Corprate Finance BBM 312

Compiled by Allan Simiyu for BBM 312 Students only
CHAPTER ONE INTRODUCTION

1.1 Introduction Whether a business concern is big or small, it needs finance to fulfill its business activities. Finance may be defined as the art and science of managing money. According to Oxford dictionary, the word finance connotes management of money. Websters Ninth New Collegiate Dictionary defines finance as the Science on study of the management of funds and the management of funds as the system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking facilities. Therefore, Finance is defined as the procurement of funds and their effective utilization in business concerns. The concept of finance includes capital, funds, money, and amount. But each word has a unique meaning. Studying and understanding the concept of finance become has an important part of the business concern. 1.2 Corporate Finance Financial Management or corporate finance, deals with procurement of funds and their effective utilization in the business entities. Financial management is the broadest of the three areas of finance and is important in all types of businesses including banks, financial institutions, industrial concerns, and retail firms, governmental institutions such as schools, hospitals and even local governmental departments. Corporate finance is concerned with budgeting, financial forecasting, cash management, credit administration, and investment analysis and fund procurement of the business concern. Other areas of finance include: a) Investments- focus on behaviour of financial markets and the pricing of securities. b) Financial Institutions - They deal with banks and other firms that specialize in bringing the suppliers of funds together with the users of funds. 1.3 Financial Management Decisions The financial manager makes decisions relating to financial objectives. These decisions include the following: 1.3.1 Investment Decision Capital budgeting decisions Every business has to decide where to allocate scarce resources. Put more prosaically, every business has to look at its available investment opportunities and decide whether to make the investment or not. In making this decision, firms have to grapple with two basic issues. The first is the rate of return that they need to make on an investment, given its risk, for it to be a good investment. The second is how to measure returns on investments, especially when the cash flows on these investments are different from accounting earnings and vary over time. In other words, the manger has to consider size, timing and risk of future cash flows 1.3.2 Financing Decisions Capital structure decisions This function is mainly concerned with determination of optimum capital structure of the company keeping in mind cost, control and risk. Generally this is a Procurement of Funds function since investments in assets must be financed somehow. Financial management is also concerned with the management of short-term funds and with how funds can be raised over the long term. There are two ways in which any business can raise financing. It can use the owners funds (equity) or it can borrow
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money (debt). Every business has to consider whether the mix of debt and equity that it uses to fund investments is in fact the right one. The financing decision examines whether the firms existing mix of debt and equity is the right one. Firms also have to pick from a variety of different financing choices short term versus long term debt, fixed rate versus floating rate debt- and determine what type of financing is best suited for them. Owners equity is less risky source but it leads to dilution of ownership of current shareholders but debt finance though cheap, exposes the company to risk of liquidation or takeover in case it fails to pay interest on such loans. 1.3.3 Dividend Decision After firms make investments with their chosen financing mix, the investments generate cash flows. When the cash flows come inform of profits, firms will have to make decisions on how much of these profits will be invested back into the business and how much returned to the owners of the business. In a publicly traded firm, cash flows can be returned either as dividends or by buying back stock. Johnson (2001) pointed out that strategic decisions involving dividend policy all have long term economic implications to the value a company creates for its shareholders. When people buy common stock (shares) they give up current consumption but expect to collect dividends and eventually sell the stocks at a profit. Therefore, return on common stock includes the cash dividend paid during the year together with an appreciation in the market price or capital gain realized at the end of the year. Therefore, shareholders of a business firm receive benefits in only two ways: appreciation of share prices and dividends received otherwise, they would rather withdraw their capital and invest somewhere else. Johnson (2001) also argued that dividends provide a signal to the public equity market as to managements expectations of the companys prospective cash flow generating ability hence leads to appreciation of market share price. It can be seen that a good company would rather pay all its earnings as dividends after all it will increase share price and shareholders wealth as well as signal that the company has a bright future. However, this will be disastrous as part of the profits should be retained and be invested back to ensure and assure shareholders of future dividends. Therefore, the finance manager must strike a balance and decide the amount of dividend to be paid 1.3.4 Risk Management Decisions The generally argued that business entities faces risks in various forms and that the higher the risk, the higher the return a business will receive. A finance manager is charged with the duty of identifying the risk, measuring the risk using various techniques and methods of risk measurement. A consultant or external experts may be used at this stage but the ultimate responsibility still lies with the finance manager. Further, a choice of strategy of managing the risk must be chosen e.g. transfer the risk to an insurance company, retain the risk or simply avoid the risk. 1.4 Financial objectives Effective procurement and efficient use of finance lead to proper utilization of the finance by the business concern. It is the essential part of the financial manager. Hence, the financial manager must determine the basic objectives of the financial management 1.4.1 Profit Maximization Profit maximization would probably be the most cited business goal, but this is not a precise objective. A business concern may also function mainly for the purpose of earning profit. Profit is the measuring techniques to understand the business efficiency of the concern and can simply be defined as the
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difference between total revenue and total cost of an activity. However, profit maximization is though the traditional goal but also narrow approach to a business concern. In quest to make profit, actions like deferring maintenance, purchasing poor quality supplies, rewarding employees poorly and other shortterm, cost cutting measures that will tend to increase profits will be encouraged. However, the following important points are in support of the profit maximization objectives of the business concern: i) It easy to understand for employees and public to report profit. ii) Profit is the parameter of the business operation. iii) Profit reduces risk of the business concern. The following important points are against the objectives of profit maximization: i) Profit maximization leads to exploiting workers and consumers. ii) Profit maximization creates immoral practices such as corrupt practice, unfair trade practice, etc. iii) Profit maximization objectives leads to inequalities among the stake holders such as customers, suppliers, public shareholders, etc. However, Profit maximization objective consists of certain drawback also: i) It is vague: In this objective, profit is not defined precisely or correctly. It creates some unnecessary opinion regarding earning habits of the business concern. ii) It ignores the time value of money: Profit maximization does not consider the time value of money or the net present value of the cash inflow. It leads certain differences between the actual cash inflow and net present cash flow during a particular period. iii) It ignores risk: Profit maximization does not consider risk of the business concern. Risks may be internal or external which will affect the overall operation of the business concern. 1.4.2 Shareholder Wealth Maximization Wealth maximization is one of the modern approaches, which involves latest innovations and improvements in the field of the business concern. Horne (2001) asserted that the objective of a company must be to create value for its shareholders. Other writers such as Brigham et al (1994) and Mauboussin (1998) added that the primary goal of a firm is stockholder wealth maximization. The use of the objective of shareholder value maximization has been advocated as an appropriate and operationally feasible goal since it provides an unambiguous measure of what the firm should seek to maximize in making any decision. Shareholder wealth maximization is also known as shareholder value maximization or net present worth maximization. The Institute of Chartered Accountants in England & Wales (ICAEW, 1999) defined shareholders perspective of shareholder value as growth in a companys share price over a period together with dividends received from it but from the managements point of view, shareholder wealth maximisation is seen as maximization of NPV of every action. Maximization of NPV translates into sustainable share price appreciation as well as dividend pay-out which mean greater shareholder value. From the definition of NPV, shareholder wealth is a long term perspective of profitability. Favourable Arguments for Wealth Maximization i) Wealth maximization is superior to the profit maximization because the main aim of the business concern under this concept is to improve the value or wealth of the shareholders. ii) Wealth maximization considers the comparison of the value to cost associated with the business concern. Total value detected from the total cost incurred for the business operation. It provides exact value of the business concern. iii) Wealth maximization considers both time and risk of the business concern. iv) Wealth maximization provides efficient allocation of resources. v) It ensures the economic interest of the society.
Unfavourable Arguments for Wealth Maximization i) Wealth maximization leads to prescriptive idea of the business concern but it may not be suitable to present day business activities. ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the profit maximization. iii) Wealth maximization creates ownership-management controversy. iv) Management alone enjoy certain benefits. v) The ultimate aim of the wealth maximization objectives is to maximize the profit. vi) Wealth maximization can be activated only with the help of the profitable position iv) of the business concern. 1.4.3 Non-Financial Objectives A company may have important non-financial objectives, which will limit the achievement of financial objectives. Examples of non-financial objectives are as follows. (a) The welfare of employees A company might try to provide good wages and salaries, comfortable and safe working conditions, good training and career development, and good pensions. If redundancies are necessary, many companies will provide generous redundancy payments, or spend money trying to find alternative employment for redundant staff. (b) The welfare of management Managers will often take decisions to improve their own circumstances, even though their decisions will incur expenditure and so reduce profits. High salaries, company cars and other perks are all examples of managers promoting their own interests. (c) The provision of a service The major objectives of some companies will include fulfillment of a responsibility to provide a service to the public. Examples are the Nairobi City Water and Sewerage Company. Providing a service is of course a key responsibility of government departments and local authorities. (d) The fulfillment of responsibilities towards customers Responsibilities towards customers include providing in good time a product or service of a quality that customers expect, and dealing honestly and fairly with customers. Reliable and quality supply arrangements, also after-sales service arrangements, are important. (e) The fulfillment of responsibilities towards suppliers Responsibilities towards suppliers are expressed mainly in terms of trading relationships. A company's size could give it considerable power as a buyer. The company should not use its power unscrupulously. Suppliers might rely on getting prompt payment, in accordance with the agreed terms of trade. (f) The welfare of society as a whole The management of some companies is aware of the role that their company has to play in exercising corporate social responsibility. This includes compliance with applicable laws and regulations but is wider than that. Companies may be aware of their responsibility to minimize pollution and other harmful 'externalities' (such as excessive traffic) which their activities generate. In delivering 'green' environmental policies, a company may improve its corporate image as well as reducing harmful externality effects. Companies also may consider their 'positive' responsibilities, for example to make a contribution to the community by local sponsorship. Other non-financial objectives are growth, diversification and leadership in research and development. Non-financial objectives do not negate financial objectives, but they do suggest that the simple theory of company finance, that the objective of a firm is to maximize the wealth of ordinary shareholders, is too simplistic. Financial objectives may have to be compromised in order to satisfy non-financial objectives
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1.5 AGENCY THEORY An agency relationship may be defined as a contract under which one or more people (the principals) hire another person or persons (the agent) to perform some services on their behalf, and delegate some decision making authority to that agent. Although ordinary shareholders (equity shareholders) are the owners of the company to whom the board of directors are accountable, the actual powers of shareholders tend to be restricted, except in companies where the shareholders are also the directors. This is refered to as Agency conflict. The day-to-day running of a company is the responsibility of management. Although the company's results are submitted for shareholders' approval at the annual general meeting (AGM), there is often apathy and acquiescence in directors' recommendations. Within the financial management framework, agency relationship exists between: (a) Shareholders and Managers (b) Debt holders and Shareholders 1.5.1 Shareholders versus Managers A Limited Liability company is owned by the shareholders but in most cases is managed by a board of directors appointed by the shareholders. This is because: 1. There are very many shareholders who cannot effectively manage the firm all at the same time. 2. Shareholders may lack the skills required to manage the firm. 3. Shareholders may lack the required time. 4. The shareholders are geographically distributed over vast areas 5. Most importantly, Shareholders are often ignorant about their company's current situation and future prospects. They have no right to inspect the books of account, and their forecasts of future prospects are gleaned from the annual report and accounts, stockbrokers, investment journals and daily newspapers. if managers hold none or very few of the equity shares of the company they work for, what is to stop them from working inefficiently? or not bothering to look for profitable new investment opportunities? or giving themselves high salaries and perks? One power that shareholders possess is the right to remove the directors from office. But 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. Even so, directors will want the company's report and accounts, and the proposed final dividend, to meet with shareholders' approval at the AGM. Conflicts of interest usually occur between managers and shareholders in the following ways: a) Managers may not work hard to maximize shareholders wealth if they perceive that they will not share in the benefit of their labour. b) Managers may award themselves huge salaries and other benefits more than what a shareholder would consider reasonable c) Managers may maximize leisure time at the expense of working hard. d) Manager may undertake projects with different risks than what shareholders would consider reasonable. e) Manager may undertake projects that improve their image at the expense of profitability. f) Where management buyout is threatened. Management buyout occurs where management of companies buy the shares not owned by them and therefore make the company a private one. Solutions to this Conflict In general, to ensure that managers act to the best interest of shareholders, the firm will: a) Incur Agency Costs in the form of: Agency costs are defined as those costs borne by shareholders to encourage managers to maximize shareholder wealth rather than behave in their own self-interests. The notion of agency costs is perhaps
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most associated with a seminal 1976 Journal of Finance paper by Michael Jensen and William Meckling, who suggested that corporate debt levels and management equity levels are both influenced by a wish to contain agency costs. There are three major types of agency costs: i) Monitoring expenses such as audit fee; ii) Expenditures to structure the organization so that the possibility of undesirable management behaviour would be limited. iii) Opportunity costs which are incurred when shareholder-imposed restrictions, such as requirements for shareholder votes on specific issues, limit the ability of managers to take actions that advance shareholder wealth In the absence of efforts by shareholders to alter managerial behavior, there will typically be some loss of shareholder wealth due to inappropriate managerial actions. On the other hand, agency costs would be excessive if shareholders attempted to ensure that every managerial action conformed to shareholder interests. Therefore, the optimal amount of agency costs to be borne by shareholders is determined in a cost-benefit contextagency costs should be increased as long as each incremental shilling spent results in at least a shilling increase in shareholder wealth b) The Shareholder may offer the management profit-based remuneration. This remuneration includes: i) An offer of shares so that managers become owners. Most publicly traded firms now employ performance shares, which are shares of stock given to executives on the basis of performances as defined by financial measures such as earnings per share, return on assets, return on equity, and stock price changes ii) Share options: (Option to buy shares at a fixed price at a future date). iii) Profit-based salaries e.g. bonus
c) Direct intervention by shareholders An increasing percentage of common stock in corporate is owned by institutional investors such as insurance companies, pension funds, and mutual funds. The institutional money managers have the clout, if they choose, to exert considerable influence over a firm's operations. Institutional investors can influence a firm's managers in two primary ways. First, they can meet with a firm's management and offer suggestions regarding the firm's operations. Second, institutional shareholders can sponsor a proposal to be voted on at the annual stockholders' meeting, even if the proposal is opposed by management. Although such shareholder-sponsored proposals are nonbinding and involve issues outside day-to-day operations, the results of these votes clearly influence management opinion. d) The threat of firing This is possible where ownership is not widely spread and dissent shareholders can raise enough votes to oust out directors e) The threat of takeover Hostile takeovers, which occur when management does not wish to sell the firm, are most likely to develop when a firm's stock is undervalued relative to its potential because of inadequate management. In a hostile takeover, the senior managers of the acquired firm are typically dismissed, and those who are retained lose the independence they had prior to the acquisition. The threat of a hostile takeover disciplines managerial behavior and induces managers to attempt to maximize shareholder value 4.2 Debt holders versus Shareholders A second agency problem arises because of potential conflict between stockholders and creditors. The relationship between long-term creditors of a company, the management and the shareholders of a company encompasses the following factors.
a) The shareholders, acting through management, have an incentive to induce the firm to take on new projects that have a greater risk than was anticipated by the firm's creditors. The increased risk will raise the required rate of return on the firm's debt, which in turn will cause the value of the outstanding bonds to fall. If the risky capital investment project is successful, all of the benefits will go to the firm's stockholders, because the bondholders' returns are fixed at the original low-risk rate. If the project fails, however, the bondholders are forced to share in the losses. On the other hand, shareholders may be reluctant to finance beneficial investment projects. Shareholders of firms undergoing financial distress are unwilling to raise additional funds to finance positive net present value projects because these actions will benefit bondholders more than shareholders by providing additional security for the creditors' claims b) Investors who provide debt finance will rely on the company's management to generate enough net cash inflows to make interest payments on time, and eventually to repay loans. However, long-term creditors will often take security for their loan, perhaps in the form of a fixed charge over an asset (such as a mortgage on a building). Bonds are also often subject to certain restrictive covenants, which restrict the company's rights to borrow more money until the debentures have been repaid. If a company is unable to pay what it owes its creditors, the creditors may decide to exercise their security or to apply for the company to be wound up. c) The money that is provided by long-term creditors will be invested to earn profits, and the profits (in excess of what is needed to pay interest on the borrowing) will provide extra dividends or retained profits for the shareholders of the company. d) If creditors perceive that shareholders are trying to take advantage of them in unethical ways, they will either refuse to deal further with the firm or else will require a much higher than normal rate of interest to compensate for the risks of such possible exploitations.
CHAPTER TWO RISK AND RETURN

