Financial Management Subject Guide

Financial management
J. Dahya, R.E.V. Groves

AC3059, 2790059
2011
Undergraduate study in Economics, Management, Finance and the Social Sciences

This subject guide is for a Level 3 course (also known as a 300 course) offered as part of the University of London International Programmes in Economics, Management, Finance and the Social Sciences. This is equivalent to Level 6 within the Framework for Higher Education Qualifications in England, Wales and Northern Ireland (FHEQ). For more information about the University of London International Programmes undergraduate study in Economics, Management, Finance and the Social Sciences, see: www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by: J. Dahya, Bacc., Macc, Lecturer in Accounting and Business Finance, Cardiff Business School, University of Wales, Cardiff. R.E.V. Groves, B.Com., MSc, PhD, FCA, Sir Julian Hodge Professor of Accounting, Cardiff Business School, University of Wales, Cardiff. It was updated in 2008 by Professor Groves. This is one of a series of subject guides published by the University. We regret that due to pressure of work the authors are unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide.
The University of London International Programmes Publications Office Stewart House 32 Russell Square London WC1B 5DN United Kingdom Website: www.londoninternational.ac.uk
Published by: University of London University of London 2008 Reprinted with minor revisions 2011 The University of London asserts copyright over all material in this subject guide except where otherwise indicated. All rights reserved. No part of this work may be reproduced in any form, or by any means, without permission in writing from the publisher. We make every effort to contact copyright holders. If you think we have inadvertently used your copyright material, please let us know.
Contents
Contents
Introduction ............................................................................................................ 1 Aims and objectives ....................................................................................................... 1 Learning outcomes ........................................................................................................ 2 Syllabus ........................................................................................................................ 2 Studying financial management .................................................................................... 2 Reading advice ............................................................................................................. 3 Online study resources ................................................................................................... 4 How to use the subject guide ........................................................................................ 5 Solutions to learning activities ...................................................................................... 6 Examination advice ....................................................................................................... 6 Summary ...................................................................................................................... 7 Abbreviations ............................................................................................................... 7 Chapter 1: Introduction to financial management ................................................ 9 Aims of the chapter ...................................................................................................... 9 Learning outcomes ........................................................................................................ 9 Essential reading ........................................................................................................ 10 Further reading ........................................................................................................... 10 Key tasks of financial management ............................................................................. 10 Financial environment ................................................................................................. 10 Organisational forms of business ................................................................................ 11 Corporate objectives ................................................................................................... 11 Role of managers ....................................................................................................... 12 Conflicts of interest and their resolution ...................................................................... 12 Corporate governance ................................................................................................ 13 Financial management and risk ................................................................................... 13 Financial management and accounting ....................................................................... 13 Financial management and taxation ........................................................................... 14 A reminder of your learning outcomes ......................................................................... 14 Practise questions ....................................................................................................... 14 Problems .................................................................................................................... 15 Chapter 2: Basic investment appraisal methods .................................................. 17 Aims of the chapter .................................................................................................... 17 Learning outcomes ...................................................................................................... 17 Essential reading ........................................................................................................ 17 Further reading ........................................................................................................... 17 Time value of money ................................................................................................... 18 Future value and compounding ................................................................................... 18 Present value and discounting .................................................................................... 18 Interest rates, discount rates and real rates ................................................................. 19 Basic investment appraisal techniques ........................................................................ 19 Application problems some considerations ............................................................... 21 What-if questions ..................................................................................................... 25 The examination ......................................................................................................... 26 A reminder of your learning outcomes ......................................................................... 26
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59 Financial management
Sample examination questions .................................................................................... 26 Practise question 2.1 .................................................................................................. 26 Problems .................................................................................................................... 27 Chapter 3: Introduction to risk and return ........................................................... 29 Aims of the chapter .................................................................................................... 29 Learning outcomes ...................................................................................................... 29 Essential reading ........................................................................................................ 29 Further reading ........................................................................................................... 29 Introduction ............................................................................................................... 29 Rate of return: a review .............................................................................................. 30 Calculating expected return, variance and standard deviation ...................................... 31 Risk and diversification ............................................................................................... 33 Market risk versus unique risk ..................................................................................... 35 A reminder of your learning outcomes ......................................................................... 35 Practise questions ....................................................................................................... 35 Problems .................................................................................................................... 36 Chapter 4: Capital budgeting risk and return .................................................. 37 Aims of the chapter .................................................................................................... 37 Learning outcomes ...................................................................................................... 37 Essential reading ........................................................................................................ 37 Further reading ........................................................................................................... 37 Introduction ............................................................................................................... 37 Measuring market risk ................................................................................................ 38 Measuring beta .......................................................................................................... 38 Portfolio betas ............................................................................................................ 39 Risk and return ........................................................................................................... 39 Capital asset pricing model ......................................................................................... 40 Project returns and the opportunity cost of capital ....................................................... 41 Capital budgeting and project risk .............................................................................. 42 A reminder of your learning outcomes ......................................................................... 43 Practise questions ....................................................................................................... 43 Problems .................................................................................................................... 43 Chapter 5: Sources of funds ................................................................................. 45 Aims of the chapter .................................................................................................... 45 Learning outcomes ...................................................................................................... 45 Essential reading ........................................................................................................ 45 Capital markets .......................................................................................................... 46 Efficient market hypothesis ......................................................................................... 46 Tests of the efficient market hypothesis ....................................................................... 47 Anomalies, fads, insider trading and doubts concerning efficiency ................................ 48 Implications of capital market efficiency ...................................................................... 48 London capital market ................................................................................................ 49 Share capital .............................................................................................................. 50 Methods of raising share capital ................................................................................. 50 Rights issues, share prices and shareholder wealth ...................................................... 51 Other sources and types of equity ............................................................................... 52 Retained earnings ....................................................................................................... 53 Long-term debt finance .............................................................................................. 53 The issue of loan capital ............................................................................................. 54 Hybrid capital ............................................................................................................. 54
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Contents
The attitude of investors and managers to the financing decision ................................. 54 A reminder of your learning outcomes ......................................................................... 55 Practise questions ....................................................................................................... 55 Problems .................................................................................................................... 55 Chapter 6: Cost of capital and valuation of a business........................................ 57 Aims of the chapter .................................................................................................... 57 Learning outcomes ...................................................................................................... 57 Essential reading ........................................................................................................ 57 Further reading ........................................................................................................... 57 The value of economic assets debt ........................................................................... 58 The value of economic assets equity ......................................................................... 59 The required return on investment .............................................................................. 60 The capital asset pricing model (CAPM) ...................................................................... 61 The cost of retained earnings ...................................................................................... 61 Valuation of warrants ................................................................................................. 62 The reasons for capital gearing ................................................................................... 62 Capital gearing and risk .............................................................................................. 63 The relationship between the level of capital gearing and the cost of capital the traditional view .......................................................................................................... 63 The relationship between the level of capital gearing and the cost of capital the Modigliani and Miller view ......................................................................................... 64 Weighted average cost of capital (WACC) ................................................................... 65 Valuation on the basis of the businesss earnings ........................................................ 65 Other approaches to share and business valuation ...................................................... 66 A reminder of your learning outcomes ......................................................................... 70 Practise questions ....................................................................................................... 70 Problems .................................................................................................................... 71 Chapter 7: Dividend policy ................................................................................... 73 Aims of the chapter .................................................................................................... 73 Learning outcomes ...................................................................................................... 73 Essential reading ........................................................................................................ 73 Further reading ........................................................................................................... 73 Introduction ............................................................................................................... 73 Dividend policy and shareholder wealth ...................................................................... 74 Dividend irrelevancy argument .................................................................................... 74 Traditional view of dividends ....................................................................................... 74 Information content of dividends ................................................................................ 75 Clientele effect ........................................................................................................... 75 Share repurchase ........................................................................................................ 76 Scrip dividends ........................................................................................................... 76 Determining dividend policy in practice ....................................................................... 77 A reminder of your learning outcomes ......................................................................... 77 Practise questions ....................................................................................................... 77 Problems .................................................................................................................... 79 Chapter 8: Financial analysis, methods and uses, and financial planning ............ 81 Aims of the chapter .................................................................................................... 81 Learning outcomes ...................................................................................................... 81 Essential reading ........................................................................................................ 81 Further reading ........................................................................................................... 81 Statement analysis ...................................................................................................... 81
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Cash based ratios ....................................................................................................... 82 Practical applications .................................................................................................. 83 Financial planning introductory comments ............................................................... 88 Financial planning process .......................................................................................... 88 Technical aspects of financial planning ........................................................................ 88 Planning outputs ........................................................................................................ 89 A reminder of your learning outcomes ......................................................................... 90 Practise questions ....................................................................................................... 91 Problems .................................................................................................................... 91 Chapter 9: Short-term finance and asset management ...................................... 93 Aims of the chapter .................................................................................................... 93 Learning outcomes ...................................................................................................... 93 Essential reading ........................................................................................................ 93 Further reading ........................................................................................................... 93 Long- versus short-term finance .................................................................................. 94 Trade credit ................................................................................................................ 94 Debt factoring ............................................................................................................ 94 Bank borrowing .......................................................................................................... 95 Specialist finance ........................................................................................................ 96 Leasing ...................................................................................................................... 96 Evaluation of sources of finance .................................................................................. 96 Management of short-term assets ............................................................................... 99 The management of cash ............................................................................................ 99 The management of trade debtors ............................................................................ 100 The management of stock-in-trade ............................................................................ 101 Working capital and the problem of overtrading ........................................................ 102 A reminder of your learning outcomes ....................................................................... 104 Practise questions ..................................................................................................... 104 Problems .................................................................................................................. 105 Chapter 10: Treasury management and international aspects of financial management ....................................................................................... 107 Aims of the chapter .................................................................................................. 107 Learning outcomes .................................................................................................... 107 Essential reading ...................................................................................................... 107 Further reading ......................................................................................................... 107 Introduction ............................................................................................................. 108 Why should financial managers of firms be concerned with options and other financial instruments? ............................................................................................... 108 Calls and puts .......................................................................................................... 108 What the value of a call option depends upon ........................................................... 109 Option valuation model ............................................................................................ 110 Using options to allow the expansion or abandonment of real assets ......................... 111 Options on financial assets ....................................................................................... 112 Why do companies hedge? ....................................................................................... 112 International financial management .......................................................................... 113 Interrelationships between variable affecting exchange rates ..................................... 114 Exchange risk exposure ............................................................................................. 116 Management of foreign exchange exposure .............................................................. 116 A reminder of your learning outcomes ....................................................................... 119 Practise question ...................................................................................................... 119 Problems .................................................................................................................. 120
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Contents
Chapter 11: Mergers, corporate restructuring and off-balance sheet funding .. 121 Aims of the chapter .................................................................................................. 121 Learning outcomes .................................................................................................... 121 Essential reading ...................................................................................................... 121 Further reading ......................................................................................................... 121 Introduction ............................................................................................................. 122 Merger waves ........................................................................................................... 122 Motives for individual mergers .................................................................................. 123 Economic theories of mergers ................................................................................... 123 Management motives ............................................................................................... 126 Takeover tactics ........................................................................................................ 127 Takeover defences .................................................................................................... 129 Glamorous defence tactics ........................................................................................ 129 Company restructuring ............................................................................................. 130 Divestments ............................................................................................................. 130 Off-balance sheet funding ......................................................................................... 131 Leasing .................................................................................................................... 131 A reminder of your learning outcomes ....................................................................... 132 Practise questions ..................................................................................................... 132 Problems .................................................................................................................. 133 Appendix 1: Review questions ........................................................................... 135 Question 1 ............................................................................................................... 135 Question 2 ............................................................................................................... 135 Question 3 ............................................................................................................... 136 Question 4 ............................................................................................................... 137 Question 5 ............................................................................................................... 137 Question 6 ............................................................................................................... 138 Question 7 ................................................................................................................ 138 Question 8 ............................................................................................................... 139 Appendix 2: Suggested solutions to review questions ..................................... 141 Solution to Question 1 .............................................................................................. 141 Solution to Question 2 .............................................................................................. 142 Solution to Question 3 .............................................................................................. 143 Solution to Question 4 ............................................................................................... 145 Solution to Question 5 .............................................................................................. 146 Solution to Question 6 ............................................................................................... 147 Solution to Question 7 ............................................................................................... 149 Solution to Question 8 .............................................................................................. 150 Appendix 3: Sample examination paper ........................................................... 151
Notes
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Introduction
Introduction
59 Financial management is a Level 3 course (also known as a 300 course) offered on the Economics, Management, Finance and the Social Sciences (EMFSS) suite of programmes. Financial management is part of the decision-making, planning and control subsystems of an enterprise. It incorporates: the treasury function, which includes the management of working capital and the implications arising from exchange rate mechanisms due to international competition the evaluation, selection, management and control of new capital investment opportunities the raising and management of the long term financing of an entity the need to understand the scope and effects of the capital markets for a company, and the need to understand the strategic planning processes necessary to manage the long and short term financial activities of a firm. The management of risk in the different aspects of the financial activities undertaken is also addressed. Studying this course should provide you with an overview of the problems facing a financial merger in the commercial world. It will introduce you to the concepts and theories of corporate finance that underlie the techniques which are offered as aids for the understanding, evaluation and resolution of financial managers problems. This subject guide is written to supplement the Essential and Further reading listed for this course, not to replace them. It makes no assumptions about prior knowledge other than that you have passed the course 25 Principles of accounting (or its predecessor, course 19 Elements of accounting and finance). This course may not be taken with 92 Corporate finance. The aim of the course is to provide an understanding and awareness of both the underlying concepts and practical application of the basics of financial management. The readings and the subject guide should also help to build in your mind the ability to make critical judgements of the strengths and weaknesses of the theories, just as it should be helping to build a critical appreciation of the uses and limitations of the same theories and their possible applications.
Aims and objectives

This course is designed to: place financial management as a clear part of the decision making, planning and control subsystems of an enterprise provide an overview of the problems facing a financial merger in the commercial world introduce the concepts and theories of corporate finance that underlie the techniques which are offered as aids for the understanding, evaluation and resolution of financial managers problems.
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Learning outcomes
At the end of this course, and having completed the Essential reading and activities, you should be able to: discuss the theoretical models underpinning the practices in financial management apply the techniques derived from the models and theories in financial management explain the long and short-term financial needs of a business describe the techniques used for the selection and management of long and short-term assets discuss and give examples of the wider aspects of financial management so as to include international considerations and the need to communicate decisions made to other members of a management team. The above provides a broad checklist for you to refer to as you work through the guide.
Syllabus
A critical perspective of the topic of finance, the role of financial managers and the place of financial markets within the business environment in developed and developing economies. Topics will be set in both national and international contexts. Sources and methods of raising finance including venture capital, public offerings, private placements and project finance. A critical review of the different forms of finance such as equity, debt and their derivatives and incorporating critical consideration of their costs individually and in combination. Valuation methods for costing the different elements of capital such as the Capital Asset Pricing Model and the Arbitrage Pricing Model. Theories of capital gearing, dividend policy and corporate restructuring and refinancing. Mergers and acquisitions. Evaluation of risk measurement theories and methods and their application to both sources of finance and to investment appraisal. Investment appraisal techniques in the certain and uncertain world, with and without constraints. Analytical tools, techniques and methods for analysing financial reports incorporating an assessment of their relevance for evaluation and planning purposes. Strategic considerations of financial planning and control, models and methods, for management of corporate liabilities and assets. Consideration of theories and techniques for management of short term funds including treasury and currency management. An introduction to risk management including hedging, futures, options and derivatives and their uses in both long and short term situations.
Studying financial management

This subject guide highlights the key theoretical and practical issues relating to financial management. The topics to be covered in this subject can be divided into six elements: the theories and techniques of appraisal and management of long-term investments under conditions of both certainty and risk
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Introduction
the various sources of long-term funds, the methods used to raise them, their individual costs and the effect of gearing in the corporate financial mix the valuation models used to derive capital costs, incorporating theoretical and empirical aspects of investors behaviour both individually and as a capital market, noting differences in capital market operations and effects between developed and developing capital markets the analytical tools necessary for corporate evaluation, valuation, prediction and planning short-term funds, their sources and management, both nationally and internationally general elements of corporate financial activity such as mergers and acquisitions, risk management, treasury management using the currency and futures markets. From the practical viewpoint, these elements of financial management can be condensed to the three broad areas of the provision, allocation and control of a businesss financial resources to enable it to achieve its objectives. The financial manager must be able to identify and quantify the amount of capital required for investment, whether this is in fixed or current assets. To do this, the manager will use financial planning models to determine the quantity of funds required. Where, why, and how the funds are obtained is all part of the financial managers function just as deciding to what use the funds should be put. Having decided upon the capital mix on the one hand, and the selection of the investments on the other, the financial manager must then fulfil the control function of this role thus ensuring that the planning goals are achieved. Overall, the financial manager has a wide and very important role.
Reading advice
Essential reading
You need to purchase or have regular access to the following textbook:
Brealey, R.A., S.C. Myers and A.J. Marcus Fundamentals of Corporate Finance. (McGraw-Hill Inc, 2007) fifth edition (Intl) [ISBN 9780073012384].
This textbook gives a good introduction to the subject, but on its own is insufficient since it does not provide the depth of discussion and analysis required for an undergraduate degree course. It is therefore necessary to read the appropriate chapters in one of the additional texts listed below to provide this depth. These texts tend to be reflective of the corporate finance perception of the subject matter rather than the more applied view of financial management. This has to be born in mind. In the text it will be referred to in this subject guide as BMM. Detailed reading references in this subject guide refer to the editions of the set textbooks listed above. New editions of one or more of these textbooks may have been published by the time you study this course. You can use a more recent edition of any of the books; use the detailed chapter and section headings and the index to identify relevant readings. Also check the virtual learning environment (VLE) regularly for updated guidance on readings.
Further reading
Please note that as long as you read the Essential reading you are then free to read around the subject area in any text, paper or online resource. You will need to support your learning by reading as widely as possible and by thinking about how these principles apply in the real world. To help you read extensively, you have free access to the VLE and University of London Online Library (see below). Other useful texts for this course include:
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (McGraw-Hill, 2008) ninth edition (Intl) [ISBN 9780073368696].
For those of you who are studying on your own who find difficulty with the recommended basic text of BMM another text is offered, but note that it does not cover the subjects to the same depth and rigour required. This supplementary primer is:
Atrill, P Financial Management for Decision makers. (FT Prentice Hall . Europe, 2005) fourth edition [ISBN 9780273702498].
Online study resources

