fair Trade Commission Act, 514
Fault and event analysis, 601
FDI, 374, 378
Feasibility and fact finding, 326
Feedback failure, 540
Finance lease, 197
Financial distress costs, 261
734
Index
G
Geared betas, 275
Gearing, 164, 260, 262, 293, 445
Gearing and ungearing betas, 471
Gearing ratios, 264
Gilts, 144
Goal congruence, 19
Going concern valuation, 441
Going private, 164, 522, 571
Goodwill, 473
Gordon's growth approximation, 229
Government securities, 144
Growth, 558
Growth rate, 227
H
Haldeman and Narayanan, 551
Hard capital rationing, 401
Hedge efficiency, 647
Hedging, 609, 713
Hedging foreign currency receipts,
638
Hedging payments, 635
Hedging with FRAs, 690
Hire purchase, 202
Historic basis, 441
Historic growth, 227
Horizontal integration, 487
H-score, 542
I
Icarus paradox, 541
Impact of legislation, 32
Impact of mergers and takeovers on
stakeholders, 518
CA Sri Lanka
Implementation, 326
Implementing phase, 326
Implications of efficient market
hypothesis, 311
Importance of leadership, 556
In the money, 658
Income risks, 594
Indirect financial distress costs, 261
Indirect quote, 623
Indivisible projects, 401
Industry regulators, 33
Inflation, 36, 340, 383
Information processing efficiency, 309
Informational processing efficiency,
309
Inherent risk, 230
Initial margin, 648
Initial public offer (IPO), 147
Insolvency legislation, 437
Institutional investors, 145
Intangible assets, 472, 473
Intangible benefits, 323
Integration sequence, 515
Intellectual capital, 472, 473
Interest cover, 66, 266
Interest rate futures, 693, 694, 712
Interest rate option, 699
Interest rate options, 712
Interest rate parity, 385
Interest rate risk, 686
Interest rate risk management, 688
Interest rate swap, 704, 705
Interest rates, 37
Internal hedging techniques, 626
Internal netting, 609
Internal rate of return (IRR), 239, 342
Internal strategies, 609
International borrowing, 186
International debt finance, 186
International diversification, 608
International Fisher effect, 386
International investment, 374
International investment appraisal,
383
Introduction, 150, 558
Inventory days, 67
Invest overseas, 374
735
Index
J
Johnson, Scholes and Whittington,
554
Joint venture, 375, 406
Jones's Integration Sequence, 515
Just-in-time procurement, 112
K
Kami, 557
L
Lagging, 627
LBO, 571
Lead payments, 642
Leading, 627
Leading and lagging, 91, 627
Lease or buy, 204
Lease or buy decisions, 204
Leasing, 196
Legislation, 32
Lessee, 197
Lessor, 197
Leverage, 66
Leveraged buyouts (LBO), 570, 571
Leveraged recapitalisations, 569
Licensing, 378
Life cycle, 293
Limiting factor, 400
Liquidations, 521
Liquidity, 67, 293
Liquidity ratios, 543
Liquidity risks, 590
Litigation risk, 380
736
Loan, 377
Loan guarantee schemes, 189
London international financial futures
and options exchange (LIFFE), 645
Long-term debt, 173
Loss of goods in transit, 381
M
Management buyout (MBO), 172,
493, 522
Management charges, 377
Management fraud, 593
Managing accounts payable, 132
Managing accounts receivable, 114
Managing foreign accounts payable,
134
Manipulation of accounts, 593
Marginal cost of capital, 246
Margins, 648
Market capitalisation, 475
Market efficiency, 466
Market response to financial
reconstruction, 572
Market risk, 230, 591
Market risk premium, 234
Market segmentation theory, 41
Market transactions method, 477
Market valuation or capitalisation,
443
Market value, 5, 264, 306
Market value added, 459
Marketability, 163
Market-to-book values, 474
Marking to market, 648, 649
Matching, 186, 689
Matching receipts and payments, 629
Maturity, 559
Maturity date, 691
Maturity matching, 135
Maximum inventory level, 109
MBO, 522
Measurement risks, 594
Medium-term finance, 172
Merger, 442, 486
Mergers and takeovers, 466, 486
Merging systems, 516
Methods of obtaining a listing, 146
CA Sri Lanka
Index
N
Negative risks, 585
Negotiated options, 658
Net assets method of share valuation,
439
Net assets per share, 69
Net operating income, 270, 469
Net operating income approach, 469
Net present value, 329
Netting, 629, 689
Nominal rates of interest, 37
Nominal value, 306
Non-annual cash flows, 332
Non-divisible projects, 401, 403
Non-financial objectives, 9
Non-quoted company, 5
Non-systematic risk, 230
Not-for-profit organisations, 19
NPV layout, 334
NPV or IRR, 344
Number of contracts, 662
O
Objectives, 4
CA Sri Lanka
P
P F Drucker, 515
P/E ratio, 69
P/E ratio (earnings) method of
valuation, 442
Paper bid, 494
Paper offer, 498
Parallel loans, 630
Particular risks, 585
PAS, 542
Payables days, 67
Payables payment period, 67
Payback method, 329
Payback period, 329
Pecking order theory, 296
Penetration pricing, 558
Performance analysis, 62
Performance analysis score, 542
Performance management systems,
565
Performance related pay, 19
737
Index
PESTEL, 552
Placing, 149
Planning phase, 325
Poison-pill, 493
Political risk, 380, 592
Pooling, 689, 690
Portfolio, 230
Portfolio reconstruction, 568
Position analysis, 326
Position limits, 609
Positive NPV, 330
Post audit, 361
Post-acquisition integration, 514, 515
Post-completion audit, 359, 361
Predicting business failure, 536