2.1 Introduction Return is the ratio of money gained or lost (whether realized or unrealized) on an investment relative to the amount of money invested over a specified period. This is when profit earned, interest received or simply the gain is expressed as a ratio or percentage of the initial cost of the investment. A rate of return measurement can be used to measure virtually any investment vehicle, from real estate to bonds and stocks to fine art, provided the asset is purchased at one point in time and then produces cash flow at some time in the future. The rate of return for an investment in an asset that does not generate other cash flow apart from growth in its value (capital gain) can be measured simply as price in the end of the period less price paid the start of the period (this gives the gain) divided by Price paid in the start of the year. Rate of return (R) = capital gain / cost of investment Rate of return (R) = (P1 P0) / P0 However, in most cases, the investment will have some cash flows as well as growth in the value of the investment. In such case gains on investments are considered to be any income received from the security plus realized capital gains. For example, suppose you purchase a share of Safaricom for Kshs. 3.5 on 1st January 2010 and at the end of the year the share price had risen to Kshs. 4.2. Suppose also that at the end of the year Safaricom Ltd pays you Kshs. 0.35 as dividend, then; Total return = capital gain + dividend Total return = (4.2 3.5) + 0.35 Total return = 1.05 1.05 Rate of return(R)= 3.5 x 100% = 30% Therefore the rate of return can be seen as summation of capital gain yield and dividend yield
Rate of return Dividend yield Capital gain yield R1 DIV1 P1 P DIV1 P1 P 0 0 P P P 0 0 0
1.1.1 Average Rate of Return Rate of return can be computed for every year, if desired, up to the number of years that are needed. These annual rates of returns can be summed together and divided by their total number to get the average rate of return. Therefore, the average rate of return is the sum of the various one-period rates of return divided by the number of period. Formula for the average rate of return is as follows:
R=
1 1 [ R1 R2 R n ] n n
R
t =1
1.1.2 Expected Return The problem with average rate of return is that it uses historical values such as prices of the asset to compute capital gain and historical dividend paid to compute dividend yield. However, sometimes investors are interested about the performance of the investment or simply the asset in the future. In such a case expected returns will be computed using probability values for all possible outcomes. Therefore, an expected return is the value that investors expect an asset to earn or lose on average over a given time period. More precisely, it is the sum of all possible financial outcomes of an asset that are weighted by the probability of the outcomes occurrence. For example, consider the probability distribution for the returns on stocks A and B provided below under various states of the economy.
State 1 2 3 4
Probability 0.2 0.3 0.3 0.2
Return on Stock A 5% 10% 15% 20%
Return on Stock B 50% 30% 10% -10%
Given a probability distribution of returns, the expected return can be calculated using the following equation: where

E[R] = the expected return on the stock, N = the number of states, pi = the probability of state i, and Ri = the return on the stock in state i.
Expected Return on Stocks A and B Stock A Stock B Although this is what one would expect the return to be, there is no guarantee that it will be the actual return. Consider another example below for an investment in real property. Economic condition 1 High growth Expansion Stagnation Decline 2.1 Risk When a company look at the available investment opportunities, it needs to determine which projects or asset will maximize the value of the company and, hence, maximize owners' wealth. That is, it analyze each project, evaluating how much its benefits exceed its costs. The projects or assets that are expected to increase owners' wealth the most are the ones with highest rate of return. But anything in the future is uncertain, so future cash flows are not certain. Therefore, for an evaluation of any investment to be meaningful, one must represent how much risk there is that the return of the investment will differ from what is expected. Risk is the degree of uncertainty. The uncertainty arises from different sources, depending on the type of investment being considered, as well as the circumstances and the industry in which it is operating. Uncertainty may be due to: Rate of Return (%) 2 34 20 7 -10 Expected Rate of Return Probability (%) 3 4 = 2x3 0.10 0.35 0.40 0.10
Economic conditions -- Will consumers be spending or saving? Will the economy be in a recession? Will the government stimulate spending? Will there be inflation? Market conditions changes in market prices for inputs, interest rates, foreign exchange rates Taxes -- What will tax rates be? Will Congress alter the tax system? International conditions -- Will the exchange rate between different countries' currencies change? Are the governments of the countries in which the company does business stable 2.2.1 The Risk/Return Tradeoff The relationship between risk and return is an essential factor in all investment decision making. Each investment a firm undertakes, for example, must offer a return that is at least as high as the return on a similarly risky investment. The concept that every rational investor, at a given level of risk, will accept only the largest expected return. That is, given two investments at the exact same level of risk, all other things being equal, every rational investor will invest in the one that offers the highest return. RiskReturn Tradeoff can be defined as the principle that potential return rises with an increase in risk. Low levels of uncertainty (low risk) are associated with low potential returns, whereas high levels of uncertainty (high risk) are associated with high potential returns. In simple words the risk-return tradeoff implies that invested money can render higher profits only if it is subject to a high possibility of being lost. It is the reason that riskier bonds pay higher coupons than other bonds. It is also the reason that bonds pay lower returns than most stocks because they are a less risky investment. Its assumed in finance that all investors are risk averse. The principle of risk aversion suggests that people, in general, avoid risky choices when alternatives exist that allow for the same level of benefit or return. That is to say that investors will not take unnecessary risk unless compensated by higher return. In the psychology, risk aversion is an often-cited construct that captures a significant amount of behavior variability that leads to three significant risk behaviours: A risk-averse investor will choose among investments with the equal rates of return, the investment with lowest standard deviation. Similarly, if investments have equal risk (standard deviations), the investor would prefer the one with highest return. A risk-neutral investor does not consider risk, and would always prefer investments with highest returns. A risk-seeking investor likes investments with highest risk irrespective of the rates of return. In reality, most (if not all) investors are risk-averse. Most investors are risk averse, seeking to minimize risk and maximize return. This behavior collectively creates intense rivalry among investors to seek out the best alternatives for themselves because investors are all looking out for their own self-interest. 2.2 Measurement of Risk Measurement of risk in investment can be differentiated into two types: i) Stand alone risk ii) Portfolio risk 2.2.1 Stand alone risk The stand-alone risk is the risk an asset would have if it were a firm's only asset and it is measured by the variability of the asset's expected returns or average rate of return. Variability of rates of return may be defined as the extend of the deviations or dispersion of individual rates of return from the average rate of return. Two measures are used: variance and standard deviation. An asset whose return fluctuates dramatically is perceived to have greater risk because the assets value at the time when the investor wishes to sell it, is less predictable. In addition, greater volatility means that, from a statistical perspective, the potential future values of more volatile assets span a much wider range. The formula is:
10
1 n 1
R
n t 1
For example, suppose from the last ten years the average return of Express Ltd and Williamson Tea is as given below. Calculate the riskness of each stock. Express Ltd Williamson Tea Average Average Return D D2 Return D D2 10 -4 16 20 -2 4 12 -2 4 25 3 9 15 1 1 30 8 64 17 3 9 10 -12 144 15 1 1 25 3 9 8 -6 36 20 -2 4 9 -5 25 10 -12 144 14 0 0 34 12 144 18 4 16 40 18 324 22 8 64 6 -16 256 140 0 172 220 0 1102 Standard Deviation 1 = 4.4% and 2 = 11.1% Some other time, risk on an investment in equity (common stock) may reflects the chance that the actual return on the investment may be very different than the expected return. Therefore, another way to measure risk is to calculate the variance and standard deviation of the distribution of expected returns of a certain security given probabilities of various expected outcomes. For example, consider the probability distribution for the returns on stocks A and B provided below under various states of the economy. Return Return on on State Probability Stock A Stock B 1 0.2 5% 50% 2 0.3 10% 30% 3 0.3 15% 10% 4 0.2 20% -10% First compute the expected returns and then compute variance using the formula where N = the number of states, pi = the probability of state i, Ri = the return on the stock in state i, and E[R] = the expected return on the stock. The standard deviation is calculated as the positive square root of the variance.