In addition to the subject guide and the Essential reading, it is crucial that you take advantage of the study resources that are available online for this course, including the VLE and the Online Library. You can access the VLE, the Online Library and your University of London email account via the Student Portal at: http://my.londoninternational.ac.uk You should have received your login details for the Student Portal with your official offer, which was emailed to the address that you gave on your application form. You have probably already logged in to the Student Portal in order to register! As soon as you registered, you will automatically have been granted access to the VLE, Online Library and your fully functional University of London email account. If you forget your login details at any point, please email: uolia.support@ london.ac.uk quoting your student number.
The VLE
The VLE, which complements this subject guide, has been designed to enhance your learning experience, providing additional support and a sense of community. It forms an important part of your study experience with the University of London and you should access it regularly. The VLE provides a range of resources for EMFSS courses: Self-testing activities: Doing these allows you to test your own understanding of subject material. Electronic study materials: The printed materials that you receive from the University of London are available to download, including updated reading lists and references. Past examination papers and Examiners commentaries: These provide advice on how each examination question might best be answered. A student discussion forum: This is an open space for you to discuss interests and experiences, seek support from your peers, work collaboratively to solve problems and discuss subject material. Videos: There are recorded academic introductions to the subject, interviews and debates and, for some courses, audio-visual tutorials and conclusions.
Introduction
Recorded lectures: For some courses, where appropriate, the sessions from previous years Study Weekends have been recorded and made available. Study skills: Expert advice on preparing for examinations and developing your digital literacy skills. Feedback forms. Some of these resources are available for certain courses only, but we are expanding our provision all the time and you should check the VLE regularly for updates.
Making use of the Online Library

The Online Library contains a huge array of journal articles and other resources to help you read widely and extensively. To access the majority of resources via the Online Library you will either need to use your University of London Student Portal login details, or you will be required to register and use an Athens login: http://tinyurl.com/ollathens The easiest way to locate relevant content and journal articles in the Online Library is to use the Summon search engine. If you are having trouble finding an article listed in a reading list, try removing any punctuation from the title, such as single quotation marks, question marks and colons. For further advice, please see the online help pages: www.external.shl.lon.ac.uk/summon/about.php
How to use the subject guide

This subject guide is divided into 11 chapters, plus appendicies. Some chapters in the subject guide are self-contained; others lead into one or more following chapters. Complete whichever chapter you are studying and the associated work before moving on. A suggested order for your studying is as follows: For each chapter, read the aims and/or introduction and the learning objectives to appreciate the scope of the material to be covered. Carefully read the suggested chapters in Brealey, Myers and Marcus, with the aim of gaining an initial understanding of the topics. Read the remainder of the chapter in the subject guide. You may then approach the Further reading suggested in Brealey, Myers and Allen. The subject guide material is aimed to identify the scope of your studying of this topic as well as attempting to reinforce the basic messages set out in Brealey, Myers and Marcus. Therefore you should pay careful attention to the examples in both the texts and the subject guide to ensure you achieve that basic understanding. By taking notes from Brealey, Myers and Marcus and then from any other books you should have obtained the necessary material for your understanding, application and later revision. Pay particular attention to the practise questions and the examples given in the subject guide. The material covered in the examples and in working through the exercises is both complementary to the textbook and important in your preparation for the examination. Ensure you have achieved the listed learning outcomes.
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Attempt the problems at the end of each chapter, and if you have the time attempt those at the end of the Brealey, Myers and Marcus chapters. Check you have mastered each topic before moving on to the next. At the end of your preparations, attempt the Sample examination questions at the end of the subject guide. Then compare your answers with the suggested solutions, but do remember that they may well include more information than the Examiner would expect in an examination paper, since the guide is trying to cover all possible angles in the answer, a luxury you do not usually have time for in an examination.
Solutions to learning activities

Solutions to certain learning activities is provided online in the VLE at http://emfss.elearning.london.ac.uk/ This is indicated in the subject guide as: See VLE for solution
Examination advice
Important: the information and advice given here are based on the examination structure used at the time this guide was written. Please note that subject guides may be used for several years. Because of this we strongly advise you to always check both the current Regulations for relevant information about the examination, and the VLE where you should be advised of any forthcoming changes. You should also carefully check the rubric/instructions on the paper you actually sit and follow those instructions. The examination paper will normally be made up of two sections each containing four questions. One section will include data handling and numerical analysis type questions each requiring analysis, composition and presentation. Each question will also have a small section requiring a written answer which may be a discussion of the theory used in the application, or a request for interpretation of your results or something related to the problem or theory used. The other section will contain essay or report-style questions requiring written answers. You will need to answer four questions with a minimum of one question from each section. Remember when sitting the examination to maximise the time spent on each question and although, throughout, the subject guide will give you advice on tackling your examinations, remember that the numerical type questions on this paper take some time to read through and digest. Therefore try to remember and practise the following approach. Always read the requirement(s) of a question first before reading the body of the question. This is appropriate whether you are making your selection of questions to answer, or when you are reading the question in preparation for your answer. In the question selection process at the start of the examination, by reading only the requirements, which are always placed at the end of a question, you then only read material relevant to your choice, you do not waste time reading material you are not going to answer. Secondly, by reading the requirements first, your mind is focused on the sort of information it should be looking for in order to answer the question, therefore speeding up the analysis and saving time.
Introduction
Remember, it is important to check the VLE for: up-to-date information on examination and assessment arrangements for this course where available, past examination papers and Examiners commentaries for the course which give advice on how each question might best be answered.
Summary
Remember this introduction is only a complementary study tool in your efforts with this subject guide. Its aim is to give you a clear understanding of what is in the subject guide and how to study successfully. Systematically study the next eleven chapters along with the listed texts for your desired success. Good luck and enjoy the subject!
Abbreviations
AIM APM ARR BMA BMM CAPM CME EMH EPS IRR ISE NPV MM MPT PA PE PI PP WACC Alternative Investment Market Arbitrage Pricing model Accounting rate of return Brealey, Myers and Allen Brealey, Myers and Marcus Capital asset pricing model Capital market efficiency Efficient market hypothesis Earnings per share Internal rate of return International Stock Exchange of the UK and the Republic of Ireland Net present value Modigliani and Miller Modem portfolio theory Peter Atrill Price earnings ratio Profitability index Payback period Weighted average cost of capital
Notes
Chapter 1: Introduction to financial management

Aims of the chapter
This chapter is clearly one of the most important in the subject guide because it deals with the fundamentals of financial management. Without a clear understanding of the fundamentals the remainder of this subject will not be easy to grasp. As with any subject area, a knowledge of the background, the environment to which the subject relates, is important as it helps to put everything learnt later into appropriate perspective. The chapter starts by looking at the key tasks of financial management. Since knowledge of the financial environment is vital to managers this comes next before the review of the differing organisational forms of business that are in use. An outline of corporate objectives follows because these form the basis of much of the theory that is covered in this subject. The roles of financial managers come next, to be followed by a discussion of some of their conflicts of interest and how they might be resolved. One area of major interest is the corporate governance debate on how the relationship between owners and controllers should be systemised to maximise the corporate gain. Brief descriptions of how risk is treated in financial management theory, and how accounting is linked in with financial management, are included and the chapter is concluded with a note of the direction and importance of taxation in todays financial decisions. The course 25 Principles of accounting, if studied carefully and fully, should have meant you already have all this background knowledge. If that is true, then perhaps only a quick review of this subject matter is necessary, but if the practise questions and problem(s) here and in the Essential text cause you any problems, then a more detailed and careful review of your prerequisite course may be needed.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and activities, you should be able to: describe the general financial environment in which corporations operate explain the importance and roles of financial markets list/outline the roles financial managers can have within an organisation outline such things as taxation, accounting information and form of business and their implications for financial management give examples of the various objectives a company may have and why the main objective is deemed to be shareholder wealth maximisation explain and give examples of how the influence of risk will permeate all aspects of financial management, the theories presented, the appraisal and selection, the changes suggested, and the control methods used.
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Essential reading
Brealey, R.A., S.C. Myers and A.J. Marcus Fundamentals of Corporate Finance. (McGraw-Hill Inc, 2007) Chapters 1, 2 and 3.
Further reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (McGrawHill, 2008) Chapter 1. Atrill, P Financial Management for Decision makers. (FT Prentice Hall Europe, . 2005) Chapters 1 and 2.
Key tasks of financial management

There are five key tasks undertaken in financial management: financial planning investment project appraisal financial decisions capital market operations financial control. Financial planning provides the means, through plans and projections, to evaluate the proposed courses of action. Similarly financial control deals with the ways and means by which the plans are achieved. The next two tasks, investment project appraisal and financing decisions are seen by some, including Brealey and Myers, as the two most important tasks. Investment project appraisal is the assessment and evaluation of the relative strengths of a companys investment propositions. The financing decisions involve the identification and choice of the sources of funds which will provide the cash to be invested into the selected projects. Part of the finance function is dealing with the capital market since a large part of the finance is obtained through the capital market, not least those funds provided by the equity owners, the ordinary shareholders. This function does not just deal with the raising of funds but also with the ongoing relationship between the company and the market place; information disseminated to the capital markets affects the markets perception of the company and the price of the companys shares, and thus wealth of the shareholder.
Financial environment
The economic and social background of a country is a major influence on a firm, on its structure and on its objectives and operations. Firms in socialist or communist countries have different structures and objectives from those that operate in capitalist economies. Countries that are still developing may not have a public market place (i.e. a stock market) in which the shares in a company can be traded. Different phases of the trade cycle have different implications for financial operations. In depressed times, interest rates payable on loans will be higher, trading conditions much more risky and so returns to shareholders may be lower or non-existent. In the capitalist economies of developed countries where there are stockmarkets, the owners of the shares in trading companies will expect returns on those shares. The quality and amount of that return, the dividend, will be one of the elements influencing the price at which the share is quoted in the market. Potential owners of shares as well as existing
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owners of shares are interested in the quoted price of a companys share and in the return obtainable from that investment. How and why those returns and share prices can be influenced will be covered later. The extent of a countrys capital markets, of which the stockmarket is but a part, vary enormously from the very large, very sophisticated, very structured markets such as London and New York to some of the very small nascent markets in some developing countries in Africa and the Middle East. Each country has its own sets of laws and regulations which provide the parameters for the structure of the entity and how it can operate on a daily basis.
Organisational forms of business

Businesses established for profit-making purposes generally are organised into one of two forms: incorporated and un-incorporated. The incorporated firm are the companies or corporations, while the unincorporated are either proprietorships or partnerships. The corporation or company is a legal entity of unlimited life, independent of its owners. The owners of a company, its shareholders, have limited liability for the debts and obligation of the company. The liability being limited to the par or nominal value of the shares or equity held. With ownership usually comes some form of control through voting rights, but this does not extend to managerial control of day to day operations. For that, management, by way of directors, have to be appointed to act as the shareholders agents. Therefore, in theory, ownership and management are likely to be separate, unless of course managers are also major shareholders. The unincorporated form of business make up the majority of the numbers of businesses, though not the majority in terms of value or employment. These businesses are generally sole proprietorships or partnerships. The liability of the owners of these entities is unlimited. They are managed by the owners and do not have a separate legal entity even though they may have a separate trading name. Ownership and management risks are intertwined which makes raising very large sums of capital almost impossible. If the owner/partners want the entity to continue to grow then usually a change in form for the entity will be necessary. In this subject guide we will be viewing financial management from the perspective of a corporate entity, but much of what is covered is also relevant to the unincorporated business.
Corporate objectives
Generally we assume that a companys objective is to increase the value of the shareholders investment in the firm. We also assume that all managers act to further that objective. Shareholder wealth maximisation is the normative objective of a company that underlies financial management theory. In practice, a company has many stakeholders, employees, customers, government, creditors, lenders as well as shareholders. As groups they have their objectives for the company and as individuals they have their own objectives for their stake in the company. Some of these individual objectives may be at slight variance with the others, for example, customers want the company to provide the product with the highest quality and lowest price, but this may not result in high profits and share price maximisation. Corporate objectives are determined by a relatively small group of senior management, probably the directors. These can
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be influenced by a number of things with an outcome which may not be shareholder wealth maximisation, and which can be allowed to vary with circumstances and over time. It is often argued in the UK financial press that though companies may be trying to increase shareholder wealth it is not with a long-term perspective but is only short-term oriented. Activity 1.1 Consider the stakeholders of a business as described earlier. Try to list what you believe are the major objectives of each group. There may be two, three or more for each group. Then try to rank each groups objectives in order of importance. Now draft your reasons for your rankings. Next assume you are the Board of Directors and you are required to publish the companys objective(s). Which one(s) would you list and why? Do they all directly or indirectly lead to shareholder wealth maximisation? Your lists could be based upon the company(s) you know or work for. Do not be surprised by the differences and variations, and do not forget the power of the financial market place in steering you towards your final selection. See VLE for solution
Role of managers
A company is a complex organisation made up of many employees each with their own objectives. In theory, the manager is expected to act in furtherance of the goals of the owners. The financial manager is expected to act as the intermediary who will undertake the tasks of financial management. That is, the manager, using the evaluation, planning and control techniques and systems, will attempt to maximise the return from the optimal selection of investments so as to satisfy the providers of finance from whom (s)he has obtained the cheapest and best combination of funds via the capital markets. However, managers may not be owners.
Conflicts of interest and their resolution

One of the major disadvantages of the corporate form is the separation of management and ownership. This separation can create costs which have been called the costs of agency since management is deemed to be the agent of the owners (the principals). Agency theory attempts to explain this situation and how conflicts between principal and agent can arise, as well as possible ways in which the costs of any such conflict can be minimised. It is argued that agents will tend to pursue their own goals and the greater the deviation of those goals from the corporate goals, the greater the agency costs. Therefore incentives should be provided to try to ensure convergence of goals between principal and agent (e.g. share option schemes). Systems should be used to monitor and ensure control of agents, for example use of annual reports, the setting up of an appropriate governance structure which restricts, minimises and hopefully enables the removal of management, and in particular directors, who abuse their powers and who are therefore not attempting to ensure the company achieves its goals.
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Corporate governance
The essence of the corporate governance debate is the effects of the particular relationship between directors and shareholders. The greater the separation between the two, the greater the potential for abuse and also the greater the possibility of suboptimal behaviour by managers as viewed by shareholders. At present in the UK there is a voluntary system of governance in place. The framework has evolved through, or been impacted upon, by six key reports starting with the Cadbury report in 1992. The various recommendations of these reports have been incorporated into the combined code which is included in the Listing Rules of the London Stock Exchange as an appendix. The rules require a company to make a disclosure statement in its annual report about its compliance with the combined code. Though not legally enforceable, the regulations require compliance and provide for penalties. Different corporate structures, business, legal and social environments require different governance requirements and systems. All this is important because it highlights the differences between the normative theory and the practical application.
Financial management and risk

Since financial management is concerned with making decisions, and decision making is concerned with the future and the future is uncertain, risk must be a major factor in all aspects of financial management. Risk may be defined as the extent to which what we estimate will happen in the future may or may not happen. If there is only one single possible outcome, there is no risk. If there are many possible outcomes and many of them are very different from our estimate of the outcome, then there is a lot of risk. Broadly speaking, both theory and practice show us that risk and return are correlated. We seek higher expected returns for investing in riskier projects. Where we perceive little risk (e.g. an investment in government securities), we are prepared to accept relatively small returns. Activity 1.2 Choose a few practical situations where a business faces the effect of risk, (e.g. projecting next years sales budget or evaluating a new investment proposal). Try to identify the causes of that riskiness. Then think of ways to try to measure it and ways to control it. See VLE for solution
Financial management and accounting

Financial management is not the same as, or even a branch of, accounting. Accounting has been defined as:
the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information. (American Accounting Association).
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Given this definition, it is clear that financial managers will be major users of accounting information. Those who work as financial managers may very well have a background in accounting. In many small businesses one person combines the roles of accountant and financial manager. Despite these facts, the role of the accountant and that of financial manager are distinctly different. The accountant is concerned with the provision of information: financial managers use information supplied by the businesss accounting system and other sources to help them to make financing and investment decisions.
Financial management and taxation

Virtually all decisions taken by financial managers have tax effects. In the UK, for example, the tax treatment of loan interest is different from that of dividends paid to shareholders. Therefore the decision between raising funds from shareholders and from lenders has tax implications. Returns from investments made by the business (i.e. profits) are taxed. It is not one of the objectives of this course to turn you into an expert on the UK tax system. It is important, however, that you have a broad appreciation of the major aspects of the UK tax system, which has much in common with the tax systems which prevail in other of the worlds countries. Activity 1.3 Think of similarities and differences between the UK tax systems and another country you are familiar with. Are there any major differences in the corporate taxation system?
A reminder of your learning outcomes