Preference shares, 153
Premium, 657
Premium for business risk, 223
Premium profits method, 476
Present value of future free cash flows
model, 453
Price skimming, 558
Pricing shares, 151
Pricing shares for a stock market
launch, 151
Primary markets, 144
Prior charge capital, 153
Private equity, 152
Probability analysis, 354
Probability distribution, 598
Problems with applying the CAPM in
practice, 236
Process risk, 589
Process specialisation, 375
Product life cycle, 557, 558
Product revitalisation, 537
Profit centre, 605
Profit centre approach, 606
Profit margin, 66
Profit maximisation, 4
Profitability and return, 64
Profitability index, 402
Project phases and stages, 324
Project specific cost of capital, 274
Project success factors, 323
Pros and cons of qualitative models,
552
738
Q
Quantitative models measuring
business failure, 542
Quantity discounts, 110
Question mark, 562
Quick ratio, 67
Quotation of forward rates, 632
R
Random walk theory, 307, 308
Ratio analysis, 62
Rational, 310
Real options, 410
Real rate of return, 340
Real rates of interest, 37
Realisable basis, 441
Receivables collection period, 67
Receivables days, 67
Reconstruction schemes, 566
Reconstruction schemes for value
creation, 567
Redeemable debt, 239
Redeemable debt capital, 239
Redemption, 176
Redemption of bonds, 176
Redemption yield, 177
Reduce interest costs, 704
Reference currency, 624
Regulation of takeovers, 512
Regulatory bodies, 32
Reinvestment assumption, 346
Relevant costs, 329
Relief from royalties method, 476
Remittance controls, 382
Re-order level, 107
Replacement basis, 441
Residual theory, 295
Restrictions on remittances, 629
CA Sri Lanka
Index
S
Sale and leaseback arrangements, 202
Scenario building, 600
Scrip dividend, 162, 298
Scrip issue, 163
SEC, 512
Secondary markets, 144
Securities and exchange commission
(SEC), 144
Securitisation, 180, 610
Security, 174, 442
Sell-offs, 520
Semi-strong form efficiency, 310, 466
Sensitivity analysis, 89, 349, 595
Settlement date, 691
Settlement discount, 122
Share buyback, 164
Share exchange, 495
Share options, 19
CA Sri Lanka
Share price, 5
Share price behaviour, 307
Share repurchase, 164
Share splits, 163
Share valuation and change in capital
structure, 466
Share warrants, 185
Shareholder investor ratios, 68
Shareholder value, 454
Shareholder value analysis, 454
Shareholders, 292
Shark repellent, 493
Short-term financial strategy, 102
Short-term sources of funding, 134
Short-term targets, 6
Short-termism, 151
Signalling effect, 293
Simulation, 600
Simulation models, 357
Single period capital rationing with
non-divisible projects, 404
Single period rationing, 401
Slatter, 539
Small- and medium-sized entities, 189
Smoothing, 689
Soft capital rationing, 400
Spare debt capacity, 420
Speculation, 605, 713
Speculative risks, 585
Spin-offs, 521
Spot exchange rate, 623
Spread, 626
Sri Lanka Securities and Exchange
Commission, 512
Stakeholder analysis, 564
Stakeholder groups, 564
Stakeholders, 16, 518, 564
Start-up investments, 375
Statement of financial position based
forecasts, 73
Stock market, 5, 144
Stock market launch, 151
Strategic approach to takeovers, 488
Strategic drift, 541, 554
Strategic failure, 541
Strategic financial management, 4
Strategic fit, 488
739
Index
T
Takeover, 436, 486
Takeover decision, 490
Takeovers and mergers code, 512
Takeovers by share exchange, 145
Target market segments, 564
Targets, 5
Tax allowable depreciation, 336, 337
Tax exhaustion, 274
Tax implications of international
investment, 381
Tax relief on interest, 241
Tax shield, 30, 417, 469
Taxation, 336, 381
Technical analysis, 307, 308
Teeming and lading, 592
Ten Commandments, 557
Term currency, 624
Term loans, 172
Term structure of interest rates, 40
Term to maturity, 40
Theoretical ex-rights price, 155
Theories of capital structure, 268
Tick value, 646
Ticks, 646
Tie-breaker clauses, 382
Timing option, 411
Tobin's 'q', 474, 475
Total return swaps, 610
Total shareholder return, 69
Trade accounts payable, 132
740
U
Uncertainty, 348
Underwriting, 150, 187
Ungeared betas, 275
Unlisted companies, 471
Unquoted company, 445, 492
Unsystematic risk, 230
V
Valuation of individual intangible
assets, 476
Valuation of intangibles, 473
Valuation of mergers and takeovers,
501
Valuation of redeemable debt, 176
Valuation prior to flotation, 471
Valuation using post-merger
dividends or cash flows, 505
Valuations, 436
Value at risk, 598
Value drivers, 455
Value for money, 20
Value of rights, 157
Valuing real options, 412
Variation margin, 648
Venture capital, 151, 524
Venture capitalist, 524
Vertical integration, 487
Vetting, 609
CA Sri Lanka
Index
VFM, 20
View of WACC, 270
W
WACC, 243
Wait, 411
Wait option, 412
Warrant, 173, 185
Weak form efficiency, 310
Weighted average cost of capital,
242, 243
White knight, 493
Withholding tax, 382
Working capital, 334
Working capital cycle, 104
CA Sri Lanka
Y
Yield adjusted ex-rights price, 157
Yield curve, 40
Yield to maturity, 177
Z
Z score, 542
Zero coupon bond, 175
ZETA score model (Altman et al), 551
Z-scores, 543, 549
741
Index
742
CA Sri Lanka