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Variance and Standard Deviation on Stocks A and B Note: E[RA] = 12.5% and E[RB] = 20% Stock A
Stock B
Although Stock B offers a higher expected return than Stock A, it also is riskier since its variance and standard deviation are greater than Stock A's 2.3 Portfolio Risk Modern portfolio theory (MPT)or portfolio theorywas introduced by Harry Markowitz with his paper "Portfolio Selection," which appeared in the 1952 Journal of Finance. Thirty-eight years later, he shared a Nobel Prize with Merton Miller and William Sharpe for what has become a broad theory for portfolio selection. Prior to Markowitz's work, investors focused on assessing the risks and rewards of individual securities in constructing their portfolios. Standard investment advice was to identify those securities that offered the best opportunities for gain with the least risk and then construct a portfolio from these. Following this advice, an investor might conclude that a certain companys stocks offered good riskreward characteristics and compile a portfolio entirely from these. Intuitively, this would be foolish. Markowitz formalized this intuition. Detailing a mathematics of diversification, he proposed that investors focus on selecting portfolios based on their overall risk-reward characteristics instead of merely compiling portfolios from securities that each individually have attractive risk-reward characteristics. In a nutshell, inventors should select portfolios not individual securities. 2.3.1 Portfolio Expected Return The Expected Return on a Portfolio is computed as the weighted average of the expected returns on the stocks which comprise the portfolio. The weights reflect the proportion of the portfolio invested in the stocks. This can be expressed as follows: where E[Rp] = the expected return on the portfolio, N = the number of stocks in the portfolio, wi = the proportion of the portfolio invested in stock i, and E[Ri] = the expected return on stock i. For a portfolio consisting of two assets, the above equation can be expressed as

Expected Return on a Portfolio of Stocks A and B Note: E[RA] = 12.5% and E[RB] = 20% Portfolio consisting of 50% Stock A and 50% Stock B Portfolio consisting of 75% Stock A and 25% Stock B
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2.4 Portfolio Risk The variance/standard deviation of a portfolio reflects not only the variance/standard deviation of the stocks that make up the portfolio but also how the returns on the stocks which comprise the portfolio vary together. 2.4.1 Two Risky Assets Portfolio
While return of a portfolio can simply be measured as the weighted average of expected returns, the riskiness of a portfolio, p, is generally not the weighted average of the standard deviations of the individual assets in the portfolio. This is because portfolio risk will be smaller than the weighted average of the assets risk (standard deviation). In fact, it is theoretically possible to combine assets that are individually quite risky as measured by their standard deviations and to form a portfolio that is completely riskless with portfolio risk p being zero. The variance and standard deviations of a portfolio depends on co-movement of the two assets which is measured by: i) Covariance ii) Correlation and also iii) Variance iv) Standard Deviation Covariance This is a measure of the degree to which returns on two risky assets move in tandem. A positive variance means that assets returns move together such that when returns of asset X is above its average the return of asset Y will also be above average and vice versa. While negative covariance means that when returns for asset X are above their mean, returns of asset Y could be below its mean. While Zero covariance means that there is no relationship between movements of the two assets. The formula for covariance is: COVxy= Example State of Economy Probability Rate of return X Y 1. 0.1 4 30 2. 0.2 5 25 3. 0.3 15 20 4. 0.3 20 10 5. 0.1 25 2 E(R)=14.4 E(R)=17.2
Deviations Dx -10.4 -9.4 0.6 5.6 10.6
DxDyPt Dy 12.8 7.8 2.8 -7.2 -15.2 -13.31 -14.66 0.50 -12.10 -16.11 -55.68
However, interpretation of the figure of -55.68 cannot be clearly made in terms of the magnitude of the association apart from simply indicating negative covariance. To solve this problem, correlation can be computed. Correlation This is a statistical measure of the association or the relationship between two variables. In finance theory, correlation can be used to measure the relationship between returns of two separate assets. Correlation coefficient r will always range between +1 and -1. Whereby
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r = +1 is called perfect positive correlation and implies that returns of the two assets moves up and down together i.e while one assets returns are gaining the other assets returns will also be gaining. Hence a portfolio of the two assets will be exactly as risky as the individual assets r = -1 is called Perfect negative correlation indicates that returns of the two assets moves in different directions. i.e as one assets returns are gaining the other assets returns are losing hence a portfolio of the two assets will have zero risk Zero correlation (r = 0) means that the returns are not at all related. However, other weakly correlated either partially negative or partially positive will form a portfolio with a lower risk than the risk of the individual assets. Correlation can be found by: Covariance XY= (std deviation of X) x (std deviation of Y) x (Correlation XY) COVxy = x y Corxy Corxy = COVxy x y Correlation of X,Y=
Covariance X,Y (std deviation X) x (std deviation Y)
Variance and standard deviation The variance of a two security portfolio is given by the following equation p2 = x 2 wx 2 + y2 wy 2 + 2wxwy Covxy or by replacing covariance with correlation, then: p2 = x2wx 2 + y2 wy 2 + 2wxwyxyCorxy while standard deviation of the portfolio will be: p = (p2)1/2 = p Example Stock A and B have the following historical return Year RA RB 1998 -18% -14.50% 1999 33% 21.80% 2000 15% 30.50% 2001 0.5% -7.6% 2002 27% 26.30% a) b) Calculate portfolio returns of stock A and B for each year assuming equal weights Calculate the portfolio of risk of stock A & B (p )
2.5 Portfolio Risk of More Than Two Asset Case Calculation of portfolio risk is quite involving when a large number of assets or securities are combined to form a portfolio. As a general rule, the riskiness of a portfolio will decline as the number of stocks in
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the portfolio increases. Perhaps we should answer the question. If we added enough, partially correlation stocks, could we completely eliminate risk? The answer is no. However, the extent to which adding assets in a portfolio reduces its risk depends on the degree of correlation among assets and obviously the co-movements of the returns of the assets. The smaller the positively correlated assets, (i.e. the more the negatively correlated assets) the lower the risk of the portfolio. Consider a two asset portfolio below and calculate the risk of the portfolio assuming that investment consists of 50% of each asset. Return of asset Return of asset State Prob W M 1 0.2 40% -10% 2 0.2 -10% 40% 3 0.2 35% -5% 4 0.2 -5% 35% 5 0.2 15% 15% You will realize that the assets are perfect negatively correlated and the portfolio has zero risk. However, in real life, its almost impossible to get assets whose correlations are zero or perfectly negatively correlated. However, where correlations among individual stocks are generally positive but less than +1.0 some, but not all risk can be eliminated but its impossible to form a completely riskless asset portfolios. Therefore diversification, which is defined as the process of holding more than one investment asset will eliminate some risk but will not eliminate the total risk. Since, most investment assets will do well when the economy is strong and badly when economy is weak, therefore even a largest portfolio will end up with a substantial amount of risk, but not as much risk as when all the monies were invested only one stock. Therefore, risk can be differentiated into two parts. a) Diversifiable/unique/unsystematic risk b) Non diversifiable/market/systematic risk Unsystematic risk Part of the asset risk that can be eliminated by diversification is called diversification or unsystematic risk. These are variations in returns that are caused by unique factors to each asset. If a well diversified portfolio is held with 40 or more stocks, uncertainties in each individual assets return will cancel one another. Examples of unsystematic risk are: -workers strike -R& D misfortunes -Formidable competitor entry market. -Loss of a big contract -Break through in innovation -government increase on tax on raw material -Access to raw materials -Unsuccessful marketing program Since these bad or good events are random and hence affect only one or a few firms, then bad event in one firm will be offsetted by good event in the other hence the variation in the overall portfolio returns will be eliminated as long as a well diversified portfolio is held. Market/systematic risks
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This is part of the risk that cannot be eliminated by diversification. This risk stems from factors that systematically affect most firms such as: - War - Inflation - Recession - High interest rates - Global credit crunch Even when an investor holds a well diversified portfolio, uncertainties and variations in the individual assets return caused by such events will not be eliminated The total risk of a portfolio can therefore be seen as consisting of two parts: one that can be eliminated by diversification and one that cannot be eliminated by diversification i.e. Total risk = systematic risk + unsystematic risk Since unsystematic risk can be reduced as more and more assets are purchased and included in the portfolio, only systematic risk will be of concern to an investor that intends to hold a well diversified portfolio. Therefore the source of risk for a well diversified portfolio is the movements in the market and not individual assets uncertainty hence also referred to as market risk. The relationship between risk and number of assets held can be depicted as in figure below where Rm = Market risk Figure 2.1: Total Portfolio Risk Portfolio return Unsystematic risk p
Systematic risk No. of assets in the portfolio In Kenya, perhaps the best and well diversified portfolio is the Nairobi Stock Exchange All shares index (NASI). The main challenge at this point is how to measure the market risk and the relationships between risk and return. 2.6 Combine a Risky Free Asset and a Risky Asset A risk-free is a security that has zero variance and zero standard deviation such as government treasury bills and bonds. Suppose Rf = 5% and f= 0 while Rj =15% and j = 6% The portfolio return will be; E(Rp) = wE(Rj) + (1-w) Rf = 0.5 x 15 + 0.5 x 5 =10%
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Since risk free asset has zero standard deviation, then covariance as well as correlation will also be zero since COVfj = fjCorfj Therefore p2 = wj2j2 + wf2 f2 + 2wjwf Covfj p2= wj2j2 p= wjj = .5 x 6% =3% This implies that portfolio risk, when one is holding a risky asset and a risk-free asset is simply given as a product of the standard deviation of the risky security and its weight. Nevertheless, the total risk will be adversely reduced as more of the risk-free asset is held To establish the relationship between risk and return of such a portfolio let us suppose that we had already decided on the composition of the portfolio i.e. one risk-free asset and one particular risky asset. The decision to be done is about the composition of the investment budget to be allocated to the risky asset wj and risk-free asset wf since: E(Rp) = wE(Rj) + (1-wj)Rf E(Rp) = wjE(Rj) + Rf -wj Rf E(Rp) = Rf + wj (E(Rj) + Rf) Since Rf = 5% E(Rj) = 15% E(Rp)= 5% + w(15 - 5)% E(Rp) = 5% + 10w This indicates that the base return of the portfolio is the risk-free rate and the portfolio expects to earn a risk premium that depends on the risk premium of the risky-asset (E(Rj)- Rf and investors exposure to the risky asset denoted by wf i.e. weight of investment budget in the portfolio invested in the risky asset. Putting the two formulae together i.e E(Rp) = 5% + 10w p= wjj We can have the following combination Weights % Expected return Std Dev of Risky asset Risk-free asset of portfolio (%) Portfolio 120 -20 17 7.2 100 0 15 6 80 20 13 4.8 60 40 11 3.6 40 60 9 2.4 20 80 7 1.2 0 100 5 0 This can be charted to show the risk-return relationship for a portfolio of risky and risk-free assets.
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Fig 2.3 Expected Return standard deviation combination
Expected Return E(Rp)
B A
Rf
1.2
6% Portfolio standard deviation (p)
7.2%
Note that at point A the investment is 100% in the risky asset and 0% in the risk free Asset but at point B, the investment is 120% in risky asset and instead of investing in risk-free asset, the investor borrows the risk-free asset and use it to buy the risky-asset. 2.7 Multiple Asset Portfolios Taking an investment in stock (shares) we can create very many portfolios combining shares in the whole market in different proportions. Two asset portfolio returns will lie on a straight line such as one in the figure above but multiple securities portfolios are located in broader area shown by figure below. The efficient portfolios will be the one with highest expected returns for a given level of risk. Portfolio on curve MNOPR will be more efficient than portfolios below the curve. Therefore, efficient frontiers is the frontier formed by the set of efficient portfolio i.e. curve MNOPR. All portfolio on MNOPR are efficient portfolio while .all portfolio below the efficient frontiers are inefficient i.e. they offer lower return at a given level of risk e.g. point Q has same return as point O but has higher risk and has same risk as point P but lower return. The choice of the portfolio will depend on the investors risk return preferences.
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Figure : Investment opportunity set Expected Returns of Portfolio P O Q
N M
Risk of Portfolios p At this point, we have successfully identified the efficient portfolios but not the most efficient portfolio. This analysis is done below by combining various portfolios and a risk-free asset. 2.7 Combining Risky Asset and Risk-Free Asset Decision
It is always efficient to hold a risk free asset in ones portfolio since this asset tends to reduce the overall risk of a portfolio. Assuming an investor wants to choose the risk-asset to hold together with of a risky asset, then various expected return - standard deviation combination lines can be drawn. All lines starting at Rf. These lines are called Capital Allocation Lines (CAL). All CAL above RfNS will give higher return for a given level of risk i.e. remembers rationality of investors. This combination can continue until point of tangent with the efficient frontier curve The portfolio at this point is called optimum risky portfolio which can be combined with a risk free asset. This can be done by holding the portfolio as if it were a single risky-asset and then combining it at various weights with a risk-free asset. This optimum risky portfolio is the most efficient portfolio in a market and it contains all assets in that particular market hence called the market portfolio. Market portfolio is a portfolio of all assets in a market where each asset is held in proportion to its market value to the total market value of all assets in the market. This portfolio dominates all other portfolios that can be formed by combining assets in the markets. The CAL passing through the optimal risky portfolio is called the Capital market Line (CML). The slope of CML is given by.
Slope of CML =
( (
E(Rm) - Rf m
) )
m
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Therefore the equation of CML will be