By the end of this chapter, and having completed the Essential reading and activities, you should be able to: describe the general financial environment in which corporations operate explain the importance and roles of financial markets list/outline the roles financial managers can have within an organisation outline such things as taxation, accounting information and form of business and their implications for financial management give examples of the various objectives a company may have and why the main objective is deemed to be shareholder wealth maximisation explain and give examples of how the influence of risk will permeate all aspects of financial management, the theories presented, the appraisal and selection, the changes suggested, and the control methods used.
Practise questions
1. Consider what objectives might be important to a company other than shareholder wealth maximisation. Describe these objectives and show how there may or may not be consistency between the different objectives. Discuss the implications of your findings. 2. How might a managers objectives differ from those of the company? What are the implications for corporate policies in order to ensure congruence between the sets of objectives?
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Problems
In BMM, attempt the following problems: Chapter 1, p.23, numbers 2, 5, 7, 8 and 9 Chapter 2, pp.44 and 45, numbers 4, 10 and 17 Chapter 3, p.65, numbers 2, 3 and 4.
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Notes
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Chapter 2: Basic investment appraisal methods

Aims of the chapter
Like the topics in the first chapter of this guide, the topics in this chapter are integral to the subject as a whole since these basic techniques of time value of money and discounting are used in numerous other aspects of financial management. So carefully learn these concepts, and the process as well as the principles and the pros and cons concerning them. This chapter defines and explains the time value of money concept and applies it to problems of investment appraisal in a certain world. The relaxation of the assumption of certainty occurs in the following two chapters. Here we concentrate on the basics since the technique can be and is used in long-term and short-term investment appraisal, in evaluation of financing methods, valuing monetary assets, risk management etc. We start by describing the time value of money and then explain the concept and approach to the computational methodology used in a practical example of investment appraisal and selection. The net present value (NPV) is described very fully both in principle and application and in how the decision rules are derived. Different sets of circumstances are introduced to show how the NPV approach can cope with the situations met in an imperfect world, (e.g. taxation, inflation, different interest rates, repeat investments, mutually exclusive investments, capital rationing). Alternative methods of appraisal are also described, such as internal rate of return and pay-back. The major problem of an imperfect world and uncertain outcomes is dealt with later in Chapters three and four.
Learning outcomes
By the end of this chapter and having completed the Essential reading and activities, you should he able to: describe and apply the time value of money in project evaluation, whether it be future or present value oriented defend the use of NPV as the method of appraisal against other suggested methods prepare evaluations of investment proposals and state which decision rule is appropriate in the specific set of circumstances.
Essential reading
Brealey, R.A., S.C. Myers and A.J. Marcus Fundamentals of Corporate Finance. (McGraw-Hill Inc, 2007) Chapters 4, 7, 8 and 9
Further reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (McGrawHill, 2008) Chapters 2, 3, 6 and 7. Atrill, P Financial Management for Decision makers. (FT Prentice Hall Europe, . 2005) Chapters 4 and 5. 17
Time value of money

Money (i.e. cash) has a different value over time; holders of money can either spend the money on consumption now or delay the consumption by investing the money until it is required for consumption. The reward for the delay in spending is the interest received by investing. The amount of interest is dependent upon the amount of time and the rate of interest. The further into the future a consumer has to wait, the greater the interest compensation required. So if one knows of a certain future receipt of cash then there must be a certain value today, which we call the present value, which will be its equivalent. By receiving today an amount of cash equal to the present value, the recipient would be indifferent between the future receipt and todays receipt. The difference between the two receipts is the time value, the compensation for the passage of time. The present value of a future amount is also known as the discounted value.
Future value and compounding

Whenever someone makes an investment, he or she expects to earn a return which can take the form of interest when the investment is in some form of monetary asset. If the interest earned is reinvested rather than withdrawn then the total amount invested grows at a compound rate. At the end of the life of the investment (at maturity) it will have a value F the future or maturity value. If P is the amount invested today at r% with compound interest for t years then the future value will be F. F = P(1 + r)
t
Present value and discounting

The converse of compounding is discounting. This uses as its basis the sane algebraic relationship but in the opposite way. The aim of discounting is to determine the present value of a future amount (i.e. todays amount) which, if invested at the rate of interest r, would achieve the future value predicted. With prospective new investments we can predict the incremental cash flows which will occur because of the investment, but as these predictions are all in money terms of differing values they must all be converted into a value at a common date (i.e. today, the day of the investment). Therefore we need to convert all cash flows into present values, todays values. So if we predict receiving F in t years time during which r is rate of interest then P is the present value of F, derived thus: P = Note F (1 + r ) 1 (1 + r)
t t
= F
1 (1 + r )
t
is the discount factor.
Using a computer, a table of discount factors for all combinations of r and t has already been prepared. This can be found at the back of all reputable texts. You should familiarise yourself with the compounding and discounting formulae and procedures and where they are used. Apply this knowledge to annuity payments or receipts. Remember an annuity is a constant annual amount and so the annuity factor for any year is the sum of the annual discount factors up to and including that year.
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Interest rates, discount rates and real rates

An interest rate is the proportionate return on an investment appropriate for the risk level of the investment. So it could be the return on a bond, a companys investment or the required return a company has to pay on its loan etc. The expression discount rate is often used synonymously with interest rates because the discount factor is derived using an interest rate. Similarly, because companies use a mixture of capital types to fund their investments, that mixture has an average cost which the company has to service. Any investments made from that mix of capital must generate flows and in the evaluation of those flows we use the discounting process. We can use the expressions cost of capital, opportunity cost of funds, as alternatives to discount rate since the discounting factor is derived using the cost of capital. You must learn the difference between real and nominal interest rates. (The terms, money and actual interest rates, are also used to mean nominal rate). The nominal rate is the rate to be found in the market place. The real rate is the rate of interest that would persist if there were no inflation or deflation. (1 + real rate)(1+ inflation rate) = (1 + nominal rate) (1+ r)(1+ i) = (1+ n) N.B. Note the short cut sometimes used to derive the nominal rate (r + i) = n. Do remember this is only an approximation and will usually lead to over-valuing the present value of the future flows. Remember that different items of operating expenditure and revenues may have their own specific inflation rates and, when undertaking an investment appraisal, all cash flows prior to discounting should be quoted in actual or money flows for the specific period. All individual and specific inflation rates will have been separately accounted for (e.g. the degree of inflation may have been different from year to year or between say wages and materials). The discount factor used should only incorporate the inflation rate relevant to the capital providers who have to be serviced and repaid from the investment. Activity 2.1 What is the time value of money? How is it different from the real and actual rates of interest of a risky investment? See VLE for solution
Basic investment appraisal techniques

Using BMM learn how to compute the net present value (NPV) for an investment, as well as an investments internal rate of return (IRR). Likewise learn how to compute the payback period (PP) and the accounting rate of return (ARR). The decision rules for each appraisal method should be learnt for the range of different types of decisions a manager might face, simple go/no go, selection between mutually exclusive projects and so on. See BMM sections 7.1 and 7.2. Activity 2.2 Solve self-tests in BMM, numbers 4.1, 4.3, 4.4, 4.5, 4.8 and 4.14.
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You must remember: that long term projects under consideration should be consistent with the long term corporate plan that the estimated cash inflows from the project when discounted to a common date, the present, exceed the estimated outflows, also discounted to the present that the theory in this section assumes certainty of knowledge and forecasting this is relaxed in the next chapter that, in practice, businesses do not wholeheartedly follow the theoretically correct route of using the net present value approach (NPV) all the time. You should learn the process of identifying, analysing and estimating the investment flows, remembering the projections should be in cash not profit flows, unless ARR is being used. Profit flows will need adjustment to cash if only profit estimates are given. You should learn the theory behind the four main analytical techniques with emphasis on why NPV is superior to IRR, PP and ARR. The amount and timing of the net cash flows of a project are crucial to the viability of an investment. Given below is an example of two mutually exclusive investments, A and B, with an explanation of why only NPV will give the correct signal to management. Assuming an annual cost of capital of 15% and estimated net actual annual cash flows as stated, then the four methods will give conflicting results. Each method has its own set of decision rules.
Project Time periods (years)
0 A B (25,000) (10,000)
NPV()
1 5,000 5,000
IRR (%)
2 12,500 10,000
3 12,500 (1,000)
4 12,500 -
Total 17,500 4,000
Payback (Years) ARR(%)
A B
4,166* 1,251
22 24*
2.6 1.5*
35* 26.7
Separately using each evaluation method the pairs of values for projects A and B are shown above. Using the NPV approach A will have an NPV of 4,166 and B an NPV of 1,251. The decision rule is to select the investment with the higher NPV regardless of the size of the original investment. Therefore A will be preferred to B, which is why it is marked with an asterisk (*). Under each of the evaluation methods and using the appropriate decision rule the preferred choice can be made. It is marked with an asterisk (*) in each case. Using the payback approach would suggest B is preferred as it has the shorter payback period. If one only used ARR, then A is preferred since it has the higher rate. Since neither method is the correct one, it is by chance one gives us the appropriate selection. The main reason for disregarding the outcomes under these two methods is that neither payback nor ARR take into account the pattern of flows (i.e. the time value of the cashflows). Also payback does not take into account the post payback flows which, in the case of A, are considerable, while for B they are less so and it even has a net outflow in one period. From the textbooks note the rationales presented for the still considerable use of payback by managers in practice. See BMM p.202 and PA pp.14043.
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In the example, though B has the higher IRR, the IRR shown is only one of the two IRRs for that project, the other being a negative value. This is because of one of the technical problems of using IRR that are exemplified in B. For example, B has multiple rates of return because the sign of the annual cash flows changes more than once in the sequence. For each change in sign in the sequence of cash flows, there will be a root to the solution of the equation which produces the IRR. Thus two sign changes, as in B, means two roots to the equation (i.e. two IRRs). Note it is possible that one or more root could be the square root of a negative number which is of no practical value. Also the IRR does not indicate the difference in the size of the projects, 24% of 10,000 is not as good as 24% of 25,000. Another problem is that IRRs reinvestment assumption for the fourth year of B is that the funds have been reinvested at 24% to enable comparison with A. This is not necessarily true. From a practical viewpoint, you should learn the capital budgeting process and, in particular, the benefits from the post audit procedure. The post-audit process should involve the comparison of actual results with the predictions for the project and provoke explanations of whatever differences have occurred, thus enabling improved forecasting in the future and improved operations too.
Application problems some considerations

When considering applications of the NPV analysis to practical situations, it is important to ensure that all flows are dealt with on an after tax basis. Similarly, in an inflationary world, when making estimates of cash flows, the specific rates of price increases must be incorporated in the analysis. Wages, raw material prices etc. may be affected by different rates of price changes. In compiling the cost of capital or opportunity cost of funds, we must use the general or average rate of inflation since it is assumed that all providers of funds have the average spending pattern used to compute a retail price index. The cost of capital is the average rate payable to the providers of the capital for the company. The cost of capital is also called the hurdle rate and the opportunity cost of funds (capital). It is called the hurdle rate because it is the minimum that has to be achieved and the opportunity cost because each element of capital has got its own opportunity cost. Therefore, you should prepare all estimates of flows in actual or money terms and then discount the net flows using the actual or money cost of capital. Many businesses are faced with decisions regarding projects that may require repetition on a known cyclical basis. For example, take a business with a fleet of vehicles. Different groups of vehicles in the fleet will need replacement on a regular basis. It is important to identify an optimum replacement period for them. The type and make of vehicle to be used by the group can be identified on cost grounds by use of the net perpetuity value and annual equivalent annuity methods. These are all derived from the NPV approach and can be learnt from BMM (see pp.19799). Finally, businesses have to take investment decisions when their financial resources are limited. Where the capital restriction will only last for one time period (normally one year) the profitability index (PI) should be used to identify the optimal selection of projects. If the restrictions are multi-period and/or multi-faceted (e.g. space or personnel) then linear or integer programming models can be used which maximise the NPV of the portfolio of projects subject to the constraint introduced.
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An alternative way of acquiring the services of an asset is to lease it rather than buy it. The same principles of evaluation should be applied to the incremental cash flows arising as a result of taking out a lease in order to see whether it is a better way of funding the asset as opposed to buying it. Worked example 1 A business is considering an investment in equipment which requires an initial outlay of 10 million. The investment will be allowed a 20% writing down allowance (depreciation) on a straight line basis for tax purposes. It is estimated the equipment will be sold at the end of the project, the end of the fourth year for 3 million. Any tax received on a loss, or paid on a gain, arising from the sale of the equipment would occur in the fifth year. The incremental revenues and costs and the annual price rises incorporated in the estimates arising from the investment are as follows:
million Years 1 2 3 4
Sales Wages (4% p.a. increases) Materials (20% p.a. increases) Other costs (5% p.a. increases) Book depreciation Net trading surplus Increases in working capital 10 7 10 2
30 11 13 11 29 1 1 2
40 15 17 12 37 3 0.5 2
50 16 19 13 46 4 0.5 1
49 5 (2.0)
The business estimates that the average annual inflation rate will be 4.5% p.a. during the five years and the businesss real after tax opportunity cost of capital is 10% p.a. The corporate tax rate for each of the five years is 30% payable a year in arrears. Required: Compute the NPV, IRR, Payback and ARR for the project. Solution to Worked example 1 First compute the depreciation for tax purposes. Obviously one uses the tax regime requirements appropriate to the country in which one is investing. Writing down allowance computation (straight line) Tax allowance Outlay Year 1 (20%) Year 2 (20%) Year 3 (20%) Year 4 Sale Year 4 10 2 8 2 6 2 4 3 1 2 2 2
Loss on sale
(The same approach can be used for reducing balance based allowances.) Then compute the tax payments or receipts based upon the taxable profits. This may require a transfer of tax depreciation for book depreciation (in this case they are similar).
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Tax computation (million) Years 1 Net trading surplus Add book depreciation Trading surplus (adjusted) Less tax depreciation Taxable profit Tax (30%) 1 2 3 2 1 0.3 2 3 2 5 2 3 0.9 3 4 2 6 2 4 1.2 4 5 1 6 1 5 1.5
Tax is paid in year following the year in which the profits were earned, i. e. tax on year 1s profits of 0.3 paid at end of year 2. Cost of capital (discount rate) (i) The actual or money rate is the rate to use. Then: (1+i) = = Thus i = (1 + 0.1)(1 + 0.045) (1 + 0.1495) 0.15 (i.e. 15%)
(Some authors and businesses use the quick way and get an approximate value by summing the real and inflation rates. Here: 10% + 4.5% = 14.5% = 15%. You should use the theoretically correct method given above unless an approximation is called for.) To calculate the NPV million Year Outlay Trading surplus (adjusted) Working capital change Sale of equipment Tax payments Net cash flows Discount factors Discounted flows Discount factors Discounted flows (10.0) (15%) (10.0) (28%) (10.0) 2.0 1.0 1.739 1.0 1.563 (0.3) 4.2 0.8696 3.176 0.7813 2.564 (0.9) 4.6 0.7561 3.025 0.6104 2.179 (1.0) (0.5) (0.5) 2.0 3.0 (1.2) 9.8 0.6575 5.604 0.4768 3.651 (1.5) (1.5) 0.5718 (0.746) 0.3725 (0.437) 3.0 (3.9) 9.1 0.4972 2.798 0.2910 (0.480) 3.0 5.0 6.0 6.0 20.0 0 (10.0) 1 2 3 4 5 Total (10.0)
The NPV at 15% cost of capital is therefore the aggregate discounted flows of 2.798 million shown above in the Total column. To obtain the NPV note that the accrued profits have been converted into cash flows by the changes in the working capital; that in arriving at the annual flows the specific price changes were used in estimating the wages, materials etc; that the average actual cost of capital had to be calculated and used; that the tax shield is provided by the writing down allowance (tax depreciation) and that tax is paid a year in arrears. (The last point depends on the individual countrys tax regime). All cash flows are assumed to arise at the end of the year concerned except for the initial outlay on equipment. The discount factors came from the present value tables and are based on a cost of capital of 15%. The annual discounted flows are computed from the
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product of the actual net cash flow for a year times its discount factor. (2 0.8696 = 1.739). The row of discounted flows are summed to give the NPV in the final column. Calculation of IRR Using the two discount rates 15% and 28% we have obtained two different NPVs, one positive and one negative. By increasing the discount rate from 15% to 8% an increase of 13%, the NPV declined from 2.798 to a negative 0.180, a total decline of 3.278. The IRR is the rate which gives an NPV equal to zero, so the rate must lie somewhere between 15% and 28%. The reduction in NPV by 2.798 from 2.798 to zero will require increasing the interest rate from 15%. The 13% increase in interest rate produced a 3.278 reduction in NPV. So if the interest rate is increased by an amount equal to the proportion of 2.798 to 3.278 of the 13% it should move from 15% to the appropriate rate which is the IRR. Thus the IRR is 2.798 (28 15) + 15 2.798 (0.480) = 11.1 + 15 = 26.1% Note: A quicker, but more approximate value could have been obtained by using the NPVs of 9.1 and 2.798 at 0% and 15% respectively. This approach would have given a much less accurate estimate of 21.66% using an extrapolation procedure (check your understanding of the method by doing your own calculation and check with the answer given). Payback Taking the net cash flows: Year 0 1 2 3 Surplus Payback = 2 + 3.8/4.6 = 2.83 years Accounting rate of return (ARR) Average inflow Average outlay = Total inflow/Project life = Outlay/2 = 19.1/4 = 10/2 = 4.775 =5 2.0 4.2 6.2 (3.8) 4.6 0.8 Flows ( million) (10.00)
ARR = Average inflow/Average outlay Profitability Index (PI) NPV PI = Initial investment = 2.798 10.00
= (4.775/5) 100 = 95.5% = 0.28
Now assume that the business has three other projects it has evaluated. Their characteristics are given below in the table along with those of the project just evaluated. If the four projects were mutually exclusive, then the asterisk indicates the preferred choice under that evaluation method.
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Project evaluation table Project A B C D Outlay 10m 25m 15m 15m NPV 2.8m 4.5m* 2.0m 3.0m IRR 26.1% 18.0% 20.0% 26.4%* Payback 2.83 yrs 2.5 yrs 1.9 yrs* 3.0 yrs ARR 96%* 50% 60% 80% PI 0.280* 0.180 0.133 0.200
Conceptually B is the preferred project from amongst the four evaluated because it has the highest NPV of 4.5 million. Using the same data and assuming now that all four projects are available for selection and are not mutually exclusive, then if the business has a maximum of 40 million to invest, the following combinations of projects are possible. The PI is used to indicate the order of selection, starting with project A. Combination (million) Combination AD AB ADC DB Outlay 25 35 40 40 NPV 5.8 7.3 7.8 7.5 Average PI 0.232 0.209 0.195 0.188
The objective is to maximise the NPV of the portfolio of investments. Here it is assumed that each project is discrete and cannot be split up. The process is to go through the projects, one by one, in descending order of PI, continuing to combine those projects that satisfy the limit placed on available funds. Here the addition of project D to A used the two highest ranked projects and had a 25 million outlay. Third ranked project is B but combining its outlay to A and Ds exceeds the limit, so the project with the next best PI is included that does not exceed the outlay limit. The combination of ADC provides the highest NPV, though some combinations seem to have higher PIs (e.g. AD). However that is a false comparison because the balance of unused funds of 15 million should be included with its zero NPV, thus giving a lower corrected average PI of 0.145. If it is assumed that all projects could be undertaken fractionally if necessary, then the combination would have been A, D and 3/5 of B, derived as follows by using the PI ranking: Project A AD 3/5B PI 0.322 0.200 0.180 0.2125 Outlay 10 15 3/5 25 40 NPV 2.80 3.00 2.70 8.50
Try and understand the applied type problems and examples used in the texts, in particular those in BMM. Understand the conceptual weaknesses and strengths of theoretical methods used and learn how to critique your methods and results.
What-if questions
Now that youve learnt the basic techniques for the analysis of investment proposals, on the assumption of operating in a world of certainty, relax that assumption and consider that in the real world, fewer things will actually occur than might have been predicted. Managers need to evaluate the effects of these possibilities in their initial prediction. There are various ways of doing this. The first is by the use of sensitivity analysis. This requires an estimate of the effect on the predicted outcome, usually NPV ,
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of changes in each variable. Effects of changes of combinations of variables can also be evaluated. It can be identified from this evaluation those variables whose changes might influence the outcome the most. Arising out of that identification, managers can assess the likelihood of the variable change, and whether it can be influenced by managerial efforts. The overall impact on the final outcome of the potential changes can be evaluated and aid the decision as to whether or not the proposal can be accepted. An extension of sensitivity analysis is breakeven analysis which can be used to assess the magnitude of change that will reduce the originally predicted NPV to zero separately for each variable. When a number of variables are interrelated, then the different combinations can be reviewed as separate possible scenarios. This is called scenario analysis, for example, managers may call for three different but consistent combinations of variables, one is the set of the most optimistic outcomes, another the set of most likely and the third, the set of the most pessimistic outcomes. This is sometimes called threepoint estimates. An extension of this approach, calling for a more sophisticated knowledge of probability distributions of outcomes, is called simulation analysis.
The examination
Extracts from discount and annuity tables will be supplied in the examination for 59 Financial management if these are relevant for any question. You can however use your own calculator to generate the factors if you so wish.

By the end of this chapter, and having completed the Essential reading and activities, you should be able to: describe and apply the time value of money in project evaluation, whether it be future or present value oriented defend the use of NPV as the method of appraisal against other suggested methods prepare evaluations of investment proposals and state which decision rule is appropriate in the specific set of circumstances.
Sample examination questions

1. What is the time value of money? 2. Discuss the pros and cons of NPV IRR and payback period as methods , of appraising investments. 3. Make a case to support the reported managerial preference for the use of IRR and payback methods in real world situations.
Practise question 2.1

Snowdon plc has a fund of 15 million to invest in new projects. It has a number of proposals to consider. The first proposal, A, is a large proposal requiring an initial investment of 13 million in plant and equipment which at the end of the projects life of 4 years will have a resale value of 4.0 million. The company has 100,000 still to pay to the consultants
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under the research and development contract for this project of 3 million. The contractual obligation will be met in 3 months time. A working capital fund of 2 million will be needed immediately to finance the build up of stock and debtors. At the end of the projects life only 1.8 million will be recovered when stocks of the product are rundown and debtors pay up. The life cycle predictions for sales volumes, prices and variable costs are as follows: Years Sales volume (000) Sales price/unit () Variable cost/unit() 1 1200 20 4 2 1920 20 4 3 960 18 4 4 600 13 4
The incremental fixed costs were forecast to remain constant over the products life which for the annual production fixed overheads were 4.15 million p.a. and administration and selling were 8.20 million p.a.. In calculating these fixed overheads the accountant had included 3.25 million p.a. for the annual depreciation write off of the new equipment. The company has a cost of capital of 15%. REQUIRED a. Calculate the payback period and accounting rate of return for project A. b. Calculate the net present value to the company of project A. See VLE for solution
Problems
In BMM attempt the following problems: Chapter 7, pp.2047, numbers 15, 19, 20, 25, 27 and 30 Chapter 8, p.234, numbers 18 and 25 Chapter 9, p.258, numbers 5 and 6.
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Notes
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Chapter 3: Introduction to risk and return

Aims of the chapter
This chapter will start by looking at, and explaining the concepts and techniques of, risk and return. We will then show how to calculate share returns. This is followed by an explanation of how to distinguish between market and unique risk, or as they are often referred to, systematic and unsystematic risk. The significance of using diversification to achieve risk reduction will then be considered.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and activities, you should be able to: estimate the opportunity cost of capital for a project using shares that have the same risk as the project calculate the expected return, variance and standard deviation for both a single investment and also for a portfolio of investments explain why a strategy of diversification reduces risk distinguish between unique risk and market risk.
Essential reading
Brealey, R.A., S.C. Myers and A.J. Marcus Fundamentals of Corporate Finance. (McGraw-Hill, 2007) Chapter 10.
Further reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (McGrawHill, 2008) Chapter 8. Atrill, P Financial Management for Decision makers. (FT Prentice Hall Europe, . 2005) pp. 170208.
Introduction
So far in your studies of financial management you have overlooked the issues that are associated with project specific risk and you have assumed that the cost of capital for a project will depend upon the risky nature of the project undertaken. In this chapter you are required to confront the issue of the relationship between the cost of capital and risk and, how this risk associated with a project can be measured. Before you start reading the recommended textbook, here is a word of advice: The cost of capital is the link between a firms financing and its investment. It measures the return the firm must earn on its assets to meet the requirements of investors. So the cost of capital provides the discount rate for evaluation of new projects and for valuing the firm as a whole, and it provides a benchmarking for the return from existing business activities.
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The introductory section to Chapter 10 of BMM, provides a useful but detailed history of capital markets and also points out that certain assets which are associated with a high degree of risk offer high returns relative to assets which offer low returns at a lower level of risk (i.e. shares are riskier than corporate bonds which are in turn riskier than treasury bills; and shares have tended to provide the highest returns in the past, far more than either bonds or treasury bills). These concepts can at first be difficult to understand but persevere through the chapter and re-read the introductory section again after you have read the whole chapter. As this chapter is only an introduction to risk and return, it is important to concentrate on the concepts and techniques used to measure risk, then process to understand why the diversification of securities reduces unique risk and not market risk. Brealey and Myers (2007) adopt a detailed approach to risk and return which may not be suited to students who are new to the subject.
Rate of return: a review

When a share is purchased from say, the London Stock Exchange, the return you will expect from the share will come in two forms: a dividend (a special form of cash interest payment to shareholders as a return for their investment in the firm) a capital gain or loss (which will depend upon whether the price of the share has increased or decreased relative to the purchase price). For instance, if you purchased a British Airways share in 20X5, when they were valued at 80 a share, and by 20X6, the value of the share had increased to 100 per share; the capital gain would be 100 80 = 20 gain. In addition, British Airways paid a dividend of 10 per share, during the year. Then the return on your investment would be: Total return = (capital gain or loss + dividend) initial price paid for the share Incidentally, this is also the basis for the Gordon Dividend model used to estimate a companys cost equity (see Chapter 5). Total return = (20 + 10)/ 80 = 37.50% (which is the nominal rate of return) nominal rate of return = (capital gain or loss + dividend) initial price paid You already know that the cost of capital will depend upon the risk of the project and you could simply define the cost of capital to be the rate of return shareholders could expect to earn if they invested in equally risky shares. Therefore, one way in which you could estimate the cost of capital is to find shares that have the same risk as the project and then estimate the expected return on those shares.
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Activity 3.1 Who ultimately bears the risk of projects undertaken by a company? (Use the diagram below as a guide to your answer.)
Dividends as returns
Cash returns for investment
Ordinary shareholders
Company
Projects
Cash to buy shares
Cash to undertake projects
See VLE for solution
Calculating expected return, variance and standard deviation

To understand the concept of the business of investing in shares, you need to appreciate how far returns may differ from their average (which is usually determined by analysing the performance of the share over a long period of time). You also need to be aware that the higher the uncertainty of the average return, the higher will be the risk associated with the share. Thus, you need to know that risk is related to the spread of the outcomes, so the more widely spread the returns were and are around the average will imply a greater investment risk. Therefore, any objective measure of dispersion will provide a reasonable measure of risk and dispersion and that is why variance and standard deviation are able to be used in this context. Variance is the average value of the squared deviations from the mean and is therefore a measure of volatility. Standard deviation is the square root of the variance and is also a measure of volatility.
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Equations Expected return = Variance = Standard deviation = variance.
To best illustrate how the expected return, the variance and the standard deviation are calculated, let us consider a simple example: Worked example 2 Suppose you own a single share in company A, which has a current market value of 10 and you expect that the future possible value of the share and the dividends at the end of the period are those set out below. Market conditions Favourable Normal Unfavourable Probability end share price 0.2 0.6 0.2 End dividend 15.00 12.50 7.50 Total end return 1.50 1.00 0.50 (16.5 10.0) (13.5 10.0) (8.0 10.0) 65% 35% -20%
You will notice that under favourable market conditions, the total return will be 65%, under normal market conditions 35% and under unfavourable market conditions 20%. The Expected Return R is calculated by multiplying each total period end outcome Ri by the probability Pi associated with its market condition and summing; Expected Return = R = P1 R1 + P2 R2+ P3 R3 = 0.2 (0.65) + 0.6 (0.35) + 0.2 (0.2) = 0.30 (i.e. 30%) The Variance, which measures how much each individual outcome differs from the average (measures dispersion and volatility) is calculated by multiplying each end period return Ri minus the expected return by R the probability Pi associated with the market condition and summing; Variance = = 0.2 (0.65 0.3)2 + 0.6 (0.35 0.3)2 + 0.2 (0.2 0.3)2 = 0.076 (i.e. 7.6%) Standard Deviation = = variance = 0.276 The Standard Deviation is simply calculated as the square root of the variance; There is also a measure of risk per unit of return which is helpful when choosing between two independent risky assets, this is the co-efficient of variation. Its use in this context assumes constant marginal utility, which may be acceptable over a short range. Co-efficient of Variation = standard deviation / R = 0.276 / 0.30 = 0.92 Thus a rational investor when choosing between two heterogeneous investments will prefer the one with the lower co-efficient of variation the lower risk per unit of return. It should be clear at this point, that other things being equal, investors will prefer an investment giving the highest expected return for a given level of risk or one that has the lowest risk for a given level of expected return. For instance, if you were told that the return on a share is expected to be 20% and you have been given three risk ratings, 30%, 15% and 10%; assuming that the 10% risk rating is associated with the lowest risk, then you will select this level of risk for the given level of return.
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Activity 3.2 You are now required to re-work the example for company A with the probability of the end share price equally likely for the three market conditions. Compare the expected returns and the standard deviations for both scenarios. See VLE for solution
Risk and diversification

In the previous worked example you calculated the expected return, the variance and the standard deviation for a single share. Should you be given the opportunity to calculate the standard deviations for a group of shares (such as that of a market portfolio), you would notice that:
The standard deviation of individual shares is generally higher than it is for a group of shares, such as the market portfolio. This is mainly due to the reduction in the volatility associated with the greater number of shares you add to than the single share that you started with. (Brealey, Myers and Marcus, 2007, p.288)
Diversification is a strategy designed to reduce risk by spreading the portfolio risk across many investments. The risk is spread amongst a large number of shares whose returns do not move in exactly the same direction and magnitude all the time. Market portfolio is the group of shares that make up the overall market. By adding additional shares to the one(s) you already have, you are not exposing yourself by having all your eggs in one basket. Worked example 3 We can now extend our initial analysis of only a single share in worked example (1) to examining more than one share and thus see the effects of diversification. Suppose, you have decided to purchase a share in company B, which has a current market value of 5 and you expect that the total end period returns for the share will be as set out below for the three market conditions already identified when analysing company A: Market condition Favourable Normal Unfavourable End period return (Gain + Dividend) 6.50 5.50 4.50 Total end period return % 30 10 10
Therefore, under favourable market conditions the total end period return will be 30%, under normal conditions 10% and under unfavourable market conditions 10%. If you now compare the individual total end period returns for both company A and company B with their combined (portfolio) returns, you will notice that both the variance and the standard deviation for the portfolio are much lower than the mean return and standard deviation for each individual share.
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Market condition
Probability
Return on share % Share A Share B
Portfolio return (50% in share A and 50% in share B) 0.5(65) 0.5(35) + 0.5(30) + 0.5(10) = 47.5 = 22.5
Favourable Normal Unfavourable Expected return Variance Standard deviation Co-efficient of variation
0.2 0.6 0.2
65 35 20 30 760 27.6 0.92
30 10 10 10 160 12.6 1.26
0.5(20) + 0.5(10) = 15.0 20 400 20 1.0
You must remember that investors with a portfolio of investments will not necessarily be concerned with the returns and standard deviation of the individual shares, they are more likely to be concerned with the risk and returns associated with their portfolio. Notice how the addition of a lower return in share B to share A reduces the overall portfolio return and how the standard deviation of the portfolio has been reduced too. The lower the risk the lower the return. Calculating the co-efficient of variation for shares A, B and the portfolio of A and B indicates share A for the higher level of risk gives a disproportionately higher return than the portfolio of A and B. The choice of investment between the three alternatives by an individual will depend on the risk and return parameters of the utility curve of the individual, but on a constant returns to risk, share A is better than B or the 50/50 combination. You will also be expected to learn and be able to apply the formulae used to calculate the expected return and the variance of the two share portfolio. Two share portfolio Expected return: Variance: Covariance: R = XR + (1 X)R
p 2 2 A 2 p A
= X + (1 X) + 2X(1 X) r
B
B 2
AB A B
cov(R ,R ) = P (R R )(R R )
A B R A A B B
When you calculate the portfolio variance you also need to consider not only the individual variances of the shares but also the way in which their returns vary as measured by the covariance (usually termed the covariance effect). Covariances can be negative as well as positive. The correlation co-efficient measures the extent to which the returns of pairs of shares vary with one another. It is important at this point to emphasise the effect of a negative covariance which is usually influenced by a negative correlation coefficient. Correlation co-efficient: Activity 3.3 You are now required to re-work the example above for a portfolio of 60% invested in company A and 40% in company B; in this question assume all other factors remain the same as in the example above. Note that the correlation coefficient between the returns of A and B is 1. See VLE for solution r = cov(R ,R ) /
AB A B A B
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Market risk versus unique risk

The risk that you will be able to eliminate by the diversification of your investments is known as unique risk or unsystematic risk. The risk that you will not be able to diversify away regardless of the different investments you add to your portfolio is generally referred to as market risk or systematic risk. Market risk occurs as a direct result of economy-wide perils that threaten all businesses. It is worth reiterating that if you only hold one share, both unique risk and market risk will be very important; but once you have a portfolio of 20 or more shares, your strategy of diversification is likely to have almost eliminated unique risk and thus leave you to handle only the risk born by every share in the marketplace market risk.