Slope of CML = Rf E(Rm) - Rf m
Fig 2.5 optimum risky portfolio T E(Rm) P Rf S R
Question Suppose Risk Free rate is 8% and market portfolio is expected to yield a return of 18% with a std deviation of 6%. If an investor desires to earn an expected rate of 15% in what combination should he hold the market portfolio and risk-free secure.
2.8 CAPITAL ASSET PRICING MODEL (CAPM)
m Risk
Consider the basic assumptions that investors are rational and the fact that diversifiable or unsystematic risk can easily be eliminated by holding a well diversified portfolio. Therefore, the most important risk is the market risk or risk inherent in a well diversified portfolio and not the total risk of an asset. This implies that investors are concerned with riskiness of their market portfolio rather than the riskiness of individual assets in the portfolio. CAPM can be used to determine the relationship between risk and return and hence determine the required rate of return on asset (expected rate of return). The primary conclusion of CAPM is that: relevant riskiness of an individual asset is its contribution to the riskiness of a well-diversified portfolio (market portfolio). Its true that an asset e.g. shares of Safaricom, might be quite risky, if held by itself, but if half of its risk can be eliminated by diversification, then its relevant risk is its contribution to the market portfolio risk. Capital Asset Pricing Model(CAPM), is used to determine a theoretically appropriate rate of return of an asset, if the asset is to be added to an already well-diversified portfolio, given that assets systematic risk represented by the value (beta) . This model was introduced by Jack Treynor, William Sharpe, John Linterner, and Jan mossin independently building on the earlier work of Harry Markowitz on diversification and modern portfolio theory. 2.8.1 Assumptions of CAPM 1. Market Efficiency It is assumed that markets are efficient and assets are prices reflect their true value basing on historical information held by investors about the assets. Market efficiency implies that a single investor cannot benefit by having some information about assets. It also implies that:
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a) There are no taxes b) There is no transaction cost for selling and buying assets c) All information is available at the same time to investors are rational. 2. Rationality of investors This implies that investors and risk averse and prefer highest expected returns for any given level of risk 3. Single time period- Investment horizon Its assumed that investors decisions are based on single time period since an expected return for six- month holding period will be different from a one year period. 4. Risk-free rate All investors can lend and borrow at a risk-free rate of interest. This is assumption was made by the portfolio theory from which CAPM is derived. 5. Investors hold a well-diversified portfolio Investors hold a well-diversified portfolio. This implies that investors will only require a rate of return for the systematic risk of their portfolios, since unsystematic risk has been removed and can be ignored. 6. Homogeneous expectations All investors agree on the expected returns and risks of assets 2.8.2 The Concept of Beta Under CAPM, risk of an individual risky asset is seen as the volatility of the assets returns in relation to the return of the market portfolio. This risk of the individual asset is its systematic risk and can be measured by measuring the co-movement of individual risky security expected return and the expected return of the market portfolio. This can also be shown by using the risk premium expected on risky asset to be directly related to the risk premium in the market portfolio. E(Rj) Rf = (E(Rm)- Rf) The term is pronounced as beta and measures the sensitivity or responsiveness of expected risk premium on the assets return to the market portfolio risk premium When restated E(Rj) = RF+ [E(Rm)- Rf] This is called the capital asset pricing model and shows the required rate of return of assets. In this model, measures the extent to which, returns on particular asset and market move together. Therefore, (betacoefficient) a Greek symbol, shows how much systematic risk a particular asset has relative to the market. By definition, a market portfolio has beta = 1.0 relative to itself. Therefore; = 1.0 indicates that when market returns moves up 10%, the asset returns also moves up 10% and vice versa. This is beta of the market portfolio = 0.5 indicates that the asset is only half as volatile as the market = 2.0 indicates that the asset is twice volatile as the market. 2.8.3 Portfolio Betas The portfolio beta can be calculated on weighted average of the individual asset bte p= w11 + w22 +.+ wnn QUESTION Suppose we had the following investment Amount Security Invested Weight A B C D 1,000 2,000 3,000 0.10 0.20 0.30
expected return 0.08 0.12 0.15 0.18
Beta 0.80 0.95 1.10 1.40
4,000 0.40 a) What is the expected return of the portfolio b) Calculate the systematic risk of the portfolio
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2.8.4 Security Market Line (SML) According to CAPM E(Rj) = Rf+ [E(Rm)- Rf] Every asset will have a different - coefficient value. Hence for a given amount of systematic risk () we can compute the expected rate of return (required rate of return). When expected returns of assets in the market are graphed against betas of assets, a graph called security market line SML will be formed. Consider that CAPM formula has only two variables E(Rj) and while other value are constant within the given investment horizon hence, the line graphed for E(Rj) (Expected/required return for any asset) on y-axis against ( the systematic risk or co-movement of assets returns and market return) will be a straight line with Rf as y-interval Consider a market with the following assets and Rf=8% and E (Rm) = 17 Assets Beta Expected return P 0.6 Q 1.0 R 1.2 S -0.2 Calculate expected return of each asset and
Fig 2.6 Security Market Line
At the point where Beta=1.0 the expected return will be equal to the market value and beyond this level where >1.0, the asset are more risky than the market portfolio returns hence fluctuates more than the market returns. Asset above the SML offers higher returns than their expected returns hence undervalued and vice versa for those below the line. 2.8.5 Differences between SML and CML a) CML represents expected returns of an efficient portfolio and they change (as a function) with the portfolio risk (std deviation) while SML shows individual assets expected returns as a function of assets systematic risk (Beta) b) Beta shows contribution of the asset to the portfolio risk while standard deviation measures portfolio risk at various proportions c) SML will contain all fairly-priced assets since there rates of return are consistent with their risk, the under priced assets will give higher return at a given level of risk hence will be above the SML line. On the other hand CML only depicts the market portfolio and risk free asset and only changes the weights as proportions of each in the portfolio.
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CHAPTER THREE CAPITAL STRUCTURE THEORY AND POLICY 3.0 Introduction According to our initial discussion on decision made by finance manager, investment decisions may precede decision on the source of funds to finance the projects selected after a capital budgeting decision. However, a decision to buy a new plant or long term investment implies a specific way of financing the project. Financing of long term projects will definitely be financed by long term source finance: equity or debt. This decision will affect the capital structure of a firm. The capital structure of a company is defined as the particular combination of debt and equity that it uses to fund its long term financing. Short-term borrowings are always excluded from the capital structure since these sources of finance is expected to finance the operating cycle or generally the current assets. When a firm uses debt capital and preference share capital ( also called fixed-charge capital or prior charge capital) in its capital structure its described as financial leverage or gearing. Gearing is the amount of debt finance a company uses relative to its equity finance. Debt finance tends to be relatively low risk for the debt holder as it is interest-bearing and can be secured 3.1 Business Risk and Financial Risk A business risk is a factor or circumstance that may have a harmful impact on the profitability and operation of the business. This can be the result of in-house conditions and certain external factors. A very good example of an external factor is the change in the demand for services or goods that the business is producing. Conceptually, all firms have a certain amount of risk inherent in its operation which may result into lower returns to shareholder. Business risk depends on a number of factors such as: a) Demand variability the more stable the demand for a firms product, other things held constant, the lower its business risk b) Sales price variability firms whose products are sold in highly volatile markets are exposed to more business risk than similar firms whose output prices are more stable. c) Input cost variability firms whose input prices are highly uncertain are expected to a high degree of business risk d) Ability to adjust output prices for changes in input costs e) Ability to develop new products in a timely, cost-effective manner f) Foreign risk exposure - firms that generate a high percentage of their earnings overseas are subject to earnings declines due to exchange rate fluctuations. g) Extent to which costs are fixed ( operating leverage) if a high percentage of costs are fixed, hence do not decline when demand falls, then the firm is exposed to a relatively high degree of business risks. On the other hand, financial risk is the additional risk placed to shareholders as a result of the decision to finance with debt. This financial risk increases greatly when a certain organization decides to use debt from financial institutions for business expansion along with equity financing. The cost of debt to the company is therefore relatively low. But the greater the level of debt, the greater the financial risk. The assets of a business must be financed somehow, and when a business is growing, the additional assets must be financed by additional capital. The financial leverage employed by a company is intended to earn more return on prior-charge capital than their costs and the surplus will increase the return on the owners equity 3.1.1 Advantages of gearing The company will have more funds to invested hence potential to increase returns. This is the main objective of debt financing as its expected that returns from the investment project will be able to pay debt interest and residual going to the shareholder. b) Having more funds to invest allows the firm to diversify their investments hence avoid some risks c) Gearing is also tax effective - the advantage to equity holders of using debt arises from the tax shield on debt, that is, the benefit to shareholders deriving from the treatment of debt for tax purposes as being deductible in arriving at an entitys taxable profits.
a)
However, the main disadvantage of increasing debt is that the additional interest payable reduces the earnings available to shareholders, thereby increasing the risk of their investment and consequently increasing the cost of
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capital, as new investors will require a higher return on equity to compensate for the increased financial risk. Though cost of debt is low increases risk, you must appreciate that debt has priority over equity and also that coupon rates of debt must be met. Thus, if an entity hits bad times and profits fall significantly or losses ensue, there may be little if any return for shareholders. Clearly, therefore, the level of an entitys gearing can affect both earnings per share and dividend policy decisions. 3.2 Measures of Gearing Measuring of financial gearing is an attempt to quantify the degree of risk involved in holding debt in a company, both in terms of the company's ability to remain in business and in terms of expected ordinary dividends from the company. The more geared the company is, the greater the risk that little (if anything) will be available to distribute by way of dividend to the ordinary shareholders. Furthermore, the more geared the company, the greater the percentage change in profit available for ordinary shareholders for any given percentage change in profit before interest and tax. This means that there will be greater volatility of amounts available for ordinary shareholders, and presumably therefore greater volatility in dividends paid to those shareholders, where a company is highly geared. That is the risk. Gearing ultimately measures the company's ability to remain in business. A highly geared company has a large amount of interest to pay annually. If those borrowings are 'secured' in any way (and bonds in particular are secured), then the holders of the debt are perfectly entitled to force the company to realise assets to pay their interest if funds are not available from other sources. Clearly, the more highly geared a company, the more likely this is to occur when and if profits fall. Commonly used measures of financial gearing are based on the statement of financial position values of the fixed interest and equity capital. They include: 3.2.1 Debt Ratio Total Debt Debt ratio = Capital Employed Debt does not include long-term provisions and liabilities such as deferred taxation. There is no firm rule on the maximum safe debt ratio, but as a general guide, you might regard 50% as a safe limit to debt. 3.2.2 Debt Equity ratio Total Debt Debt-equity ratio = Shareholders Equity Debt in the formulas above refers to prior charge capital is capital which has a right to the receipt of interest or of preferred dividends in precedence to any claim on distributable earnings on the part of the ordinary shareholders. On winding up, the claims of holders of prior charge also rank before those of ordinary shareholders. a company is low geared if the gearing ratio is less than 100%, highly geared if the ratio is over 100% and neutrally geared if it is exactly 100%. 3.2.3 Interest coverage ratio The interest coverage ratio is a measure of financial risk which is designed to show the risks in terms of profit rather than in terms of capital values. PBIT Interest coverage ratio = Interest The reciprocal of this, the interest to profit ratio, is also sometimes used. As a general guide, an interest coverage ratio of less than two times is considered low, indicating that profitability is too low given the gearing of the company. An interest coverage ratio of more than seven is usually seen as safe. 3.3 Effect Capital Structure on Shareholder Wealth The primary objective of a company in using financial leverage or gearing is to magnify the shareholders return under favourable economic conditions. The role of debt in magnifying return of shareholders is based on assumption that the prior-charge capital can be obtained at a cost lower than the firms rate of return on capital
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employed i.e. ROCE or ROI. If a company can generate returns on capital in excess of the interest payable on debt, financial gearing will raise the return to shareholders. Gearing will, however, also increase the variability of returns for shareholders and increase the chance of corporate failure. A company will only be able to raise finance if investors think the returns they can expect are satisfactory in view of the risks they are taking. 3.3.1 Earnings per share EPS = Profit attributable to ordinary shareholders Number of ordinary shares = (PBIT I) (1 T) S
Where t = tax rate, I = interest payable, PBIT Profit before Interest and Tax, S no. of shares EPS in common language is the amount of money that a unit of share is able to earn in a particular period. This tells us how a company is doing in relation to the number of shares it has. Earnings per share, (EPS) is widely used as a measure of a company's performance by investors. A company must be able to sustain its earnings in order to pay dividends and re-invest in the business so as to achieve future growth. The relationship between these two figures above in the EPS formula can be used to evaluate alternative financing plans by examining their effect on earnings per share over a range of PBIT levels. Its objective is to determine the PBIT indifference points amongst the various alternative financing plans. The indifference points between any two methods of financing can be determined by solving for PBIT the following equation: (PBIT I) (1 T) S1 = (PBIT I) (1 T) S2
Example Edted Company has 10,000 m Kshs.1 shares in issue and wants to raise Kshs. 5,000 m to fund an investment by either: a) Selling 2,500 m shares at Kshs.2 each or b) Issuing Kshs. 5,000 m 10% loan stock at par The income tax rate is 40%. Evaluate whether the company should issue debt or equity assuming that its main objective is to increase EPS The company's attitude will depend on what levels of earnings it expects and also the variability of possible earnings limits. Variations from what is expected will have a greater impact on earnings per share if the company chooses debt finance. 3.3.2 Price-Earnings Ratio You will remember that the price-earnings ratio is calculated in the following way:
Price Earnings ratio = This is same as Price Earnings ratio =
Market price of share EPS Total market value of equity Total earnings
In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per shilling of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay Kshs.20 for Kshs.1 of current earnings. In other words, P/E ratio shows current investor demand
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for a company share. Since the value of the P/E ratio reflects the market's appraisal of the share's future prospects. If earnings per share falls because of an increased burden arising from increased gearing, an increased P/E ratio will mean that the share price has not fallen as much as earnings, indicating the market view positively the projects that the increased gearing will fund. 3.3.3 Dividend Cover You will recall that the dividend cover is the number of times the actual dividend could be paid out of current profits. Dividend cover = Profit attributable to ordinary shareholders Total Dividends EPS DPS
Dividend cover =
It is shows proportion of profit on ordinary activities for the year that is available for distribution to shareholders has been paid (or proposed) and what proportion will be retained in the business to finance future growth. A dividend cover of 2 times would indicate that the company had paid 50% of its distributable profits as dividends, and retained 50% in the business to help to finance future operations. Retained profits are an important source of funds for most companies, and so the dividend cover can in some cases be quite high. A sharp fall in Dividend Cover could mean that a company did not make good profit this year but, the management went ahead to pay the normal dividend, this shouldnt be a cause of worry if there is prospect for growth in the company To judge the effect of increased gearing on dividend cover, you should consider changes in the dividend levels and changes in dividend cover. If earnings decrease because of an increased burden of interest payments, then: a) The directors may decide to make corresponding reductions in dividend to maintain levels of dividend cover. b) Alternatively the directions may choose to maintain dividend levels, in which case dividend cover will fall. This will indicate to shareholders an increased risk that the company will not be able to maintain the same dividend payments in future years, should earnings fall. 3.3.4 Dividend yield Remember that the dividend yield is calculated as follows: Dividend Per Share Dividend yield = Market Price per Share We have discussed how increased gearing might affect dividends and dividend cover. However with dividend yield, we are also looking at the effect on the market price of shares. If the additional debt finance is expected to be used to generate good returns in the long-term, it is possible that the dividend yield might fall significantly in the short-term because of a fall in short-term dividends, but also an increase in the market price reflecting market expectations of enhanced long-term returns. How shareholders view this movement will depend on their preference between short-term and long-term returns. QUESTION A summarized statement of financial position of Rufus is as follows. Assets less current liabilities Debt capital Share capital (20 million shares of Kshs.1) Reserves
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150,000,000 (70,000,000) 80,000,000 20,000,000 60,000,000