By the end of this chapter and having completed the Essential reading and activities, you should be able to: estimate the opportunity cost of capital for a project using shares that have the same risk as the project calculate the expected return, variance and standard deviation for both a single investment and also for a portfolio of investments explain why a strategy of diversification reduces risk distinguish between unique risk and market risk.
Practise questions
1. The shares of Carbs Ltd, a chain of bookstores, will generate the following payoffs to shareholders in the following year: Market condition Favourable Normal Unfavourable Dividend Share price 3.00 1.50 0 20 11 0
Suppose, if the company is faced with unfavourable market conditions it will go out of business. Assume that the three possible market conditions are equally likely. The shares for Carbs Ltd are currently trading at 10.00 per share. You are required to calculate the expected return and standard deviation of the returns to the shareholders of Carbs Ltd. 2. You are now required to extend the analysis performed in Question 1 to examining more than one share and note the effects of diversification. Suppose you have now decided to purchase a share in Bards Ltd, a chain of fashion retail outlets, which has a current market value of 12.00 and you expect that the expected return for this share will be 2.00, the variance will be 4.00 and the standard deviation 2.00. You are required to calculate the combined portfolio returns for Carbs Ltd and Bards Ltd (assuming 50% in each share), the portfolio variance, the portfolio standard deviation, the portfolio covariance and assuming the portfolio correlation coefficient between the two shares is 0.8. 3. Discuss what would happen to the opportunity cost of capital if investors suddenly became especially prudent and generally less willing to bear investment risk. See VLE for solution
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Problems
Attempt the following problems in BMM: Chapter 10, p.268, selftest 10.1, p.289, numbers 8, 14, 17 and 18. Attempt the following problems in BMA: Chapter 8, numbers 3, 4 and 8.
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Chapter 4: Capital budgeting risk and return

Aims of the chapter
In this chapter the concepts of market risk and beta will be described and this will include how each can be measured. The capital asset pricing model (CAPM for short) will be introduced and, through the use of beta, applied to the concept of risk and the measurement of market and investment risk. The relationship of market risk and the risk of a share to the rate of return that investors require will be explained. This required return, or opportunity cost of capital, will be described and calculated and its application in capital budgeting and project risk derivation shown.
Learning outcomes
By the end of this chapter and having completed the Essential reading and activities, you should be able to: calculate and interpret the risk associated with macroeconomic factors (market risk) for a share compare the rate of return that investors demand and the market risk of a share calculate the opportunity cost of capital for a project and be able to explain its relationship to the company cost of capital.
Essential reading
Brealey, R.A., S.C. Myers and A.J. Marcus Fundamentals of Corporate Finance. (McGraw-Hill Inc, 2007) Chapter 11.
Further reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (McGrawHill, 2008) Chapters 8, 9 and 10.
Introduction
In Chapter 3 you were required to confront the basic relationship between the cost of capital and risk, and how risk associated with a particular project could be measured. In the final section of Chapter 3 you were required to understand why the diversification of shares reduces unique risk (firm-specific risk) and not market risk (associated with macroeconomic events faced by all firms). As unique risk can be diversified away by holding a large portfolio of shares, investors will need to earn a higher rate of return to persuade them to take on market risk. As this chapter is a logical extension of the previous chapter (Introduction to risk and return), it is important that you concentrate on the concepts and techniques used to measure and interpret the market risk of a security and then proceed to relate the market risk of a share to the rate of return that investors demand and finally, show how the opportunity cost of capital of a project can be calculated. Before you start reading Chapter 11 in BMM
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here is a word of advice. The first section to this chapter introduces you to measuring market risk and the beta of shares (which is mainly empirical in nature), and the second section of this chapter extends your understanding of the basic risk and return relationship by introducing the capital asset pricing model and the security market line. At a glance, both these sections may seem to be very technical and the language used by the authors may prove to be difficult to understand at first but we recommend that you persevere through the entire chapter and then revisit the earlier sections for a fuller understanding. We thoroughly recommend that you also follow-up this chapter in BMM by reading the corresponding chapters in BMA.
Measuring market risk

By holding a portfolio of investments comprising shares in different businesses, in different industries, it is possible to diversify away quite a lot of the risk. However, part of the risk of share ownership cannot be diversified away. This is because this part of the risk relates to factors which affect all businesses and their returns. This part of risk is known as market risk or systematic risk; it is caused by macroeconomic factors like changes in interest rates, changes in oil prices, etc. Total risk of investing in a particular share involves: Unsystematic risk (or project specific risk) which is diversifiable by holding a large portfolio of shares. Systematic risk (or market risk) which is risk borne by all companies. Risk premium is the difference between market return and the return from the risk free asset. The part of total risk which cannot be diversified away requires a risk premium to compensate investors for bearing it. This risk premium relates to the extent to which the particular share is affected by the macroeconomic factors associated with systematic risk. Beta is a measure of movements of a shares return to the return on the market portfolio. As risk depends upon exposure to macroeconomic events, it can be measured as the sensitivity of a shares return to fluctuations in returns on the market portfolio as a total market portfolio consisting of all types of investments is difficult to establish, a substitute such as the FT All Share Index is used as a proxy for the market portfolio. This sensitivity is termed as the shares beta ().
Measuring beta
As you will have already worked out, some shares will be less affected than others by market fluctuations. Investment managers generally refer to these as follows: where shares are not very sensitive to market fluctuations and therefore have a beta less than one defensive shares and where shares are sensitive to market changes and therefore have a beta value greater than one aggressive shares. Obviously investors will want to hold a portfolio of aggressive shares should they expect the market to rise in the near future and hold a portfolio of defensive shares should they anticipate the market will fall in the near future.
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Procedure for measuring real companies betas (in the UK):

1. Follow the rates of return for a particular UK company, usually monthly/weekly returns over a particular time period and also track the returns for a proxy of the market index such as the FT All Share Index over the same period. 2. Plot the observations (i.e. the company share returns on the y-axis and the proxy for the market returns over the same period on the x-axis). 3. Fit a line of best fit showing the average returns for the share at different market returns. 4. Beta of the share will be the slope of the fitted line (usually calculated in practice using a technique known as regression analysis). Activity 4.1 At this point you may find it useful to go through how BMM calculate the betas for Turbot-Charged Seafood, Amazon.com and Exxon Mobil.
Portfolio betas
The diversification of shares decreases the variability from unique risk but not from market risk. The beta of a portfolio of shares is just an average of the betas of the individual shares in the portfolio, weighted by the investment in each share. Worked example 4 Calculate the portfolio beta if you have invested 25% in ICI shares, 25% in British Airways shares and 50% in British Petroleum shares; and their respective betas are 1.2, 1.0 and 0.8. Solution to Worked example 4 The portfolio beta is calculated as follows: (0.25 1.2) + (0.25 1.0) + (0.5 0.8) = = 0.3 + 0.25 + 0.4 0.95
Risk and return

The market risk premium can be defined as the difference between the market return and the return on risk-free treasury bills; usually a proxy is adopted for the market return such as the FTSE 100 all share index (in the UK) or the S & P 500 index (in the US) and the return on the risk free asset is the interest payable on treasury bills issued by the government. For example, if the return on the risk-free asset is 4.0% and the return on the market portfolio is 13.0% then the risk premium is 13.0 4.0 = 9.0%. You must remember that the risk-free treasury bills will have a zero beta and the fully diversified market portfolio will have a beta of one; therefore, if you are told that the return on treasury bills is 4% and the return on the market portfolio is 13%, you should be able to plot the expected return against the beta; as illustrated below. The bold line represents the security market line which shows the relationship between expected return and beta.
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Figure 4.1 Plot of expected return against beta
From this figure, you will notice that given the expected return for riskfree treasury bills (zero beta asset) and the expected return for the market portfolio (unitary beta asset), you will be able to calculate the expected return for any asset which has a beta between zero and one. For example, if you have a portfolio split evenly between risk-free assets (which offer an interest rate of 4%) and the market portfolio (which offers an expected return of 13%) the expected return for the portfolio will be: (0.5 13%) + (0.5 4%) = 8.5% You can also calculate the expected return for this example more formally by using the following formulae: i. Market risk premium = (rm rf) = 13% 4% = 9% ii. Risk premium of an investment = (rm rf) You multiply (i) by beta as beta measures risk relative to the market on any asset. iii) Risk premium of an investment with beta of 0.5 and market risk premium of 9% = (rm rf) = 0.5 9% = 4.5% iv) Total expected return (r) = risk-free rate + risk premium of investment = rf + (rm rf) = 8.5%
Capital asset pricing model

ri = rf + (rm rf) where: ri is the required rate of return on a particular investment i rf is the risk-free rate
is a measure of the extent to which investment i is affected by macroeconomic factors

rm is the expected average return from investing in the market portfolio of shares.
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This formula is commonly used to calculate expected returns and states the basic risk-return relationship called the Capital Asset Pricing Model or CAPM. According to the CAPM, expected rates of return for all securities and all portfolios lie on the security market line as illustrated above. The basic idea behind the CAPM is that investors expect a reward for waiting and taking on risk. The riskier the investment, the greater the expected return. Therefore, if you invest in a risk-free asset, you just receive the rate of interest, say 4%, whereas if you invest in risky shares, you can expect to gain an extra return or risk premium, say 9% for the increased risk you take on by investing in shares. So if you invest in something twice as risky as the market (i.e. = 2) then the risk premium is doubled. CAPM is the theory of the relationship between risk and return which states that the expected risk premium on any share equals the shares beta multiplied by the market risk premium. Remember, the CAPM is only a model of risk and return. However, the CAPM does capture two simple but fundamental ideas useful to investment managers. First, almost everyone agrees that investors require some extra return for taking on risk. Secondly, investors are principally concerned with the market risk (the risk which they cannot diversify away). To calculate the returns that investors are expecting from particular shares, you require the risk-free rate, the expected market risk premium, and beta. For example, if the interest on treasury bills is 4% and the market risk premium is 10% and the beta for Company Z shares is 0.65 then the expected return on Company Z shares will be: Expected return = risk-free rate + (beta market risk premium) = 4% + (0.65 10%) = 10.5% Activity 4.2 Calculate the expected return for a share if the risk-free rate of return is 8% and the market premium is 12% and the beta for the company share is 0.87. Then discuss how the beta for a company may be calculated in practice. See VLE for solution
Project returns and the opportunity cost of capital

The opportunity cost of capital is the return that investors give up by investing in the project rather than in securities of equivalent risk. Worked example 5 Company Y has forecasted the cash flows on a project and estimate that the internally required rate of return on this project (internal rate of return) is 10%. Risk-free treasury bills offer a return of 4% and the expected risk premium is 7%. Calculate whether the project is feasible if a. the project is a sure thing (i.e. the beta is zero) b. the beta for company Y is 0.4 c. the beta for company Y is 0.9.
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Solution to Worked example 5 To answer this question you need to calculate the opportunity cost of capital. Since we have already established in an earlier chapter that NPV is the best criterion for project selection we need to note in this question that the selected hurdle rate (cost of capital) is the relevant rate for a particular risk level. Thus if a company presently had assets with risk class of 0.40 the required return the hurdle rate in the calculation below is 6.8%, but if faced with a new riskier area of business with of 0.90 then the hurdle rate is 10.30%. If the company has a zero beta then r = 4% + (0 7%) = 4% If the company has a beta of 0.4 then r = 4% + (0.4 7%) = 6.8% If the company has a beta of 0.9 then r = 4% + (0.9 7%) = 10.3% Company Y would only consider the project if the beta was either zero or 0.4. If the beta is 0.9 then company Y should not take on the project as the project is riskier than the internal rate of return required by the firm (i.e. 0.3% is more than 10%). i. The corporate cost of capital is based on a portfolio of assets with individual betas =
ii. When we are analysing whether a project is feasible the selection of an individual
project beta (or individual area of business beta) will be preferred to the companys cost of capital as the latter will be a weighted average of all project betas for the company (the average of the betas for all business areas). In practice, the security market line is a good indicator for project acceptance. If the return on the project lies above the security market line, then the return is higher than investors can expect to get by investing in the capital market. Activity 4.3 Should the company accept a project (for the worked example above) if the beta for the project was (i) 7.5%, (ii) 4.7% or (iii) 8.9%? See VLE for solution
Capital budgeting and project risk

Long before the risk-return relationship was established financial managers realised that, other things being equal, risky projects were not as desirable as those which were considered to be safe projects, and thus would require a higher rate of return. In this way the company cost of capital equated to the expected rate of return demanded by investors, which was determined by the average risk of the companys assets and operations. Since investors will require a higher rate of return from a high-risk company than from a low-risk company, high-risk firms will have a higher company or asset cost of capital and they will therefore set a higher discount rate for their new investment opportunities. The project cost of capital may differ from the company cost of capital as it will depend upon the use to which the companys capital is put. Therefore, the project cost of capital will depend upon the risk of the project and not upon the risk of the companys existing business.
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By the end of this chapter and having completed the Essential reading and activities, you should be able to: calculate and interpret the risk associated with macroeconomic factors (market risk) for a share compare the rate of return that investors demand and the market risk of a share calculate the opportunity cost of capital for a project and be able to explain its relationship to the company cost of capital.
Practise questions
1. Discuss whether, according to the CAPM, the expected rate of return of a share with a beta less than zero would be more or less than the riskfree rate? Why would investors be willing to invest in such a security? 2. Share A had a beta of 0.5 and investors expect it will provide a return of 5 per cent. Share B has a beta of 1.5 and investors expect it to give a return of 13 per cent. Use the CAPM to find the market risk premium and the expected rate of return on the market. 3. A firm is considering the following projects, and the expected returns calculated by the way of IRRs are as follows: Project A B C D Beta 0.8 0.5 1.6 1.2 Expected return 13% 12% 19% 18%
a. The risk free rate is 4% and the market return is 16%. If the firm has a current single cost of capital as 16%, which projects have a higher cost of capital than the firms? b. Which projects should be accepted? See VLE for solutions
Problems
Attempt the following problems in BMM: Numbers 1, 8 and 11 (pp.31316). Attempt the following problems in BMA: Chapter 9, p.231, numbers 5 and 8 Chapter 10, pp.26061, numbers 9, 10 and 13.
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Notes
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Chapter 5: Sources of funds

Aims of the chapter
The first part of this chapter introduces you to the theory and practice of capital markets. It considers the concept of an efficient capital market with its implications for the raising of capital and the assurances for a fair game situation for the transfer of funds between investors. The types and the degrees of efficiency have been tested in many and various ways with more recent research findings highlighting certain anomalies which give support to those who have questioned the concept. Discrepancies in types and degrees of efficiency between different international markets also have been identified. The efficient market hypothesis has important implications for all market operators and their agents. The second part deals descriptively with the main methods of raising equity and debt funds, as well as including details of the characteristics and costs of using them. Implications, benefits and costs of the alternative methods of funding and raising the funds are considered due to their importance to a company.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and activities, you should be able to: describe the nature and types of capital markets explain the efficient market hypothesis, its different levels, the anomalies and deviations between theory and practice as well as the ability to summarise the evidence that has been produced as support both for and against the hypothesis explain the implications of market efficiency for the various operators who use the markets or provide information regarding them (e.g. investors, companies raising funds and financial analysts) discuss how the financial markets operate particularly with respect to the provision of funds for companies list/outline the range of securities used to generate funds for companies including a more in-depth insight of the main forms of debt and equity.
Essential reading
The chapters in PA and BMA are included as Essential reading here as well as those in BMM. The former adds the necessary depth of required background knowledge to that provided in the latter text.
Brealey, R.A., S.C. Myers and A.J. Marcus Fundamentals of Corporate Finance. (McGraw-Hill Inc, 2007) Chapters 6.1, 6.2, 6.66.8, 13 and 14. Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (McGrawHill, 2008) Chapters 14, 15 and 16. Atrill, P Financial Management for Decision makers. (FT Prentice Hall Europe, . 2005) Chapters 6 and 7.
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Capital markets
In Chapter 7 of PA and Chapter 16 of BMA these are examinations of the workings of the London Stock Market in the UK and the Securities and Exchange Commission (SEC) in the USA, respectively. This description of London is, in principle, a description of the typical capital market found in most of the worlds developed countries. It is important to note how capital markets have two separate, but linked, functions. These are a primary one for fund raising, and a secondary one which provides the opportunity for the providers of funds to liquidate their investments. Note that this latter function is a vitally important one because, without the facility to exit from an investment, few people or institutions would be prepared to make investment funds available. Thus this marketplace is providing the needed interface for investors to interact with the companies, through their management, that wish to raise funds as well as other investors who may wish to buy or sell existing financial assets. Note carefully what is meant by capital market efficiency (CME). CME does not require that the market is a perfect one in the sense that perfect markets are referred to by economists. Neither does CME require that any investors have perfect knowledge of the future. CME is concerned with the extent to which the knowledge which does exist about a particular security is fully taken account of in its market price. Thus the price at which a security is traded today may, with the advantage of information which may subsequently come to light, be above or below the true worth of the security. CME requires that the price at which that security is traded today rationally reflects all of the information which is available today. Learn the assumptions underpinning the definition of a perfect capital market and how the economists perfect market becomes the financial managers efficient capital market and the sufficient conditions for that. Note, use and understand how the notion of being involved in a fair game proves the basis for discussion here. Activity 5.1 Write out the economists assumptions for a perfect market and corporate finances assumption for an efficient capital market. Show the links between the two lists. See VLE for solution There are three types of efficiency: allocational pricing operational The majority of the research findings in the literature when discussing efficiency are related to pricing efficiency. It is to this that the Efficient Market Hypothesis (EMH) relates.
Efficient market hypothesis

There are three forms or levels of efficiency: weak, semi-strong and strong: weak form, means that one cannot consistently earn better-thanaverage investment returns as a result of studying past patterns of prices for particular securities; thus people who draw charts of past share price movements, and try to detect patterns of share price
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movements, would not gain as a result. This correctly suggests that share prices move in an apparently random way, rather than following repeating patterns. This randomness could be seen as a market which is irrational; however, bearing in mind that CME means that all information is reflected in share prices, only relevant new information will affect them. Since the emergence of new information will not follow a pattern, this has the effect that share prices follow an apparently random walk semi-strong form, where better than average returns cannot be consistently earned by studying publicly available information about the enterprise; this study of public information, for example the published accounting reports of companies, would not be expected to be advantageous strong form, where better than average returns cannot be earned as a result of having access to information which is not available to the public; thus, people who have unpublished information, perhaps because they work for a particular business, would not expect to gain as a result. So somehow, because the market is efficient, it prevents people from consistently earning better-than-average returns. Activity 5.2 Take a local paper which quotes daily share prices. Select a company and plot the closing share prices for the 5 days in one week with time on the x axis. Draw a line of best fit through those five points. Then plot the next Mondays closing price. By reading the paper about Mondays market activities try to explain why the plot for Mondays price is where it is, on, above or below the trend line you have drawn. Is your explanation drawn from the weak, semi-strong or strong form? It is important to understand that, if a market is efficient in the strong form, it must also be efficient in the semi-strong form and the weak form. Similarly, if a market is efficient in the semi-strong form, it must also be efficient in the weak form. These distinctions are useful. This is because evidence, which consists of the results of a large number of research studies, tends to suggest that the worlds capital markets are efficient in the weak and semi-strong form, but not in the strong form. In other words, those who have relevant information which is not generally known, can expect to earn better than average investment returns.
Tests of the efficient market hypothesis

Researchers have conducted the greatest number of tests on the weak form of the hypothesis. You should be able to summarise the outcome of these tests which have used a variety of statistical techniques, for example serial correlation and run tests. Tests have looked for data patterns that might have particular properties similar to different frequency distributions random-walk, sub-martingale, simple sequences of increases or declines all with the aim of being able to derive a trading rule which would enable the investor to out-perform the market using a simple buy and hold strategy. The tests have been performed on numerous different markets, over different time periods, etc. The results have not been uniform in outcome. The differences in results can be explained by many features developed country markets versus developing country markets, monthly versus daily versus weekly prices, upward versus downward price trends etc.
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The tests on the semi-strong form have also been numerous and again produced results lacking in consistency. The tests using data from developed country markets have tended to support the conclusion that the market adjusts quickly (i.e. efficiently, to publicly available information). Results from developing market studies have been much fewer and have tended to suggest a lower degree of efficiency. The strong form tests have been least successful in their proof of the strong form of efficiency in the markets. Clearly there are still circumstances that exist where investors under the strong form could, and do, earn above average profits. This is in spite of legislation in some countries in the markets outlawing particular operations (e.g. insider trading).
Anomalies, fads, insider trading and doubts concerning efficiency

There are now many published articles on the anomalies in the evidence investigated for proof of EMH (e.g. day of the week effect, trading hours of the day effect, even month of the year, size anomalies and small company effect). These anomalies help to explain why the anecdotal evidence quoted by interested parties of abnormal profits can be explained. Even so there is not evidence of consistent above average gains accruing to groups of investors who have based their trading upon those results. Again, it is fair to say that there is sufficient anecdotal evidence of investor behaviour of following fads, being caught for insider training etc. to indicate that theory and practice are not quite in line.
Implications of capital market efficiency

You should particularly note the implications of CME for financial managers. Not surprisingly, these implications are the reason why CME is included in the syllabus. The major implications are: Accounting misinformation will not fool investors generally. There is a body of evidence which suggests that attempts by corporate managers to make alterations to the accounting bases, to figures published in annual accounts which have the effect of giving a changed view of the profit for a period or the assets on the balance sheet, will not affect the market price of the businesss shares; this is provided that the facts concerning the alterations to the accounting bases are made public. However not everything may be made public and in any case some manipulation may be possible within the guidelines and thus not published. There are numerous reasons why management wants financial information presented in a particular way (e.g. income smoothing because of the link with a management remuneration scheme). There is no need for the large body of analysts and others in the securities and investment industry. Reality is different due in part to human nature. Investors are best advised to buy a portfolio of shares and to hold those shares rather than looking for opportunities to buy cheap shares this is because securities reliably reflect all known information about a business, so if shares look cheap it is illusory all that will happen is that the investor will waste time and money seeking out the cheap shares, then spend money on agents fees etc. to sell part of the existing portfolio and replace it with the cheap shares.
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The timing of issues of new shares by businesses is not an important question. It seems that corporate managers are frequently concerned not to issue shares at a point where share prices are historically low, since in order for the issue to be successful the new issue would have to be at a low price; this is irrational if current share prices reflect all that is known about the business. Only where the businesses managers have economic information about the business, that they have yet to release into the public domain would delay be justified. Again anecdotal evidence can show in specific instances where during a particular short period businesses did lose out by having to issue at the wrong time. Possibly the shift in research findings is reflecting a genuine lessening of CME over recent times, perhaps caused by an effective decline in the number of individual investors active in the market. Possibly it reflects the use of more sophisticated research techniques in recent studies, which are leading to a truer view of things. Review question Critically comment on each of the following statements: a. The stock market is depressed at the moment. This is a very bad time for our business to make an issue of new shares to the public. b. If stock market prices are efficient, it means that all investors have complete information about all of the shares quoted in that market. c. The stock market cannot be semi-strong efficient, otherwise you wouldnt have all those well paid analysts spending most of their working day poring over business reports and other published information. Solution to review question a. This implies that the current issue price will make the existing shareholders worse off because the new shares will be sold for less than they are really worth. This is inconsistent with efficient capital market theory, which says that the current price rationally reflects all information about the business and, therefore, fairly values it. There is no reason to believe that share prices will rise again, in any case. If the share issue is to be a rights issue, the issue price will not affect the wealth of the shareholders. b. Stock market efficiency does not mean what the quote says. Market efficiency means that all known (strong form) or all publicly known (semi-strong form) information is rapidly and rationally reflected in security prices. For efficiency to exist it is not necessary for all investors to have the relevant information, simply for investors to have it between them. It certainly does not mean that what investors know is correct. As all relevant information relates to the future, it is not possible to know it for certain.
c. A paradox of capital market efficiency is that it is as a result of people looking for inefficiencies and exploiting them that the market forces drive prices rationally.
London capital market

This is a generic title given to a considerable number of specific and specialist markets. It includes such markets as the ISE, the International Stock Exchange of the UK and the Republic of Ireland, the Alternative Investment Market (AIM), European Association of Security Dealers Automated Quotation (EASDAQ) and so on.
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Activity 5.3 Write out and learn the outline of the processes of the main exchange and the rationale and difficulties concerned with the other markets and their requirements. See VLE for solution
Share capital
Much of the content of the introductory sections concerning the characteristics of limited companies and the main forms of share capital have been dealt with in your earlier studies and so should be familiar to you. When dealing with the main forms of share capital you should note the decline in recent years of the popularity of preference shares and the likely reasons for this.
Methods of raising share capital

You must study carefully the various methods of raising share capital. Note the distinction between an offer for sale and a public issue of shares. In the former case, shares to be issued are sold to an issuing house which, in turn, offers the shares to the general public whereas in the latter case a company will make a direct offer of its shares to the public. From a business viewpoint, a public issue entails greater risk as the public may not wish to subscribe for the shares offered. Consequently, it is a less popular method of raising equity finance. It is important to appreciate that a tender issue is not a method of issuing shares but rather a method of determining the price at which shares are issued. The method of issue could be an offer for sale or a public issue, which would use the tender approach to identify the striking price at which the issue would take place. A tender issue has distinct advantages for a business where uncertainty surrounds the appropriate price at which to price the shares. Such uncertainty may be due to such factors as stock market volatility or the unique nature of the business. A tender issue will help avoid underpricing the share, which means the investor will lose potential profits on the issue, or overpricing, which means the business may experience an unsuccessful share issue. However, many investors find it difficult to decide on an appropriate tender price and so prefer a fixed price share issue. All the above methods of issue do not place restrictions upon the company as to whom it can offer the shares. A company wishing to extend its share capital may wish to place restrictions and an example of how it can do it is by use of a rights issue. A rights issue offers existing shareholders the opportunity to participate in any new share issue and to maintain control of the business. The advantages and disadvantages of this form of issue should be carefully noted.
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Rights issues, share prices and shareholder wealth

It is also important to appreciate the effect of a rights issue on both share prices and shareholder wealth. Study the worked example below. Worked example 6 Mulberry Chemicals plc has the following capital structure: 000 25p ordinary shares Share premium account Retained profit 15,000 2,000 4,560 21,560 The ordinary shares are currently being traded on the stock exchange at 1.80 each. At a recent board of directors meeting it was decided to undertake an ambitious expansion programme and to finance this with a one-for-five rights issue at 1.50 per share. Required: a. Calculate: i. the theoretical ex-rights price of a share ii. the price at which the rights are likely to be traded. b. Identify and evaluate the options available to an investor holding 1,000 ordinary shares in the company upon receipt of the one-for-five rights offer. Solution to Worked example 6 a. The theoretical ex-nights price is: 5 ordinary shares @1.80 1 rights share 9.00 1.50 10.50 Value of a single share following the rights 10.50/6 = 1.75 The value of the rights may be calculated as follows Value of one share following the rights issue: Less cost of rights share Value of the rights 1.75 1.50 0.25
b. The investor can take up the rights issue, sell the rights, or let the rights offer lapse (i.e. do nothing). Each of these options may be evaluated as follows: Value of original 1,000 share investment prior to announcement of rights issue: 1,000 @ 1,80 = 1,800 Take up rights issue (i.e. acquires 200 more shares @ 1.50) Value of investment following rights issue (1,200 @ 1.75) Less cost of acquiring rights shares (200 1.50) 2,100 300 1,800
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Sell rights Value of investment following rights issue (1,000 @ 1.75) Add sale of rights (200 0.25) Do nothing Value of investment following rights issue (1,000 @ 1.75) 1,750 1,750 50 1,800
Thus, in theory, the investor should be in the same financial position whether he sells the rights or takes up the rights issue. Allowing the rights offer to lapse will place the investor in a worse financial position than the other options. However, in practice, the business may sell the rights on behalf of the investor and pass on the proceeds thereby putting the investor in the same financial position as if he had sold the rights. From the viewpoint of a business, the price at which a rights issue is offered is important but not critical. Clearly the business wishes to issue as few shares as possible when raising its funds, so it will not tend to make a rights issue when the market is at a low, but rather to do it in a buoyant share market. However, given that a business wishes to raise a specific amount of money, it is not really important whether, say, 100,000 shares are issued @ 3 per share or 200,000 shares are issued @ 1.50 per share. The value of the underlying assets held by the business and the proportion of those assets to which each shareholder has a claim will be the same. It is, however, important to ensure the offer price is below the market price of the shares for the rights issue to be successful.
Other sources and types of equity

You should be able to explain the difference between preference shares and ordinary shares along with the variety of each sort and the advantages and disadvantages for each. Similarly, you should note the gaps in the capital market for providing equity funds. The larger and thus more public the company the easier it is to raise funds through the market. With private companies, both large and small gaps have been identified since it is much more difficult for them to raise risk capital when required. It is possible, for example, that fixed interest borrowing is no longer available because a company may have borrowed to their limit, so these smaller companies have to turn elsewhere. The providers of risk capital, are known as venture capitalists. You will find details of their aims, needs, style etc. of financing in the text. Within the general title, venture capitalists, can be found various subgroups of fund providers, some funded by financial institutions like pension funds, others made up of local groups of individuals with some money and expertise to offer who are called business angels. The efficiency and effectiveness of the market place for such funds depends very much on the quality of the network between such providers; the smaller the needs and provisions the poorer it gets. Activity 5.4 Write a brief paragraph explaining the advantages and disadvantages of the different forms of equity. See VLE for solution
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Retained earnings
A business may prefer to use retained earnings rather than a new issue of shares as a source of equity funds. This policy would have the following advantages: Issue costs and delays in receiving the new injection of funds are avoided. There is no risk of failure to obtain the necessary funds or existing shareholders suffering some dilution of control. It is easier to secure funds in this way as retained profits will already be held by the business in some form or other. New shares issues are usually subject to a great deal more scrutiny by investors and their advisers than profit retentions. A policy of retention may also be preferred by investors. Some investors may prefer to receive returns from their shares in the fore of capital gains rather than dividends. Moreover, as capital gains are only normally taxed when the gain is realised, the investor has some control over the timing of their tax liability.
Long-term debt finance

The early sections in the readings describing the main characteristics of long-term debt should again be familiar to you as a result of your earlier studies. However, these characteristics are dealt with in rather more detail than before. The issue of loan capital can bring certain advantages to a business and its shareholders. These advantages include: By employing loan capital to help finance the business, the returns to equity shareholders will increase providing the returns from the funds invested exceed the cost of servicing the loan. Loan capital is normally perceived as being less risky by investors than equity shares as loan interest is payable before share dividends and security is normally provided by the business for the loan this lower level of risk results in lower expected returns by lender than equity shareholders. In the UK, interest on loan capital is viewed as an allowable business expense which can be offset against profits for taxation purposes this is not the case for dividend payments. The degree of sophistication and variety now available in bond or quasi-bond securities has grown enormously over the recent past through the increasing competitiveness within the financial markets. Examples of these new types are junk bonds, deep discounted bonds, mezzanine finance, interest-rate swaps and debt-equity swaps. The use of loan capital to finance a business, however, also brings certain disadvantages: The higher the level of borrowing the higher the level of financial risk associated with the business. The level of borrowing is also known as the amount of gearing. Interest must be paid irrespective of the profit level and capital must be repaid on maturity of the debt. This higher level of risk is likely to mean that equity shareholders will seek higher returns in compensation.
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The business may also be required to accept loan covenants as part of the loan agreement (e.g. maintaining a certain level of liquidity, seeking permission from existing lenders before raising new loan capital etc.) which will restrict managements freedom of action. Although interest rates are generally lower than equity returns, there can be occasions when the returns on loan capital are higher than those on equity capital.
The issue of loan capital

Long-term debt is likely to be issued by a business where some of the following conditions prevail: Earnings are relatively stable over time or on an increasing trend. Adequate security for the debt exists. The existing level of gearing is fairly low for the particular business sector. There is a risk of a change in the pattern of control from the issue of new equity shares. However the level of borrowing, gearing, will also be influenced by the companys profitability and the present and future underlying economic conditions. The higher the gearing the greater the gains in earnings for shareholders in times of increasing profits, conversely in times of declining profits the higher the gearing the faster the decline in earnings per share. Thus, simplistically, it is better to be low geared in low profit or declining profit periods; in growth and high profit periods it is better for the company to be highly geared.
Hybrid capital
A clear distinction between share and loan capital is not always possible and so you should cover carefully the sections on the major forms of hybrids in order to understand their characteristics and objectives.(See BMA Chapter 15 or PA Chapter 7.) Most forms can be evaluated in similar ways to warrants and options, which are covered in a later chapter.
The attitude of investors and managers to the financing decision

When new finance is sought from the issue of either long-term debt or equity shares the views of existing investors and the management of the business are important. The attitude of existing equity shareholders is likely to be influenced by: the perceived benefits and costs of gearing (the mix of debt and equity) the potential problem of dilution of control through a reduction in the proportion of voting equity held financial implications of additional calls for funds, including the likely risks and returns arising from the equity option and the effect of the investment on the investors consumption pattern. Existing lenders will be concerned that any new debt issued by the business does not undermine their status or increase the level of risk borne. (Often their position will be protected by restricting loan covenants and so permission may have to be sought before the business can issue a new class of debtor.)
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Managers are employed to act in the best interests of the shareholders although they may feel that a high level of gearing increases their own level of risk. They may be more willing to take on higher levels of gearing where their remuneration is linked closely to profits generated.

By the end of this chapter, and having completed the Essential reading and activities, you should be able to: describe the nature and types of capital markets explain the efficient market hypothesis, its different levels, the anomalies and deviations between theory and practice as well as the ability to summarise the evidence that has been produced as support both for and against the hypothesis explain the implications of market efficiency for the various operators who use the markets or provide information regarding them, (e.g. investors, companies raising funds and financial analysts) discuss how the financial markets operate particularly with respect to the provision of funds for companies list/outline the range of securities used to generate funds for companies including a more in-depth insight of the main forms of debt and equity.
Practise questions
1. Discuss reasons why, in your view, the stock markets of the world will never achieve the strong form of the efficient market hypothesis. See VLE for solution
Problems
Attempt the following problems in BMM p.171, number 8; p.368 number 8; p.386 numbers 15 and 17. Attempt the following problems in BMA pp.38182, number 9 and 19; p.406, number 10; p.433, numbers 7 and 8.
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Notes
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Chapter 6: Cost of capital and valuation of a business

Aims of the chapter
In this chapter we start by investigating the costs of the main capital components, debt and equity. We show the various models suggested to derive these costs. The valuation models described and discussed relate to activities of investors and managers in the market place. Money raised from these different sources is then invested by the company and its managers to obtain maximum return. Investments will only be made when it can be shown that they will at least overcome the hurdle of achieving the cost of capital, the cost of the funds injected. This cost of capital comes from the particular combination of funds and their costs. So this chapter covers the rationale and derivation of a companys cost of capital. It is a weighted average cost because the total funds have a number of different types of funds, each with their individual cost and quantity. Gearing is the name given to the degree or level of debt used in the total capital of a firm. As the level of gearing varies, it will influence a companys average cost of capital and so this will be discussed for its implications, both in theory and practice. Approaches to valuing shares and business from a practical viewpoint will be covered since they will be dependent upon the theories which can provide guidance for a companys financing methods and costs.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and activities, you should be able to: calculate the value of debt and equity and their respective costs using alternative approaches describe and give an evaluation of the strengths and weaknesses of the different approaches to the derivation of the estimation of debt, equity and business valuations explain the influence of gearing on capital structure both in a conceptual framework and in applications such as raising new capital derive and calculate the weighted cost of capital for a company compute the valuation of a business provide a reasoned evaluation of the best way a company should raise new capital.
Essential reading
Brealey, R.A., S.C. Myers and A.J. Marcus Fundamentals of Corporate Finance. (McGraw-Hill Inc, 2007) Chapters 5, 6, 11, 12 and 15.
Further reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (McGrawHill, 2008) Chapters 4, 5, 9, 10, 18 and 20. Atrill, P Financial Management for Decision makers. (FT Prentice Hall Europe, . 2005) Chapter 8. 57
The value of economic assets debt