80,000,000 The company's profits in the year just ended are as follows. Profit from operations Interest Profit before tax Taxation at 30% Profit after tax (earnings) Dividends Retained profits 21,000,000 6,000,000 15,000,000 (4,500,000) 10,500,000 6,500,000 4,000,000
The company is now considering an investment of Kshs.25 million. This will add Kshs. 5 million each year to profits before interest and tax. a) There are two ways of financing this investment. One would be to borrow Kshs.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. b) Whichever financing method is used, the company will increase dividends per share next year from 32.5 cents to 35 cents. 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 Kshs. 6 million plus the interest cost of any new debt capital. Required a) Produce 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. a) Calculate the effect on gearing as at the end of next year, with each financing method. b) Explain whether either or both methods of funding would be acceptable. 3.4 Effect of Capital Structure on the Cost of Capital The cost of capital is the rate of return that the enterprise must pay to satisfy the providers of funds, and it reflects the riskiness of providing funds. 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. The cost of capital can therefore be measured by studying the returns required by investors, and then used to derive a discount rate for DCF analysis and investment appraisal. The cost of capital is also an opportunity cost of finance, because it is the minimum return that investors require. If they do not get this return, they will transfer some or all of their investment somewhere else. Here are two examples. 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. The cost of debt is likely to be lower than the cost of equity, because debt is less risky from the debt holders' viewpoint. In the event of liquidation, the creditor hierarchy dictates the priority of claims and debt finance is paid off before equity. This makes debt a safer investment than equity and hence debt investors demand a lower rate of return than equity investors. Debt interest is also corporation tax deductible (unlike equity dividends) making it even cheaper to a tax paying company. Arrangement costs are usually lower on debt finance than equity finance and once again, unlike equity arrangement costs, they are also tax deductible. The creditor hierarchy will be as below with increasing risk and hence required rate of return.
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1 Creditors with a fixed charge 2 Creditors with a floating charge 3 Unsecured creditors 4 Preference shareholders This means that the cheapest type of finance is debt (especially if secured) and the most expensive type of finance is equity (ordinary shares). 3.4.1 Cost of ordinary share capital New funds from equity shareholders are obtained either from new issues of shares or from retained earnings. Both of these sources of funds have a cost. a) Shareholders will not be prepared to provide funds for a new issue of shares unless the return on their investment is sufficiently attractive. b) Retained earnings also have a cost. This is an opportunity cost, the dividend forgone by shareholders. Using dividend valuation model If we begin by ignoring share issue costs, the cost of equity, both for new issues and retained earnings, could be estimated by means of a dividend valuation 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: d d d d d P0 = + + +.+ = 2 3 n (1+ke) (1+ke) (1+ke) (1+ke) ke Therefore, d ke = P0 Where: Ke is the cost of equity capital d is the annual dividend per share, starting at year 1 and then continuing annually in perpetuity. P0 is the current share price EXAMPLE Cygnus has a dividend cover ratio of 4.0 times and expects zero growth in dividends. The company has one million Kshs.1 ordinary shares in issue and the market capitalisation (value) of the company is Kshs.50 million. After-tax profits for next year are expected to be Kshs.20 million. What is the cost of equity capital? Using the dividend growth model Shareholders will normally expect dividends to increase year by year and not to remain constant in perpetuity. The fundamental theory of share values states that the market price of a share is the present value of the discounted future cash flows of revenues from the share, so the market value given an expected constant annual growth in dividends would be: P0 = d0 (1+g) d0 (1+g)2 d0 (1+g)n + +.+ (1+ke) (1+ke)2 (1+ke)n d0 (1+g) (ke - g) = d1 (ke - g)
P0 =
Therefore ke = OR d1 P0 + g
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ke =
QUESTION A share has a current market value of 96 cents, and the last dividend was 12 cents. If the expected annual growth rate of dividends is 4%, calculate the cost of equity capital. Using Capital Asset Pricing Model
d0(1+g) P0 + g
The capital asset pricing model can be used to calculate a cost of equity and incorporates risk. The CAPM is based on a comparison of the systematic risk of individual investments with the risks of all shares in the market. 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. This expected return will be the cost of the shares of that particular company. The model states that: E(Rj) = Rf+ [E(Rm)- Rf] EXAMPLE Investors have an expected rate of return of 8% from ordinary shares in Algol, which have a beta of 1.2. The expected returns to the market are 7%. What will be the expected rate of return from ordinary shares in Rigel, which have a beta of 1.8? Note That retained earnings are a component of equity, and therefore the cost of retained earnings (internal equity) is equal to the cost of equity as explained above. 3.5 The Cost of Debt Capital The cost of debt capital represents the cost of continuing to use the finance rather than redeem the securities at their current market price. I P0 The interest on debt capital is likely to be an allowable deduction for purposes of taxation and so the cost of debt capital and the cost of share capital are not properly comparable costs. This tax relief on interest ought to be recognised in computations. The after-tax cost of irredeemable debt capital is: I (1 - T) Cost of debt Kd net = P0 Cost of debt Kd = EXAMPLE Owen Ltd has in issue 10% bonds of a nominal value of Kshs.100. The market price is Kshs.90 ex interest and tax rate is 30%. Calculate the cost of this capital if the bond is irredeemable 3.5.3 The Cost of Preference Shares For preference shares the future cash flows are the dividend payments in perpetuity so that: Cost of preference shares Kpref = d P0
Where P0 - is the current market price of preference share capital after payment of the current dividend d - is the dividend received and kpref - is the cost of preference share capital
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Don't forget however that tax relief is not given for preference share dividends. When calculating the weighted average cost of capital the cost of preference shares is a separate component and should not be combined with the cost of debt or the cost of equity. 3.5.3 The Weighted Average Cost of Capital WACC is the average cost of the company's finance (equity, bonds, bank loans) weighted according to the proportion each element bears to the total pool of capital. A general formula for the weighted average cost of capital (WACC) k0 is as follows.
Where
ke - is the cost of equity kd - is the cost of debt Ve - is the market value of equity in the firm Vd - is the market value of debt in the firm T - is the rate of company tax
Market values should always be used if data is available. Although book values are often easier to obtain, they are based on historical costs and their use will seriously understate the impact of the cost of equity finance on the average cost of capital. If the WACC is underestimated, unprofitable projects will be accepted. EXAMPLE: An entity has the following information in its statement of financial position. Kshs.'000 Ordinary shares of Kshs. 0.5 2,500 12% unsecured bonds 1,000 The ordinary shares are currently quoted at Kshs.1.30 each and the bonds are trading at Kshs. 7, 200 per Kshs.10, 000 nominal. The ordinary dividend of Kshs. 0.15 has just been paid with an expected growth rate of 10%. Corporation tax is currently 30%. Calculate the weighted average cost of capital for this entity. Marginal cost of capital approach Marginal cost is the new or the incremental cost of new capital (equity and debt) issued by the firm. WACC is cost of sources of finance that already employed. WACC can be used to evaluate the performance of management in raising funds by comparing it with existing ROCE or ROI. However, where new funds are to be raised, to finance a new investment project, the cost of new capital should be ascertained. This cost of new or incremental capital is known as the marginal cost of capital. MCC = (New WACC X New Total MV) (Old WACC X Old Total MV) Change in market value
Example Georgebear has the following capital structure: Source of finance Equity Preference Bonds After tax cost % 12 10 7.5
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Market value 10 2 8
20 Georgebears directors have decided to embark on major capital expenditure, which will be financed by a major issue of funds. The estimated project cost is Kshs.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 companys new weighted average cost of capital, and its marginal cost of capital. OPTIMAL CAPITAL STRUCTURE THEORIES When we consider the capital structure decision, the question arises of whether there is an optimal mix of capital and debt which a company should try to achieve. Under the traditional view there is an optimal capital mix at which the average cost of capital, weighted according to the different forms of capital employed, is minimised. However, the alternative view of Modigliani and Miller is that the firm's overall weighted average cost of capital is not influenced by changes in its capital structure. The traditional Theory Under the traditional theory of cost of capital, the cost declines initially and then rises as gearing increases. The optimal capital structure will be the point at which WACC is lowest. The traditional view of capital structure is that there is an optimal capital structure and the company can increase its total value by a suitable use of debt finance in its capital structure. The assumptions on which this theory is based are as follows: a) The company pays out all its earnings as dividends. b) The gearing of the company can be changed immediately by issuing debt to repurchase shares, or by issuing shares to repurchase debt. There are no transaction costs for issues. c) The earnings of the company are expected to remain constant in perpetuity and all investors share the same expectations about these future earnings. d) Business risk is also constant, regardless of how the company invests its funds. e) Taxation, for the time being, is ignored. The traditional view is as follows: a) As the level of gearing increases, the cost of debt remains unchanged up to a certain level of gearing. Beyond this level, the cost of debt will increase. b) The cost of equity rises as the level of gearing increases and financial risk increases. There is a nonlinear relationship between the cost of equity and gearing. 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 optimum level of gearing is where the company's weighted average cost of capital is minimised. 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.
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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.
Pecking order theory The Pecking Order Theory or Pecking Order Model was developed by Stewart C. Myers and Nicolas Majluf in 1984. It states that companies prioritize their sources of financing (from internal financing to equity) according to the Principle of information asymmetry (difference) between management and investors. It states that firms will prefer retained earnings to any other source of finance, and then will choose debt, and last of all equity. The pecking order theory does not take an optimal capital structure as a starting point, but instead asserts the empirical fact that firms show a distinct preference for using internal finance (as retained earnings or excess liquid assets) over external finance. If internal funds are not enough to finance investment opportunities, firms may or may not acquire external financing, and if they do, they will choose among the different external finance sources in such a way as to minimise additional costs of asymmetric information. The order of preference will be: Retained earnings Straight debt Convertible debt Preference shares Equity shares The pecking order theory is based on the idea of asymmetric information between managers and investors. Managers know more about the true value of the firm and the firms riskiness than less informed outside investors. To avoid the underinvestment problem, managers will seek to finance the
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new project using a security that is not undervalued by the market, such as internal funds or riskless debt. Reasons for following pecking order a) It is easier to use retained earnings than go to the trouble of obtaining external finance and have to live up to the demands of external finance providers. b) There are no issue costs if retained earnings are used, and the issue costs of debt are lower than those of equity. c) Investors prefer safer securities, that is debt with its guaranteed income and priority on liquidation. d) Some managers believe that debt issues have a better signalling effect than equity issues because the market believes that managers are better informed about shares' true worth than the market itself is. Their view is the market will interpret debt issues as a sign of confidence, that businesses are confident of making sufficient profits to fulfil their obligations on debt and that they believe that the shares are undervalued. By contrast the market will interpret equity issues as a measure of last resort, that managers believe that equity is currently overvalued and hence are trying to achieve high proceeds whilst they can. However an issue of debt may imply a similar lack of confidence to an issue of equity; managers may issue debt when they believe that the cost of debt is low due to the market underestimating the risk of default and hence undervaluing the risk premium in the cost of debt. If the market recognises this lack of confidence, it is likely to respond by raising the cost of debt. The main consequence in this situation will to be reinforce a preference for using retained earnings first. However debt (particularly less risky, secured debt) will be the next source as the market feels more confident about valuing it than more risky debt or equity. Limitations of pecking order theory i) It fails to take into account taxation, financial distress, agency costs or how the investment opportunities that are available may influence the choice of finance. ii) Pecking order theory is an explanation of what businesses actually do, rather than what they should do. Studies suggest that the businesses that are most likely to follow pecking order theory are those that are operating profitably in markets where growth prospects are poor. There will thus be limited opportunities to invest funds, and these businesses will be content to rely on retained earnings for the limited resources that they need. The Trade-Off Theory It refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. This theory is often set up as a competitor theory to the Pecking Order Theory of Capital StructureThe trade-off models have dominated the capital structure literature. The tax benefit-bankruptcy cost trade-off models (DeAngelo and Masulis (1980)) predict that firms will seek to maintain an optimal capital structure by balancing the benefits and the costs of debt. The benefits include the tax shield whereas the costs include expected financial distress costs. An important purpose of the theory is to explain the fact that corporations usually are financed partly with debt and partly with equity. It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including
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bankruptcy costs of debt (risk of dissolution) and non-bankruptcy costs staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder infighting. Trade-off theory of capital structure can also include the agency costs from agency theory as a cost of debt to explain why companies don't have 100% debt as expected from Modigliani and Miller since such decision will increase agency costs. Financial distress arises when a firm is not able to meet its debt obligations such as payment of debt interest and principal. The direct cost of financial distress refers to the cost of insolvency of a company. Once the proceedings of insolvency starts, the assets of the firm may be needed to be sold at distress price, which is generally much lower than the current values of the assets. A huge amount of administrative and legal costs are also associated with the insolvency. Indirect cost of financial distress relates to the actions of employees, managers, customers, suppliers and shareholders in response to excessive gearing. For example: i) Employees will be demoralised and worried about their future hence low efficiency and productivity ii) Customers may fear liquidation and hence worry about quality of products iii) Suppliers will curtail or discontinue credit for fear of liquidity problems iv) Investors will demand higher premiums hence firm may not be able to raise additional capital
The Net Operating Income (Modigliani-Miller (MM)) view of WACC The theory of business finance in a modern sense starts with the Modigliani and Miller (1958) capital structure irrelevance proposition. Franco Modigliani and Merton Miller developed the M&M Propositions I and II. Before them, there was no generally accepted theory of capital structure. Modigliani and Miller argued that, in perfect capital markets without taxes and transaction costs, a firms market value and cost of capital remains invariant to the capital structure changes. They added that the value of the firm depends on the earnings and risk of its assets i.e business risk rather than the way in which assets have been financed. MM hypothesis can be explained in two propositions: Proposition I:
Where: VU = the value of an ungeared (unlevered) firm (price of buying a firm composed only of equity), and VL = the value of a geared firm (price of buying a firm that is composed of some mix of debt and equity) This proposition states that the value of a firm is the same regardless of whether it finances itself with debt or equity. The weighted average cost of capital is constant. Suppose there are two firms with identical assets, operates in same market segments and have equal market share. They are expected to have same net operating income and exposed to similar business risk (normal fluctuations in profit). It is logical to expect same expected rate of return from assets or opportunity cost of capital of the two firms to be identical even when one firms assets are financed by 100% equity(ungeared) while the other firms assets are financed by 50% debt and 50% equity (geared)
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Therefore, proposition I is that total market value is independent of debt-equity mix and is given by capitalizing the expected net operating income by the capitalization rate which is the expected return on assets also called opportunity cost of capital.
Value of the firm = NOI Ka Net operating Income Opportunity cost of capital
V1=
For a levered firm expected net operating income is the sum of income of shareholders (dividend, note that no taxes also called net income) and income for debtholders (interest). The value of levered firm will be the sum of expected rate of return on equity and debt. This is same as the firms WACC.
WACC = KL = NOI VL
In case of unlevered firm, the entire NOI is shareholders Net Income hence WACC will be equal to opportunity cost of capital.
WACC = KU = NOI VU
Since values values of the levered firm and unlevered firm and the expected NOI do not change with financial leverage, WACC will also not change with change in gearing. Therefore, the conclusion of proposal I is that two firms with identical assets, irrespective of how they have been financed, cannot command different market values. However, incase one firm has a higher value, investors will switch their finances to the undervalued firm in a process called arbitrage until equilibrium is reached. Proposition II
ke is cost of equity. k0 is the company unlevered cost of capital (i.e. assume no leverage). kd cost of debt. D / E is the gearing ratio. Gearing does not affect NOI, opportunity cost of capital (return on assets) and WACC but increases shareholder returns (EPS and ROE) while at the same time increase financial risk (higher variability of shareholders return) hence higher required rate of return on equity i.e.(cost of capital).