The value of an economic asset is determined by the economic benefits which are expected to be generated by that asset. Thus an economic asset is something that has value to the owner only because it is expected to generate economic benefits. This contrasts with an asset that has value, partially or completely, for sentimental reasons. Thus, to the typical shareholder, a share in a business has value only because it is expected to generate future economic benefits, ultimately in the form of cash. Therefore the market value of a debenture, or debt, will be the present value of a combination of the interest payments and capital repayment(s). Assuming a loan with market value today of L0, a term of years n, annual interest payment of it, repayment at maturity of M, and cost of debt Kd the present value of the cash flows L0 is given below:
This is the discounted cash flow the lender will receive over the outstanding life of the loan. Introducing taxation adds minor complications to the formula. Kd, the yield to maturity and cost of debt, will exceed the nominal interest rate it /100 when the present price of the loan L0 is less than the nominal value of the loan. The maturity value M is usually the same as the nominal value. Worked example 7 Solo plc has some loan stocks which are quoted at rates per 100 nominal value. The interest rate for each type (based on the nominal value) is 7.5% per annum. The corporation tax rate is 33%. There is no capital gains tax. The first type is a perpetual loan stock and is quoted at 93 per 100 nominal value. The second type has the same yield (cost) and interest rate but is quoted at a different market price because it only has a two-year life. At the end of the maturity period the nominal value of 100 will be repaid. Required: What is the cost of the perpetual loan stock? Using this cost calculate what the market value of the second type should be Solution to Worked example 7
= 5.4% This example considers loan stocks which are perpetual (i.e. they are not scheduled to be redeemed). Where this is not the case the redemption cash flow must also be taken into account. So using Kd
= 99.31
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The value of economic assets equity

Likewise, the value of a share will be a function of the expected future economic benefits (dividends) from owning it. It will also be a function of the required rate of return from owning the share. This in turn will depend upon the levels of return available from investments in the same risk class (i.e. it is the opportunity cost of finance to the shareholder). Logically, the value (P0) of a share at any particular point in time is the sum of the discounted values of expected future dividends, where Dl, D2 etc. are the dividends which will be received in respect of the share after one year, two years etc. and Ke is the required rate of return. Thus:
(This assumes dividends are payable annually and that the current years dividend has already been paid and the company continues forever so t equals infinity). Thus the dividend for year four is more heavily discounted than that of, say, year two because the benefit will not occur until two years later. Obviously, in real life, estimating the dividend which will be paid on the shares in future years is problematic. One solution is to assume that dividends will remain constant at the current level. Another is to assume a constant growth rate. Though each of these approaches can be criticised as being oversimplifications in real life, they do provide helpful starting points in the valuation process. Where a constant level of dividends is envisaged:
Where a constant rate of increase in the size of dividend of g is envisaged:
By rearrangement of this equation we get
which is the equity cost of capital. This is known as the Gordon Dividend model, named after the author who derived it many years ago. Learn it and its strengths and weaknesses. It is a simple way deriving a companys cost of equity, the prospective dividend yield plus the predicted capital growth in share price. Worked example 8 Apex plc has just paid a dividend for this year on its ordinary shares. Next years dividend is expected to be 0.25 per share. Given the level of interest rates in the economy and the risk associated with the dividends investors require a return of 17% per annum. Required: Calculate the value of an ordinary share in Apex plc. a. assuming a constant level of dividends, and b. assuming a constant level of growth of dividends of 6% per annum.
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Solution to Worked example 8 a. Assuming a constant level of dividends: P0 = D1/ Ke = 0.25/17% = 1.47 b. Assuming a constant rate of increase in the size of dividend: P0 = D1/(Ke g) = 0.25/(0.17 0.06) = 2.27 Note how much more valuable a share is when it is expected that the annual dividend will increase each year. This explains why, in real life, we find that the shares of businesses which are seen as having good growth prospects are valued more highly compared with those whose future is seen as more static. Both BMM and BMA give good descriptions of the theory and derivation of the debt and equity valuation models which are based on the application of the NPV concept.
The required return on investment

A question which needs to be addressed is how do we select the required rate of return from a share? As has already been said, this should be the opportunity cost of finance. In other words it is that which the investor could earn from a similar investment. By similar is meant over the same time scale and with a similar level of risk. So, the investor needs to be compensated for having the money tied up (delaying consumption) and for bearing the risk. Thus: The required return equals a risk free rate of interest (perhaps the return from UK government short term securities) plus a risk premium (related to the level of risk associated with the particular investment). There is a model for deducing the appropriate risk premium which is based on modern portfolio theory (MPT). The basic tenet of MPT is that it is easy and cheap to avoid much of the risk of investing in shares. This is simply achieved by not putting all of your eggs in one basket. By holding a portfolio of investments comprising shares in different businesses in different industries it is possible to diversify away quite a lot of the risk. Consequently, investors will not be able to obtain a risk premium for bearing this part of the risk, which is known as specific (or unsystematic) risk. There is, however, part of the risk of share ownership which cannot be diversified away. This is because this part of the risk relates to factors which affect all businesses and their returns. This part of the risk is known as systematic or market risk. It is caused by macroeconomic factors like changes in interest rates, changes in fuel prices etc. Thus: Total risk of investing in a particular share equals specific risk (diversifiable) plus systematic risk (undiversifiable).
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The part of the risk which cannot be diversified away requires a risk premium to compensate investors for bearing it. This risk premium relates to the extent to which the particular share concerned is affected by the macroeconomic factors associated with systematic risk.
The capital asset pricing model (CAPM)

This has been dealt with earlier, in Chapter 3, and is only included here as a refresher and introduction to the capital asset pricing model which will be used to derive a companys cost of equity. The formal statement of the relationship between the required rate of return from a share and the level of risk is given by CAPM, this is: Ri = Rf + i (Rm Rf) where: Ri Rf is the required rate of return on a particular investment (i) is the risk-free rate of interest is the measure of the extent to which the investment i is affected by macroeconomic factors which cause systematic risk is the expected average return from investing in shares generally.
i
Rm
The second term on the right hand side of CAPM is the average risk premium for all shares (Rm Rf), multiplied by the risk factor (i ) of the particular share (i) concerned.
s for most businesses which are traded on the International Stock Exchange are published and are readily available.
(In the previous section we used Ke for cost of equity, its equivalent in the CAPM model above is Ri which can be replaced by Ke in that equation when estimating a companys cost of equity.) This model like all others has its weaknesses, which you should learn. It has a potential successor which is called the Arbitrage Pricing Model (APM). It argues that return is linearly related to a number of risk factors for which factor indices can be found and used and thus give a truer relationship. Ri = Rf + 1F1 + 2F2 + + e where Rf is the riskless rate, and F1, F2 etc.are the indices for the various risk factors influencing the return with 1, 2 etc.the sensitivity of the shares return to those factors, and e is the random unexplained unrelated element in the return of the (i)th security. Empirical testing of this model is still ongoing. There are no solid results yet proving or disproving this theory.
The cost of retained earnings

It is normal practice for businesses to pay dividends of an amount less than their after tax earnings for the year. Thus some of the increase in the assets to which the profit gave rise typically remains in the business and is reinvested or ploughed back. It is tempting to believe that this source of finance costs the shareholder nothing and, therefore, is cost free to the business. This is not true, however. Were all of the profits paid to shareholders by way of dividend, the shareholders would obviously have more cash than if part of the profit is retained. Logically, the cost to the shareholders of their money being reinvested by the business is the same as the original investment. The same level of interest rates and risk apply to the reinvested profits as apply to the original investment.
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Activity 6.1 Describe and evaluate various methods of calculating the costs of debt and equity. Explain with reasons the differences between the types of costs and between the different methods of computation. See VLE for solution
Valuation of warrants
A warrant is a right to purchase a given number of shares, at a stated price on a given date(s) in the future. The expectation is that the share price will rise and be well above the exercise price on that future date. Raising equity can be achieved when the warrant is taken up by its holder at the due date. Generally warrants are issued as sweeteners, incentives to help induce lenders make the loan to the company. In theory the value of a warrant in the market is (P0 E) N, where P0 is the market price of the ordinary share today, E is the exercise price of the warrant and N the number of shares each warrant allows the holder to buy. Since there may be some considerable time between the present day and the exercise date then a more sophisticated model is necessary to value a warrant. The thrust of the model is: M0 Pw = VD + Vw where M0 Pw VD Vw price of share(s) today for which the warrant can be exchanged price of the warrant today present value of the-after-tax dividends receivable over remaining life of warrant. present value of the cost of exercising the warrant at the end of its life.
It is not necessary to learn the various formulae needed in order to derive a warrants price since risk has to be incorporated. What is important is to learn the main conceptual approach to valuing the different types of capital.
The reasons for capital gearing

What distinguishes fixed return capital from equity capital, in the present context, is cost. Since providers of fixed return capital are not exposed to as much risk as are the equity holders, they are prepared to accept relatively low returns. In some cases (e.g. where the business is well established in a stable industry and the finance is secured on a quality asset) the risk is very small indeed. In such cases the business would not need to offer much above the rate of interest currently available on government securities. In other cases (e.g. preference shares) the risk is much greater, but it is still likely to be significantly less than the ordinary shares of the same business. All of this means that fixed return capital is relatively cheap and this is its attraction. A further reason for the cheapness of most forms of fixed return capital is the fact that interest payments are tax deductible, whereas the reward of shareholders (i.e. profit) is fully taxed. This means that the net cost to the business, and therefore to shareholders, is the amount of interest less the tax rate. So a loan with an interest rate of 10% per annum would cost only 6.7% (i.e. 10% less tax at 33%), assuming a Corporation tax rate of 33%.
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Capital gearing and risk

On the face of it capital gearing seems, from the shareholders point of view, too good to be true. It is not necessarily quite as good as it seems, however. A problem with capital gearing is risk. The obligation to make fixed interest payments exposes the shareholders to increased risk. If you examine Tables 15.2 and 15.3 on pp.3989 of BMM you will see this point clearly illustrated. When there is capital gearing, the effect of alterations in the level of (pre-interest) operating profit is multiplied. At low levels of profit the shareholders returns are hit heavily by the need to make interest payments. At high levels of profit the benefits to the shareholders are good. Essentially, where the business is earning a rate of return on its assets which is greater than the cost of the fixed return finance, gearing is beneficial to shareholders. Where the return on assets is below the cost of the fixed return finance ordinary shareholders suffer. Naturally, no business will raise fixed return finance at a cost which is above the estimated future rate of return on the businesss assets. Thus the expectation would be that the net effect of capital gearing would be beneficial to ordinary shareholders. Since ordinary shareholders do not know for certain, however, what level of profits will be earned in future, whether the effect of capital gearing will be beneficial or detrimental is not certain. This increased uncertainty will make the ordinary shareholders place less value on their shares than they otherwise would. The greater the level of capital gearing (i.e. the higher the proportion of total finance which is raised from fixed return sources), the greater the risk to which the ordinary shareholders are exposed. Note also in Table 15.3 that the level of cover for interest payments becomes less at higher levels of gearing. Though not shown in the example it is possible that the markets perception of the differences in financial risk may produce different Price Earnings ratios (PE ratio) at different levels. Multiplying the EPSs by the P ratios will give the possible share price .E. anticipated under each financing alternative. Activity 6.2 Work through the review question at the end of this chapter.
The relationship between the level of capital gearing and the cost of capital the traditional view
The view of capital gearing that broadly prevailed until 1958 was that there were clear benefits to the ordinary shareholders because the weighted average cost of capital (WACC) would tend to fall as the capital gearing level was increased, at least up to moderate levels of capital gearing. This would have a beneficial effect on the shareholders because the lower the WACC, the more the business would be worth. Since increases in the value of the business accrue to the ordinary shareholders, gearing up to moderate levels would be beneficial. The traditional view is illustrated in Figure 8.11 on p.335 of PA or Figure 15.6 of BMM. This shows that, as the level of capital gearing increases, WACC falls. This is because of the increasing proportion of the significantly cheaper fixed return finance. As the level of gearing increases, the ordinary shareholders perceive a higher level of risk and, as a consequence, require higher returns to compensate for this. These higher levels of return demanded by ordinary shareholders are not sufficient, at lower levels of gearing, to outweigh the advantage of the much cheaper fixed return capital. At
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higher levels, however, the ordinary shareholders will start to see their returns as being more and more risky and they will require much higher returns. Similarly, as gearing levels increase, the providers of the fixed return finance start to perceive an increase in the riskiness of their own returns. The higher amount of interest and preference share dividend that the business is committed to paying will, at high levels of gearing, place in jeopardy the businesss ability to meet all of these obligations. Thus the business will only be able to raise more fixed return capital by offering increasingly higher rates of interest and preference dividend. At some point the increased requirements of both groups of providers of finance will drive up WACC. Thus WACC will initially decline as the gearing level is increased. At some level of gearing it will reach a minimum value after which it will increase again. There is therefore an optimal level of gearing at which WACC is at a minimum and the value of the business (and each ordinary share) is at a maximum.
The relationship between the level of capital gearing and the cost of capital the Modigliani and Miller view
Modigliani and Miller (MM), two US economists, who both went on to win Nobel prizes, published a paper in 1958 which fundamentally challenged the traditional view. MM argued, with the support of some rigorous analysis, that it is illogical to argue that the value of a business is related to how that business is financed. The value of the business is based on the future cash flows which are expected to be generated by that businesss operations; these will not alter with the method of financing. MM conceded that fixed return finance is cheaper than equity finance because it is less risky, but they argued that introducing fixed return finance into the businesss capital structure will not lower WACC, because the demands of the ordinary shareholders will precisely counteract the effect of the cheaper fixed return finance. Thus the cost of capital is independent of the level of gearing. The relationships are shown graphically in Figure 8.13 on p.337 of PA. The MM analysis was based on several assumptions, most of which do not strictly hold in real life. It is quite reasonable to argue that the lack of reality of most of the assumptions does not seriously undermine the broad conclusions of MM. One of them, however, the assumption of no taxes, seriously flaws the MM logic. This is because loan interest is tax deductible. This means that there is significant effect on the businesss net cash flows and, therefore, the value of the business as a result of this tax deductibility. In 1963 MM dropped their no-taxes assumption and concluded that the higher the level of capital gearing, the lower the WACC and the higher the value of the business and of each ordinary share. Another of the MM assumptions, whose lack of reality could seriously call their conclusion into question, relates to the effective cost to the ordinary shareholders of the business getting into financial distress (going into liquidation). If a business has capital gearing, the likelihood of it being unable to meet its contractual financial commitments is increased. The higher the level of gearing, the higher the probability of financial collapse. The problem with financial distress is that it costs money. This is because legal fees, and other costs of selling off the businesss assets to meet financial obligations, would be incurred. There is also the cost that assets which may have a particular value to the business, may not fetch this value if they have to be sold piecemeal. Thus:
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the value of the geared business equals the value of the equivalent ungeared business plus the value of the tax advantage minus the value of the cost of financial distress. A review question which utilises the MM theories is given in Chapter 12. Activity 6.3 Describe the assumptions underpinning MMs original propositions concerning a companys cost of capital. Show how the relaxation of the assumptions affects the propositions. See VLE for solution
Weighted average cost of capital (WACC)

The overall cost of capital for the business is the average for the various sources, weighted according to each ones importance to the business. WACC is often used as the yardstick by which the businesss own investments are judged. It can be written as Ka the after-tax weighted average cost of capital:
where Ke and Kd are the costs of equity and debt respectively, Ve and Vd the market values of equity and debt respectively and tc, the corporate tax rate. Learn the different approaches to the weights used in the formula, market values, book values, past or present weights, average or marginal or target debt/equity levels. Ensure that you are able to discuss why, thanks to agency costs and a pecking order theory, management may not be found to fully follow a target debt/equity approach in spite of the arguments in its favour. Similarly, we must remember to combine the weighted s of equity and debt, found from empirical study, to give the asset or project beta risk for the company as a whole. It is shown thus:
a = e
Ve + Vd
Ve
+ d
(Ve + Vd)
Vd
Remember too that the corporate asset beta just so defined is also the weighted average of the individual project betas of the investments being undertaken by the company at the time.
Valuation on the basis of the businesss earnings

In principle it should not matter whether a business pays out all of its earnings as dividend, from a valuation point of view. Assuming that the rate of return on the investment is constant, if a business pays out all of its profits as dividend this should lead to a constant dividend each year. If the business retains a fixed proportion of each years profit for reinvestment (broadly what seems to happen in real life) then dividends will grow by a steady rate each year. Thus, in theory, whether we base the valuation on
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dividends or on earnings should not, in theory, lead to a different value being placed on the shares.
Other approaches to share and business valuation