Proposition II states that: the higher the gearing level the higher the required return on equity (cost of equity). The formula is derived from the theory of weighted average cost of capital (WACC) and implies that: a) The cost of debt remains unchanged as the level of gearing increases. b) WACC is constant c) The cost of equity rises in such a way as to keep the weighted average cost of capital constant. Assumptions of net operating income approach
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Modigliani and Miller made various assumptions in arriving at this conclusion, including: a) A perfect capital market exists, in which investors have the same information, upon which they act rationally, to arrive at the same expectations about future earnings and risks just as the management. b) There are no tax c) There is no transaction costs. d) Debt is risk-free and freely available at the same cost to investors and companies alike. e) The firm distributes all net earnings to shareholders
MM HYPOTHESIS UNDER CORPORATE TAXES The 1958 paper stimulated serious research devoted to disproving irrelevance as a matter of theory or as an empirical matter. This research has shown that the Modigliani-Miller theorem fails under a variety of circumstances. The most commonly used elements include consideration of taxes, transaction costs, bankruptcy costs, agency conflicts, adverse selection, lack of separability between financing and operations, time-varying financial market opportunities, and investor clientele effects. In reality corporate income taxes exists and debt interest payments are tax allowable deductions hence debt financing is advantages to the firm. In their 1963 article, MM show that the value of the firm will increase with debt due to deductibility of interest payment for tax computation and the value of levered firm will be higher than unlevered firm. In 1963 Modigliani and Miller modified their theory to admit that tax relief on interest payments does lower the weighted average cost of capital. The savings arising from tax relief on debt interest are the tax shield. They claimed that the weighted average cost of capital will continue to fall, up to gearing of 100%.
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Interest tax shield provided by debt is a cash flow and will increase the value of the levered firm by the value of the interest shield. Therefore, the higher the debt, the higher the interest shield hence the higher the value of the firm. Theotically, the value of a levered firm is at highest when employing 100% debt. For the value of the firm to increase, the discounting factor (WACC) whould be decreasing. In essense, the higher the debt the lower the WACC FAST FORWARD
0 Practical considerations in determining the Capital Structure Policy According to Pandey (2005) some companies do not plan their capital structures; it develops as a result of the financial decisions taken by the financial manager without any formal policy and planning. He added that these companies may prosper in the short-run, but ultimately they may face considerable difficulties in raising funds to finance their activities. Theoretically, the financial manager should plan an optimum capital structure for his company. The optimum capital structure is one that maximizes the market value of the firm. Two similar companies may have different capital structures if the decision makers differ in their judgment of the significance of various factors. A totally theoretical model perhaps cannot adequately handle all those factors, which affect the capital structure decision in practice. These factors are highly psychological, complex and qualitative and do not always follow accepted theory, since capital market is not perfect and the decision has to be taken under imperfect knowledge and risk. The board of the directors or the Chief Financial Officer (CFO) of a company should develop an appropriate or target structure, which is most advantageous to the company. This can be done only when all these factors are relevant to the companys capital structure decision, are properly analyzed and balanced. The capital structure should be planned generally keeping in viewing the interests of the equity shareholders and the financial requirements of a company. Some of the most important considerations are:
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a) Assets- Tangible fixed assets serve as collateral to debt. In the event of financial distress, the lenders can access these assets and liquidate them to realize funds lent by them. Companies with higher tangible fixed assets will have less expected costs of financial distress and hence, higher debt ratios such as Bamburi cement Kenya breweries Ltd etc. On the other hand, those companies, whose primary assets are intangible assets, will not have much to offer by way of collateral and will have higher costs of financial distress. Companies have intangible assets in form of human capital, relations with stakeholders, brands reputation such as Scan group Ltd, and their values start eroding as the firm faces financial difficulties and its financial risk increases. b) Growth opportunities- Firms that are in the growth stage of their cycle typically finance that growth through debt, borrowing money to grow faster. The conflict that arises with this method is that the revenues of growth firms are typically unstable and unproven. As such, a high debt load is usually not appropriate. More stable and mature firms typically need less debt to finance growth as its revenues are stable and proven. These firms also generate cash flow, which can be used to finance projects when they arise. c) Debt tax shields- Debt interest is tax deductibility, hence reduces the tax liability and increases the firms after-tax free cash flows hence increase the value of the firm. The tax advantage of debt implies that firms will employ more debt to reduce tax liabilities and increase value. d) Management Style- Management styles range from aggressive to conservative. The more conservative a management's approach is, the less inclined it is to use debt to increase profits. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company's earnings per share (EPS). e) Financial flexibility and operating strategy- Financial flexibility means a companys ability to adapt its capital structure to the needs of the changing conditions. The company should be able to raise funds, without undue delay and cost, whenever needed, to finance the profitable investments. It should also be in a position to redeem its debt whenever warranted by the companys operating strategy to and needs. It should also be able to substitute one form of financing for another to economize the use of funds. Flexibility depends on loan covenants, option to early retirement of loans which will be more unfavourable with increased debt and financial slack (unused debt capacity). f) Loan covenants- Restrictive covenants are commonly included in the long-term loan agreements and debentures. These restrictions curtail the companys freedom in dealing with the financial matters and put it in an inflexible position. Covenants in loan agreements may include restrictions to distribute cash dividends, to incur capital expenditure, to raise additional external finances or to maintain working capital at a particular level. g) Financial slack- The financial flexibility of a firm depends on the financial slack it maintains. The financial slack includes unused debt capacity, excess liquid assets, unutilized lines of credit and access to various untapped sources of funds. The financial flexibility depends a lot on the companys debt capacity of a firm and the higher is the unused debt capacity. Therefore, a company should not borrow to the limit of its capacity, but keep available some unused capacity to raise funds in the future to meet some sudden demand for finances. h) Control- In a company, the directors are elected representatives of equity shareholders. Therefore, directors have maximum voting rights in a concern as compared to the preference shareholders and debenture holders. Inclusion of debt leads to external control inform of loan
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covenants. The existing management team not only wants control and ownership but also to manage the company, without any outside interference. On the other hand existing shareholders will resist issue of additional share capital because its likely to dilute their degree of control and ownership. However, this can be resolved by use of rights issue and bonus shares instead of cash dividends. i) Issue costs- Issue or floatation costs are incurred when the funds are externally raised. Generally, the cost of floating debt is less than the cost of floating an equity issue. This may encourage companies to use debt than issue equity shares. Retained earnings do not involve flotation costs. j) Choice of investors- The companys policy generally is to have different categories of investors for securities. Therefore, a capital structure should give enough choice to all kind of investors to invest. Bold and adventurous investors generally go for equity shares and loans and debentures are generally raised keeping into mind conscious investors. k) Capital market condition- In the lifetime of the company, the market price of the shares has got an important influence. During the depression period, the companys capital structure generally consists of debentures and loans. While in period of boons and inflation, the companys capital should consist of share capital generally equity shares. l) Period of financing- When company wants to raise finance for short period, it goes for loans from banks and other institutions; while for long period it goes for issue of shares and debentures. m) Cost of financing- In a capital structure, the company has to look to the factor of cost when securities are raised. It is seen that debt at the time of profit earning of company prove to be a cheaper source of finance as compared to equity shares where equity shareholders demand an extra share in profits.
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CHAPTER FOUR DIVIDEND POLICY AND THEORY Introduction Dividend policy is defined as the policy used by a company to decide how much it will pay out to shareholders in dividends. The profits of a company when made available for the distribution among its shareholders are called dividends. In theory, the objective of a dividend policy should be to maximize a shareholders return so that the value of his investment is maximized. Shareholders return consists of two components: dividends and capital gains. Dividend policy has a direct influence on these two components of return. From the share valuation model, the value of a share depends very much on the amount of dividend distributed to shareholders. Dividend payout ratio is another important indicator: This ratio indicates how much of the profit is distributed as dividend to shareholders. 100 per cent minus payout percentage is called retention ratio Dividend payout ratio = Dividend per share Earnings per share There is considerable debate on how dividend policy affects firm value. Some researchers believe that dividends increase shareholder wealth (Gordon, 1959), others believe that dividends are irrelevant (Miller and Scholes, 1978), and still others believe that dividends decrease shareholder wealth (Litzenberger and Ramaswamy, 1979). On the relationship between dividend policy and value of the firm, different theories have been advanced. These theories can be grouped into two categories: a) Theories that consider dividend decision to be irrelevant b) Theories that consider dividend decision to be relevant since dividends either increase the shareholder value or reduce the shareholder value. DIVIDEND RELEVANCE: WALTERS MODEL Professor James E. Walter argues that the choice of dividend policies almost always affect the value of the firm. He devised an easy and simple formula to show how dividend can be used to maximize the wealth position of shareholders. According to Walter, in the long run, share prices reflect the present value of future stream of dividends. Retained earnings influence stock prices only through their effect on further dividends. His model, one of the earlier theoretical works, shows the importance of the relationship between the firms return, r, and its cost of capital, k, in determining the dividend policy that will maxmise the wealth of shareholders. Walters model is based on the following assumptions: Internal financing the firm finances all investment through retained earnings; that is, debt or new equity is not issued. Constant rate of return r. this also implies constant Net Income (PAT) and hence constant EPS since no. of shares is constant Constant cost capital k. 100 per cent payout or retention. That is all earnings are either distributed as dividends or reinvested internally immediately. Constant EPS and DPS- earnings and dividends never change. Infinite time the firm a very long or infinite life. Walters formula to determine the market per share is as follows: P= DPS + r (EPS DPS) /k k k Where P = Market price per share
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DIV = Dividend per share EPS = earnings per share r= firms rate of return (average) k = firms cost capital or capitalization rate According to Walters Model dividend policy should depend on availability of investment opportunities since i) For firms where r > k. The firm will generate more income from investing retained earnings and earn a rate of r higher than cost of capital. Therefore, the more the retained earnings the higher the share price hence the lower the payout ratio the higher the market value per share. The companys value will be highest when payout ratio is 0%. This is the optimal payout ration ii) For firms with r = k. retained earnings will only generate enough to pay investors. The dividend policy will have no effect on market value per share hence there is no optimal payout ratio iii) For firms with r < k. rate of return on investments is lower than cost of capital paid to investors. Earnings are rather distributed to investors so that they can invest somewhere else. Optimal payout ratio is 100% Example: A Ltd. paid a dividend of Kshs. 5 per share for 2010. The company follows a fixed dividend payout ratio of 30% and earns a return of 18% on its investments. Cost of capital is 12%. The expected price of the shares of A Ltd. using Walters Model calculated the share price and advise on what should be the optimal dividend policy DIVIDEND RELEVANCE: GORDONS MODEL Myron Gordon develops one very popular model explicitly relating the market value of the firm to dividend policy. Gordons model is based on the following assumptions: All equity firm the firm has no debt No external financing is available only retained earnings would be used to finance any expansion. Constant return - the internal rate of return, r, of the firm is constant. Constant cost of capital the appropriate discount rate k for the firm remains constant. Perpetual earnings the firm and its stream of earnings are perpetual. No taxes Constant retention - The retention ratio, b, once decided upon, is constant. Dividends have a constant growth rate g. the growth rate is approximated by the model g = br where g is the annual growth rate in dividends b is the proportion of profits that are retained r is the rate of return on new investments So, if a company retains 65% of its earnings for capital investment projects it has identified and these projects are expected to have an average return of 8%: g = br = 0.65 x 8% = 5.2% Cost of capital greater than growth rate. The discount rate is greater than growth rate, k > br = g. If this condition is must be fulfilled
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According to Gordons dividend-capitalization model, the market value of a share is equal to the present value of an infinite stream of dividends received by the shareholders thus: DIV0 DIV0 (1+g) + (1+g)2 P0 = +.+ DIV0 (1+g)n (1+k) (1+k)2 (1+k)n When summed together, DIV0 (1+g) P0 = k-g DIV1 k-g
Gordons model conclusions about dividend policy are similar to that of Walters model. This similarity is due to the similarities of assumptions that underlie both the models. Example Maisha Ltd has a current dividend per share of Kshs. 0.27 per share with retention ratio of 70% and the required rate of return for stock (shares) is 15%. Given that rate of return on new investments is 10%, use Gordons model, calculate the market value per share of Maisha Ltd and discuss what should be the optimal payout ratio for Maisha Ltd according to Gordons model. THE BIRD-IN-THE-HAND THEORY The essence of the bird-in-the-hand theory of dividend policy (advanced by John Litner in 1962 and Myron Gordon in 1963) is that shareholders are risk-averse and prefer to receive dividend payments rather than future capital gains. Shareholders consider dividend payments to be more certain that future capital gains thus a bird in the hand is worth more than two in the bush. Gordon concludes that, under conditions of uncertainty, dividend policy does affect the value of a share even when r = k. This view is based on the assumption that under conditions of uncertainty, investors tend to discount distant dividends (capital gains) at a higher rate than they discount near dividends. Investors, behaving rationally, are risk-averse and, therefore, have a preference for near dividends to future dividends. Other scholars such as Graham and Dodd (1934) also argued that a typical investor would most certainly prefer to have his dividend today and let tomorrow take care of itself and given two companies in the same general position and with same earnings power, the one paying the larger dividend will always sell at a higher price. Myron Gordon stated that when dividend policy is considered in the context of uncertainty, the appropriate discount rate, k, cannot be assumed to be constant. In fact, it increases with uncertainty; investors prefer to avoid uncertainty and would be willing to pay higher price for the share that pays the greater current dividend, all other things held constant. In other words, the appropriate discount rate would increase with the retention rate DIVIDEND IRRELEVANCE THE MILLER-MODIGLIANI (MM) HYPOTHESIS According to Miller and Modigliani (MM), under a perfect market situation, the dividend policy of a firm is irrelevant, as it does not affect the value of firm, They argue value of the firm depends on the firms earnings that result forms its investment policy. Thus, when investment decision of the firm is given, dividend decision split of earnings between dividends and retained earnings is of no significance in determining the value of the firm
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This theory also called dividend irrelevant theory recognizes that any shareholder can in theory construct his or her own dividend policy (homemade). For example, if a firm does not pay dividends a shareholder who want 5% dividend can create it by selling 5% of his stock. Conversely, if a company pays higher dividends than an investor desires, the investor can use unwanted dividend to buy additional shares of the company. Therefore an investor can buy or sell shares without incurring costs, the firms dividend policy will be irrelevant. The assumptions of this theory are: i) No transaction costs ii) No corporate taxes iii) Perfect markets Unfortunately, investors will incur brokerage costs and in some countries capital gain taxes. While dividends are taxes at a withholding tax rate and perfect market do not exist. So MM irrelevant theory may not be true, However, MM argued that all economic theories are based on simplifying assumptions, and that the validity of a theory must be judged by empirical tests, not by realism of its assumptions RESIDUAL THEORY The essence of the residual theory of dividend policy is that the firm will only pay dividends from residual earnings, that is, from earnings left over after all suitable (positive NPV) investment opportunities have been financed. Retained earnings are the most important source for financing for most companies. A residual approach to the dividend policy, as the first claim on retained earnings will be the financing of the investment projects. With the residual dividend policy, the primary focus of the firms management is indeed on investment, not dividends. Dividend policy becomes irrelevant, it is treated as a passive rather than an active, decision variables. The view of management in this case is that the value of firm and the wealth of its shareholders will be maximized by investing the earnings in the appropriate investment projects, rather than paying them out as dividends to shareholders. Thus managers will actively seek out, and invest the firms earnings in, all acceptable (in terms of risk and return) investment projects, which are expected to increase the value of the firm. Dividends will only be paid when retained earnings exceed the funds required to finance the suitable investment projects. Conversely when the total investment funds required exceed retained earnings, no dividend will be paid. ASSIGNMENT Read on tax preference theory CONSIDERATIONS IN DIVIDEND POLICY According to the theories, dividend policy has an impact on the value of a firm. In practice every firm follows some kind of dividend policy. However, to develop a long term dividend policy, the management should make a balance between the following factors: i) Firms investment opportunities and long-term financial needs- this is because raising external funds is more costly than retaining earnings to facilitate future investments. Young firms still experiencing growth will have more investment opportunities than mature firms while declining firms may not have profitable investment opportunities ii) Shareholders expectations- shareholders are the legal owners of the business and their demands must be made unless convinced otherwise. They may either prefer dividends or capital gains. This is called the Clientele effect which means that different groups or clientele of shareholders prefer different dividend payout ratio. For example a retired individual prefer
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cash income hence higher payout ratio while wealth investors or young investors prefer reinvestment since they have less need for current income hence prefer capital gains than dividend payments. A definite dividend policy followed for a long time tends to attract and retain a certain type of clientele. iii) Signaling effect and information asymmetry- different investors have different views on both the level of future dividend (future company performance) and riskiness (uncertainty of payment of those dividends) and managers have better information about the future prospects. It has been observed that increase in dividends is often accompanied by an increase in share prices and vice versa. A dividend reduction or a smaller-than-expected increase is a signal that management is forecasting poor earnings in the future and vice versa. This is called the signaling effect of dividend announcements iv) Stability of Earnings- The nature of business has an important bearing on the dividend policy. Industrial units having stability of earnings may formulate a more consistent dividend policy than those having an uneven flow of incomes because they can predict easily their savings and earnings. Usually, enterprises dealing in necessities suffer less from oscillating earnings than those dealing in luxuries or fancy goods. v) Age of corporation - Age of the corporation counts much in deciding the dividend policy. A newly established company may require much of its earnings for expansion and plant improvement and may adopt a rigid dividend policy while, on the other hand, an older company can formulate a clear cut and more consistent policy regarding dividend. vi) Liquidity- Availability of cash and sound financial position is also an important factor in dividend decisions. A dividend represents a cash outflow, the greater the funds and the liquidity of the firm the better the ability to pay dividend. The liquidity of a firm depends very much on the type investments despite having recorded high profits. For example firms in property industry may have high profits as a result of appreciation of market prices of houses but they may not imply availability of cash from a cash flow statement point of view. vii) Extent of share Distribution- Nature of ownership also affects the dividend decisions. A closely held company is likely to get the assent of the shareholders for the suspension of dividend or for following a conservative dividend policy. On the other hand, a company having a good number of shareholders widely distributed and forming low or medium income group would face a great difficulty in securing such assent because they will emphasize to distribute higher dividend. viii) Economic conditions- Business cycles also exercise influence upon dividend Policy. Dividend policy is adjusted according to the business oscillations. During the boom, prudent management creates food reserves for contingencies which follow the inflationary period. Higher rates of dividend can be used as a tool for marketing the securities in an otherwise depressed market. The financial solvency can be proved and maintained by the companies in dull years if the adequate reserves have been built up. ix) Government Policies- The earnings capacity of the enterprise is widely affected by the change in fiscal, industrial, labour, control and other government policies. Sometimes government restricts the distribution of dividend beyond a certain percentage in a particular industry or in all spheres of business activity as was done in emergency. The dividend policy has to be modified or formulated accordingly in those enterprises. The company Act restrict that dividends can only be paid out of profits and not capital reserves and assets. x) Past dividend Rates. While formulating the Dividend Policy, the directors must keep in mind the dividend paid in past years. The current rate should be around the average past rate. If it has been abnormally increased the shares will be subjected to speculation. In a new concern, the company should consider the dividend policy of the rival organisation. xi) Ability to Borrow- Well established and large firms have better access to the capital market than the new Companies and may borrow funds from the external sources if there arises any
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need. Such Companies may have a better dividend pay-out ratio. Whereas smaller firms have to depend on their internal sources and therefore they will have to build up good reserves by reducing the dividend payout ratio for meeting any obligation requiring heavy funds. xii) Policy of Control- Policy of control is another determining factor is so far as dividends are concerned. When higher dividends are paid, less will be retained hence external financing (such as issue of shares) will be the only way of financing investments. If the directors want to have control on company, they would not like to add new shareholders and therefore, declare a dividend at low rate. Because by adding new shareholders they fear dilution of control and diversion of policies and programmes of the existing management. xiii) Repayments of Loan- A Company having loan indebtedness are vowed to a high rate of retention earnings, unless one other arrangement is made for the redemption of debt on maturity. It will naturally lower down the rate of dividend. Sometimes, the lenders (mostly institutional lenders) put restrictions on the dividend distribution still such time their loan is outstanding. Formal loan contracts generally provide a certain standard of liquidity and solvency to be maintained. xiv) Time for Payment of Dividend- When should the dividend be paid is another consideration. Payment of dividend means outflow of cash. It is, therefore, desirable to distribute dividend at a time when is least needed by the company because there are peak times as well as lean periods of expenditure. Wise management should plan the payment of dividend in such a manner that there is no cash outflow at a time when the undertaking is already in need of urgent finances. Types of Dividends Cash Dividends: This is the most common and popular method of sharing a company's profits. A portion of the company's profits is paid to shareholders as shillings per share. A company must have enough cash to pay this type of dividend. Bonus or Stock Dividends: When dividends are given in the form of additional shares of the same company or its subsidiary corporation according to the proportion of the shares owned. This is always done on pro-rata basis. They are always issued in addition to cash dividends. Bonus issue increases the number of paid-up shares but do not dilute ownership. Most effective for a firm with non cash profit Property Dividends: Property dividends are paid out in the form of products or services provided by the corporation. They are paid in the form of assets such as gold, silver, cocoa beans etc. by companies. Special Dividends Special Dividends are offered rarely, such as during times when the company wins litigation, when the company sells a business or liquidation of investments. Some companies also offer special dividends when they have high amount of excess cash, in order to boost the market value of their stocks. Sometimes these special dividends are documented as return of capital, meaning the company is returning a portion of the money invested by the shareholders and hence these dividends also called capital dividends
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CHAPTER FIVE FIXED INCOME SECURITIES AND TERM STRUCTURE OF INTEREST RATES 1.1 Introduction According to Brigham and Houston (2004), a Bond is a long-term contract under which the borrower agrees to make payments of interest and principal, on specific dates, to the holders of the bond. In addition, Nairobi Stock Exchange (2008) defined a bond as a loan between a borrower and a lender in which the borrower promises to pay the lender some interest quarterly or semi-annually at some date in the future as well as promises to repay the initial money invested by the lender. Jones (1993) added that bonds are Fixed-Income Securities because the interest payments and principal repayment for a typical bond are specified at the time the bond is issued and fixed for the entire life of the bond. There are different types of bonds such as: i) Treasury Bonds and notes, which are issued by the Government of Kenya like Fixed Rate Treasury Bonds. Notes maturities ranges below ten years while bonds maturities ranges from 10 to 30 years ii) Corporate bonds are issued by corporations such as East African Development Bank bond (EADB), Faulu Kenya Ltd, PTA Bank Ltd which had recorded turnover US$82,000 in last four years to 2007( Osano,2007). iii) Municipal bonds - though not so common on most markets - are issued by local governments. In Kenya, we do not have any municipal bond but another type of bond is the international bonds. iv) International bonds. There are two types of international bonds: Foreign bonds and Eurobonds. Foreign bonds are issued by borrowers from a country other than the one in which the bond is sold. The bond is denominated in the currency of the country in which they marketed. They are given colourful names based on the country in which they are sold. For example, foreign bonds sold in USA are called Yankee bond while Yendenominated bonds sold in Japan are called Samurai bonds and British pound denominated bonds sold in UK are called bulldog bonds. Eurobonds are bonds issued in currency of one country but sold in a different country. For example, US dollar-denominated bonds sold outside US and not necessarily in Europe. Or Kenya shilling-dominated bonds sold in New York or London 1.2 Common Features of a Bond Par value. Bonds usually carry a face value called that normally represents the amount of money the firm borrows and promises to repay on maturity. Maturity date is the specified date on which the bond issuer must repay or return the par value. Coupon rate. Represents the rate at which interest will be paid per year as a percentage of the face value. For example, East African Development Bank bond sold on Kenyan is quoted as EADB FXT/2004/7 issued on 7th August 2004 and to mature on 1st August 2011 with a fixed interest rate of 7.50% face value of Kshs. 720,000,000. In this example, the maturity date is 7 th August 2011 and par value is Kshs. 720 M which can be split and sold in small values of Kshs.100. Most bonds have an original maturity date (the maturity at the time the bonds were issued) while others have call provisions. Many corporate bonds contain a call provision, which gives the issuing corporation or body the right to call the bonds for redemption before its original maturity. However, bonds may be issued with a provision that they not callable until several years mostly 5 to 10 years
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after they are issued. This is termed this as deferred call, and the bonds are said to have call protection. Other types of bonds i) Zero coupon bonds are bonds that are issued at a discount to their redemption value, but no interest is paid on them. Since these bonds that do not pay coupon at all, but are offered at a substantial discount below their par value. These securities are called zero coupon bonds or "zeros" ii) Original issue discount (OID) bond or Deep discount bonds are bonds issued at a price which is at a large discount to the nominal value of the notes, and which will be redeemable at par (or above par) when they eventually mature. Investors might be attracted by the large capital gain offered by the bonds, which is the difference between the issue price and the redemption value. However, deep discount bonds will carry a much lower rate of interest than other types of bond iii) Debenture is unsecured bond backed only by issuer's financial soundness. iv) Convertible bond when the bondholder is given the option, under specific terms to turn the bond into the corporation and receive a stated number of common stocks. They are bonds that give the holder the right to convert to other securities, normally ordinary shares, at a predetermined price/rate and time. v) Warrants are options that permit the holder to buy stock at a stated price (callable bonds) or to sale bonds back to the company prior to maturity at a prearranged price (putable bonds). Such bond like convertibles offer lower interest rates. vi) Extendable bonds are bonds that give investors the right to extend their term beyond a specified date and are common among private sector issuers in developed countries and in international financial markets, but not among public sector issuers both in developed and emerging markets. vii) Income bonds are bonds that only pay interest when income is made by the company viii) Indexed, or purchasing power bonds are bonds that pay interest based on inflation index. They were introduced by Brazil and Israel. Indexed bonds issued by US treasury are also called treasury inflation protected securities. 2.1 Bond Rating Bonds generally promise to pay a fixed flow of income, that income stream is not risk-less unless the investor can be sure the issuer will not default on obligation. While government treasury notes and bonds may be treated as free of default risk, this is not true of corporate bonds. Bonds default risk can be rated by Moodys Investor Services, Standard & Poors Corporation, Duff and Phelps and Fitch Investor services. They assign letter grades to the bonds of corporations and municipalities to reflect their assessment of the safety of the bond issue. The top rating is AAA lowest rating is D for S&P rating and use + and to provide a finer rating. According to Willis and Salters (2008), On April 17, 2008, Standard & Poor's Ratings Services assigned its long-term 'A' counterparty and insurer financial strength ratings to Kenya-based African Trade Insurance Agency (ATI). Bonds rated BBB or above are considered investmentgrade bonds, whereas lower-rated bonds are classified as speculativegrade or junk bonds. Some companies, especially insurance companies are not allowed to invest in junk bonds. Bonds Indentures A bond indenture is the contract between the issuer and the bond holder. Part of the indenture is a set of restrictions called protective covenants on the firm issuing the bond to protect the rights of the bond holders. Such restrictions may include provisions on collateral, sinking fund, dividend policy and further borrowing. Subordination of further debt clause or me first rule restrict the amount of further borrowing in event of bankruptcy , additional debt will be subordinated or be paid only after the fist debt is cleared.
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Dividend restriction clause limits the amount of dividend the firm is allowed to pay so as to force the firm to retain assets rather than paying them out to stockholders. Collateral covenant deals with issues of security. If the collateral is property, the bond is called a mortgage bond, if collateral is other securities held by the firm then the bond is termed a Collateral trust bond , if its equipment then the bond is called an equipment obligation bond while unsecured bonds are debentures. Bond Valuation Jones (1993) urged that a security's estimated value determines the price that investors place on it in an open market. He added that a security's estimated value is also called intrinsic value and according to Fama (1959) fundamental value theory, intrinsic value is the present value of the expected future cash flows from the asset. Bonds value will therefore be given by the following formula: Value of bond = Vb = INT (1+Kd) 1 + INT INT + M (1+Kd) 2 (1+Kd) n (1+Kd) n
Example: Calculate the value (price) of newly issued bond Kshs.10, 000 with a 10-year maturity, with a 10 % coupon rate. Assume that the market interest rate to be 10%. Time 1 2 3 4 5 6 7 8 9 10 PV factors @10% Cash flow interest 1,000 0.9091 1,000 0.8264 1,000 0.7513 1,000 0.6830 1,000 0.6209 1,000 0.5645 1,000 0.5132 1,000 0.4665 1,000 0.4241 11,000 0.3855 PRICE OF THE BOND = PV 909.09 826.45 751.31 683.01 620.92 564.47 513.16 466.51 424.10 4240.98 10,000.00
The bonds value will be sold at par Kshs. 10,000 since Coupon interest is 10% while required rate is also 10%. Hence when the coupon rate is equal to the market rate required by investors, the bond will be sold at par. Example: Suppose bond above was issued to earn coupon interest at 7 percent and required interest rate (market rate) remains at 10%. Then the bonds value will be Kshs. 8,156.63. Therefore when the coupon interest rate is below the required interest rate then the price or value of the bond will be lower than the par value.
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Time 1 2 3 4 5 6 7 8 9 10
PV factors @10% Cash flow (Kshs.) interest 700 0.9091 700 0.8264 700 0.7513 700 0.6830 700 0.6209 700 0.5645 700 0.5132 700 0.4665 700 0.4241 10,700 0.3855 PRICE OF THE BOND =
PV 636.36 578.51 525.92 478.11 434.64 395.13 359.21 326.56 296.87 4125.31 8,156.63
Example: Suppose bond above was issued to earn coupon interest at 12 percent and required interest rate (market rate) remains at 10%. Then the bonds value will be Kshs. 11, 228.91. Therefore when the coupon rate is higher than the required interest rate, the price or value of the bond will be above the par value. This because the bond will be more attractive to investors as it will offer a higher interest than what the market will be offering (market interest rate) Time 1 2 3 4 5 6 7 8 9 10 PV factors Cash flow @10% interest 1,200 0.9091 1,200 0.8264 1,200 0.7513 1,200 0.6830 1,200 0.6209 1,200 0.5645 1,200 0.5132 1,200 0.4665 1,200 0.4241 11,200 0.3855 PRICE OF THE BOND = PV 1090.91 991.74 901.58 819.62 745.11 677.37 615.79 559.81 508.92 4318.08 11,228.91
In valuation of bonds, like any other asset on the basis of future cash flows, the only problem is determining the denominator or discounting rate. The appropriate discount rate is the bond's required rate of return or simply called yield. In most cases, this is seen as the bond market rate of interest. Bonds Yields Unlike the coupon rate which is constant, the bond's yield varies from day to day depending on current market conditions. There are various types of yields:
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a) Yield To Maturity YTM is the interest rate that makes the present value of a bonds payments equal to its price. Jones (1993) defines it simply as the return you will an on an investment in bonds if it's held to maturity and is generally same as the market rate of interest Kd. YTM can be found by solving the equation of determination of bond value for Kd . YTM is the internal rate of return on an investment in the bond and can be interpreted as the compound rate of return over the life of the bond under assumption that all bonds coupons can be reinvested at an interest rate equal to the bonds yield to maturity hence YTM widely accepted as proxy of average return.
Value of bond = Vb = INT (1+Kd) 1
+ INT INT + M (1+Kd) 2 (1+Kd) n (1+Kd) n
b) Current yield This is computed as the annual interest payment divided by the bond's current price. Unlike the YTM current yield does not represent the return that investors should expect to receive from holding the bond. But it provides information regarding the amount of cash income that a bond will generate in a given year. Current yield for zero coupon bonds is zero which is confusing information. Current Yield = INT . Current price c) Yield To Call (YTC) When you buy the bond that is callable and the company called it, and then the yield to maturity will not be earned. When the current interest are below the outstanding bond's coupon rate, the company can call this bonds and replace them with bonds that have a lower coupon rate same as the prevailing market rate. When callable bonds are called, the yield is calculated using interest earned and call price. YTC can be calculated by solving the equation below for Kd. Bond market analysts might be more interested in YTC than with YTM for a callable bond.
Price of the bond = INT + INT INT + Call price (1+Kd) 1 (1+Kd) 2 (1+Kd) N (1+Kd) t
Bond Analysis For effective analysis of a bond portfolio, it's important that in addition the investor analyses the levels of nominal interest rates, the difference in yields for a given category of bonds also known as the term structure of interest rates, and difference in yields that exist between different sectors also called yield spreads.
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The Term Structure of Interest Rates According to Jones (19993) term structure of interest rates refers to the relationship between time to maturity and yields for a particular category of bonds at a particular point in time. Term structure of interest rates describes the relationship between long and short term rates. It is important to corporate treasurers who must decide whether to borrow by issuing long or short term debt and to investors who must decide whether to buy long- term or short term bonds. Thus its important to understand how long and short term rates relate to each other and what causes shifts in their relative position. The term structure is usually plotted in the form of a yield curve, which is a graphical depiction of the relationship between yields and time to maturity for bonds. The horizontal axis represents time to maturity, whereas the vertical axis represents yield to maturity.
The rest of notes are covered as an assignment: DISCUSS THE THEORIES OF TERM STRUCTURE OF INTEREST RATES Under this assignment, discuss determinants of yield curve which are risk premiums that determine the nominal interest rate of a security. Expressed by the relationship below: Nominal Interest Rate = k = k* + IP + DRP + LP + MRP
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Corprate Finance BBM 312

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CHAPTER ONE INTRODUCTION

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CHAPTER TWO RISK AND RETURN

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Probability 0.2 0.3 0.3 0.2

Return on Stock A 5% 10% 15% 20%

Return on Stock B 50% 30% 10% -10%

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Deviations Dx -10.4 -9.4 0.6 5.6 10.6

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Covariance X,Y (std deviation X) x (std deviation Y)

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Fig 2.3 Expected Return standard deviation combination

Expected Return E(Rp)

6% Portfolio standard deviation (p)

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Figure : Investment opportunity set Expected Returns of Portfolio P O Q

Therefore the equation of CML will be

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Fig 2.5 optimum risky portfolio T E(Rm) P Rf S R

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expected return 0.08 0.12 0.15 0.18

Beta 0.80 0.95 1.10 1.40

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Fig 2.6 Security Market Line

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Price Earnings ratio = This is same as Price Earnings ratio =

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150,000,000 (70,000,000) 80,000,000 20,000,000 60,000,000

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