There are various other approaches to valuing shares, or whole businesses and also deriving the resultant cost of equity. These approaches include estimating the future cash flow which the business will generate from its commercial activities and discounting these to arrive at their net present value. Another possibility is to value each of the businesses assets and deduct the amounts owed to creditors to deduce the net value of the business. One of the assets might be goodwill (i.e. the asset which arises from the expectation that the business will earn higher than normal profits in future). By normal is meant the level of profits which the average business in the same line of business might be expected to earn. In theory all valuation methods, correctly applied, should give the same result. In practice this is unlikely to occur. Share valuation is very difficult and is completely surrounded by the need to make assumptions about various aspects of the future. So from whatever valuation method we use we can work back, if necessary, and derive a companys cost of equity. The value of a companys equity and its cost are intertwined. Review question selection of a source of capital Bycraft plc, a business whose most recent published accounts are summarised as follows: Balance sheet as at 31 August 2007 million Fixed assets Current assets Less: creditors, amounts falling due within one year Net current assets Total assets less current liabilities Creditors, amounts falling due after more than one year Long term loan 74 53 21 108 32 76 Capital and reserves Called up share capital 160 million ordinary shares of 0.25 each Profit and loss account balance 40 36 76 Profit and loss account for the year ended 31 August 2007 Turnover Profit on ordinary activities before taxation Taxation on profit on ordinary activities Profit on ordinary activities after taxation Dividends paid Retained profit
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million 87
143 24 6 18 9 9
The directors are keen to undertake an expansion programme for the business. This would require an immediate cash outlay of 40 million. This could be done by making a rights issue, at a price of 0.50 per share, sufficient to raise the 40 million. Alternatively, the business could borrow the money at an annual interest rate of 11%. The expansion programme is expected to generate increased profit, before interest and tax, by 10 million each year, starting in the year ending 31 August 2008. Future levels of profit are expected to remain at the 2007 level and corporation tax is expected to be levied at the rate of 25% of the profit after interest. Required: a. Compute the earnings per share figures for 2008 under each of the two financing options and comment on reasons for the difference between the two EPS figures. b. Deduce the level of total profit, before interest and tax, at which the earnings per share figure is the same under each of the two financing options. c. State what factors should the directors take into account regarding the choice between the two financing options? Solution to review question a. Equity finance option million Existing profit before tax Additional profit Corporation tax @ 25% Profit after tax Existing shares (millions) Rights issue (40 million/0.50) New total (millions) Earnings per share (25.5/240) Debt finance option million Existing profit before tax Additional profit Less: Interest Corporation tax @ 25% Profit after tax Earnings per share (22.2/160) 24.0 10.0 34.0 4.4 29.6 7.4 22.2 0.138 24.0 10.0 34.0 8.5 25.5 160 80 240 0.106
The EPS is higher for the debt financing option. This is due to the tax relief on the interest and the lower cost of debt relative to equity due to lower risk. According to Modigliani and Miller, only the tax gain will benefit shareholders. The increased risk caused by increasing the capital gearing, will exactly cancel the effect of the lower cost of debt. The real world may be different.
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b. Let p be the profit at equal EPS EPS equity option p(1 0.25) 240 million p = = = EPS debt option (p 4.4)(1 0.25) 160 million 13.2 million
c. The main factors which should be considered in making the choice of financing include: the volatility and growth pattern predicted for the businesss earnings the rate and certainty of corporation tax potential liquidation cost attitudes of the shareholders and directors to risk possible market changes to P.E. rating of the company current and future interest rates returns on equity expected by the shareholders effects on share price restrictions (covenants etc.) caused by debt financing.
Review question valuation of a share and/or business Allemby Ltd is a small unquoted company, whose most recent published accounts are summarised as follows: Balance sheet as at 30 September 2007 million Fixed assets Current assets: Less: creditors, amounts falling due within one year Net current assets Total assets less current liabilities Creditors, amounts falling due after more than one year Long term loan Capital and reserves Called up share capital 10 million ordinary shares of 0.50 each Revaluation reserve Profit and loss account balance 5.0 1.5 5.2 11.7 Profit and loss account for the year ended 30 September 2007 million Turnover Profit on ordinary activities before taxation Taxation on profit on ordinary activities Profit on ordinary activities after taxation Dividends paid Retained profit 31.7 3.6 1.1 2.5 1.1 1.4 5.7 11.7 15.3 10.2 5.1 17.4 12.3
You have found a business, similar to Allemby Ltd in terms of type of activity, which is quoted on the Stock Exchange. This business has a dividend yield of 3.89% and a price earnings ratio of 21.6. Advance Corporation Tax is 20/80 of the dividends paid.
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Required: Calculate the price of Allemby Ltds shares on each of the following bases: earnings yield dividend yield net assets. What reservations would you have about the quality of each of these valuations? Solution to review question Earnings yield approach (Using data from comparable company combined with Allenbys data.) EPS of Allemby Ltd = 2.5m/10m = 0.25 per share. PE ratio of the other business is 21.6 therefore the price per share of Allemby Ltd is estimated at 21.6 0.25 = 5.40. The problems with this basis of valuation include: How appropriate is the other business for valuation purposes how similar is it to Allemby Ltd? It might be better to use the average for a range of businesses rather than base the valuation on just one quoted busines Particular differences between the two businesses which may cause problems relate to capital gearing and the tax positions. How typical of Allemby Ltd are the 2007 profits? It may well be inappropriate to base the valuation on just one years profit. Values are based on expected future events, not the past, in any case. The lack of marketability of unquoted shares tends to make them less valuable than those of their quoted counterparts. Dividend yield approach Dividend (gross) per share of Allemby Ltd = (1.1m 100/80)/10m = 0.1375 per share. DY of the other business is 3.89%, therefore the price per share of Allemby Ltd is 0.1375/0.0389 = 3.53. The problems with this basis of valuation include: As with the earnings yield method, how appropriate is the other business data for valuation purposes? An obvious area of dissimilarity might be the dividend policy of the other business. How typical of Allemby Ltd is the 2007 dividend? Future dividends should, in any case, be the basis of the valuation. To what extent are dividends the determinants of value? There is more than one school of thought on this point. The lack of marketability of unquoted shares tends to make them less valuable than those of their quoted counterparts. Net assets approach According to the balance sheet, the net assets stand at 11.7m or 1.17 (i.e. 11.7m/ 10m) per share. This is completely out of line with the other two valuations. Apart from the weaknesses of those valuation bases, the following points are relevant: Balance sheet values are not the same, nor are they intended to be the same, as market values. Broadly speaking fixed assets are valued at cost, less an allowance for depreciation where relevant; current assets tend to be valued at the lower of cost and net realisable value. This tends to mean that balance sheet values understate assets relative to their economic value.
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The existence of a revaluation reserve implies that the business has not strictly followed the normal rule for valuing fixed assets in the balance sheet. It appears that the assets are undervalued relative to their economic value or that goodwill exists but does not appear on the balance sheet. This point is based on the fact that the business made a pre tax return on book capital of 31% (i.e. 3.6m/11.7m 100) in 2007 this is a very high return.

By the end of this chapter, and having completed the Essential reading and activities, you should be able to: calculate the value of debt and equity and their respective costs using alternative approaches describe and give an evaluation of the strengths and weaknesses of the different approaches to the derivation of the estimation of debt, equity and business valuations explain the influence of gearing on capital structure both in a conceptual framework and in applications such as raising new capital derive and calculate the weighted cost of capital for a company compute the valuation of a business provide a reasoned evaluation of the best way a company should raise new capital.
Practise questions
1. Berks plc has been told by its bankers that it has reached its overdraft limit of 100million and that it would be a good time to go to the long term capital market and raise funds. The bank suggested that 210million be raised by one of two methods, either by a 15year debenture which could cost 18million interest (gross) per annum, or by a rights issue @1.50 per share in proportion of 7 to 15 shares. Berks plc recently published its last Balance Sheet which is: million Non-Current Assets Current Assets Less Current Liabilities* Represented by Ordinary Share Capital (200 million /shares) Retained Earnings 200 250 450 * Where Current Liabilities include bank overdraft of 100million. Note this would be repaid out of the 210million raised. Post balance sheet publication, but prior to raising of any long-term capital, the Company announced a 1 for 2 bonus issue of ordinary shares. The founding family of Berks still own 60% of the equity and wish to remain the majority shareholding group. The companys profit after interest but before tax for the past year amounted to 140million. The corporate tax rate is 50%. 300 250 50 450 400
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If 210million is raised by either of the two methods it is predicted that the net profit, before charging any interest on loans or debentures, for the next three years will be 186million, 130million and 210million respectively. If the rights issue method is used the Price Earnings (PE) ratio will remain as it is at 10x, but if funds are raised by long term debentures, the PE ratio will fall to 9x. If the total debt to total assets ratio rises to above 50% then the P .E. ratio will be reduced by a further unit. REQUIRED a. For each of the two capital raising methods, provide a table that shows what the companys share price will be for the next three years, assuming the issue of shares or debentures is successful. Show what the balance sheet of the company will be like under each method after the capital raising. (14 marks) b. What is the minimum number of shares the family must subscribe for under a rights issue in order to retain their voting majority? (2 marks) c. Calculate the amount of net profit before interest expense and taxation for the shareholders to be equally well off under either method. (4 marks) d. Write a short report to the family shareholders giving your views and recommendations for the raising of the 210million. (5 marks) 2. Describe and discuss what considerations have to be taken into account when selecting the next installment of finance a company is considering to undertake. See VLE for solution
Problems
Attempt the following problems in BMM: Chapter 5, numbers 4 and 5; Chapter 6, number 4; Chapter 12, numbers 2 and 11. Attempt the following problems in BMA: p.80, numbers 2 and 4; p.109 numbers 5 and 6; pp.49193, numbers 1, 2 and 8; pp.55455, numbers 1 and 7.
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Notes
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Chapter 7: Dividend policy

Aims of the chapter
Corporate dividend policy or how companies can provide a return to share holders by way of a cash distribution or other means is one of the more important financial decisions management has to make. So this chapter will cover how a firms value can or cannot be affected by the chosen dividend policy. It starts by mentioning the irrelevancy argument before discussing and describing other theories such as the traditionalist approach, the information content of dividends, the clientele effect. Some practical aspects concerning the determination of the policy in practice, such as what is and whether to pay non-cash dividends are covered. Non-cash dividends would include scrip dividends and share repurchases.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and activities, you should be able to: explain how companies decide on dividend payments describe and critique the theory and practice of corporate dividend policy describe and discuss alternative views on the effect of dividend policy explain the informational aspects of dividend payments explain the impact of tax on the dividend decision.
Essential reading
Further reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (McGrawHill, 2008) Chapter 17. Atrill, P Financial Management for Decision makers. (FT Prentice Hall Europe, . 2005) Chapter 9
Introduction
In Chapter 16 of BMM you will be exposed to the theory and practices associated with corporate dividend policy. We will present opposing views on the effects of dividend policy on the valuation of shares and discuss the significance of the traditional view of dividends. It also addresses informational aspects concerning dividend payments and potential clientele effects and how dividend payments are set in practice. The general intention of this chapter is to provide an in-depth discussion on the controversial question of how dividend policy affects firm value. Dividend policy has been the source of some controversy over the years. In this chapter we consider the nature surrounding that controversy and the factors which influence dividend policy in practice. We also consider alternatives to dividend payments which a business might consider.
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Ex-dividend date determines whether a shareholder is entitled to receive a dividend payment; investors who are registered as holding the firms shares before this date are entitled to the dividend.
Dividend policy and shareholder wealth

A share is similar to any other economic asset insofar as its value is related to the future cash flows which it generates. As dividends normally represent the cash flows received from holding shares, it may at first seem that the interests of shareholders would be best served by the business adopting the highest dividend policy it is able to sustain. However, we will illustrate that this may not necessarily be the case.
Dividend irrelevancy argument

The argument put forward by Modigliani and Miller (MM) concerning the irrelevance of dividends is particularly important and you should study it carefully. The most important aspect of their argument concerns the notion that share values are not influenced by the particular dividend policy of the firm. MM point out that shareholders can create their own dividend policy by selling or cancelling dividends by buying shares in the firm. Therefore, it would be illogical for share values of identical firms to be different because of differences in their dividend policies (i.e. dividend policy is irrelevant for identical businesses). Furthermore, MM suggested that firms should only invest in all projects which are likely to yield a positive NPV when discounted at the appropriate cost of capital. If the firm still has surplus liquid funds after undertaking all positive NPV projects then this surplus should be paid to the shareholders as a dividend payment. Note the restrictive assumptions upon which the MM position is based. Much of the controversy concerning dividend policy is based on the extent to which imperfections and inefficiencies in the real world destroy the hypothetically derived MM case. Many proponents of the MM irrelevancy argument believe that the most serious imperfection is the different treatment of dividends and capital gains for taxation purposes. However, in the UK, the differential treatment of capital gains and dividends is less pronounced today than in the past.
Traditional view of dividends

The traditional view of dividends, the notion that MM challenged, is that dividends are important in determining share value as 1.00 received as a cash dividend today is worth more than 1.00 retained by the firm. This basic idea is based upon the argument that investors apply a lower discount rate to current dividends than they do to future dividends on the grounds that future dividends have a higher level of risk associated with them. This idea therefore suggests that, as the risk of dividend payment in the future is associated with a higher firm risk, managers of the firm can reduce this risk by adopting a strategy of a high dividend payout policy. However, this is illogical as risk is associated with the type of business operations undertaken by the firm and not as a result of whether the return from shares occurs now or at a later date. Risk arising from an investment will already have been taken into account when determining the appropriate discount rate, therefore to deflate future dividends because of this risk is in fact, double counting.
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Activity 7.1 It is well documented in academic circles that share prices tend to rise when firms raise their dividend payout and drop when firms cut their target payout ratio. Discuss how it can be said that dividend policy is irrelevant? See VLE for solution
Information content of dividends

As the board of directors of a firm will know more about the financial position and the prospects of the firm than others, dividends can be used by them to signal information about the future prospects of the firm to investors. A number of academic writers have highlighted the role of dividends in sending signals to the capital market. You will notice when reading the relevant sections that it is the difference between the size of the dividend payment announced and the expectations of the market concerning the size of the dividend which is important. Thus, a higher than expected dividend payment may convey to investors that the board of directors has a level of confidence in the firms future, which was not expected by the stock market. MM view the concept of the information content of dividends as only a temporary phenomenon. They respond to a higher than expected market reaction to dividends as suggesting that, as more information becomes available to the stock market, the change in share price due to the unexpected size/magnitude/direction of the dividend announced would occur anyway.
Clientele effect
It is often argued that different investors are attracted to the shares of different businesses on the basis of the particular dividend policy being pursued by the firm. Often investors will be concerned about their tax position when deciding which business to invest in. An individual with a high marginal rate of income tax, for example, may prefer to invest in a firm which has a low dividend payout policy. This is because of the different treatment of capital gains and dividend income for tax purposes in the UK. However, pension funds (which in the UK are exempt from taxation) may prefer their financial managers to invest in firms which offer the highest dividend payment policies particularly as the pension fund will require a stream of relatively liquid funds to meet the payments due to its pensioners. Therefore, the preference for a regular stream of income may be a further important factor which may encourage investors to choose a particular business to invest in. A relatively volatile dividend payout pattern is likely to be unpopular with most investors. Such volatility can create a feeling of uncertainty which is likely to lead investors to invest in firms where the dividend policy is more stable and which may have a dividend policy which may meet their needs more closely. This feeling of uncertainty in firms which have a volatile dividend policy may command a lower share price and a higher cost of capital for the firm. The shares are deemed to be riskier and thus a higher return is required, which causes the price to fall. In light of the arguments presented above concerning the information contents of dividend payouts, many academic writers and critics advocate firms to adopt a stable dividend policy based on a target payout ratio. When firms are likely to dramatically veer away from their target payout, the market should be given as much warning and information as possible concerning the probable change in the dividend policy.
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Activity 7.2 Outline the main points which should be considered when deciding upon corporate dividend policy. See VLE for solution Firms usually have a long-run target dividend payout ratios. This ratio is the fraction of earnings paid out as dividends.
Share repurchase
In the UK, companies are permitted to re-purchase their own shares under company law. This provides an alternative method of cash payment to investors in preference to dividend payments. From an investors point of view, a share re-purchase can have certain tax advantages and also provide investors with the choice of whether to sell or to hold on to their shares. However, share re-purchase can create greater uncertainty for investors than a stable dividend policy. In addition, should the shares of a particular firm not be actively traded (commonly referred to as the phenomenon of thin trading), there is a risk that the re-purchase will either overprice the shares (to the detriment of the shareholders who decide to hold on to their shares) or underprice the shares (to the detriment of shareholders who wish to sell their shares). When reading the relevant sections in the books note the possible motives for share re-purchase and also remember that in an MM world, investors would be indifferent as between a share re-purchase and a cash dividend, as the effect on shareholder wealth from both these events would be the same.
Scrip dividends
As another alternative to a cash dividend firms may decide to pay a scrip dividend to its shareholders, which is a dividend paid in the form of new shares instead of cash. In essence, a scrip dividend is no different from the firm deciding to retain the profits from the financial year and not to pay shareholders any cash dividends. Therefore, the value of the business will remain unchanged and, although a greater number of shares will be in issue following the scrip dividend, the total value of shares issued will still remain the same. Following a scrip dividend, should investors prefer, they may create a dividend for themselves by selling shares if cash is required and they may also find that there may be certain tax advantages in receiving a scrip dividend rather than a cash dividend. Obviously, you must remember that transaction costs will be incurred when shares are sold. In addition, other practical issues such as the lack of a ready market for the shares, the problem of indivisibility (whereby shareholders may be unable to dispose of the precise number of shares necessary for their cash needs) and also the inconvenience involved in making changes to investment portfolios may make the issuing of a scrip dividend an unattractive choice. In many instances investors will have a choice of receiving either a scrip dividend or a cash dividend. Those who opt for the scrip dividend will benefit by having an increased share in the value of the firm while those choosing a cash dividend will benefit from receiving an immediate payment.
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Activity 7.3 Explain the importance of share repurchase and scrip dividends. In what circumstances are they likely to be preferred to cash dividends? See VLE for solution
Determining dividend policy in practice

Both empirical evidence and casual observation seem to suggest that the directors of businesses consider the dividend decision to be very important and that the maintenance of a stable dividend policy is preferred over time. There seems to be a high degree of reluctance in firms to raise dividend levels unless the directors of the firm are confident that the higher payout ratio can be sustained over a long time period. Similarly, there is usually a reluctance for firms to cut dividends because of the (adverse) signals which such an action may elicit. There is also evidence to suggest that directors of a firm consider the firms level of earnings to be the most important influence on the dividend decision. However, in your reading you will also come across other factors which may guide the directors of a firm in determining the dividend policy in practice; and it is important that you understand how these factors impact on the dividend decision.

By the end of this chapter, and having completed the Essential reading and activities, you should be able to: explain how companies decide on dividend payments describe and critique the theory and practice of corporate dividend policy describe and discuss alternative views on the effect of dividend policy explain the informational aspects of dividend payments explain the impact of tax on the dividend decision.
Practise questions
1. Describe what is meant by the term the information content of dividends. 2. Explain the clientele effect and its impact on setting corporate dividend policy. 3. The financial director of Sugary plc is preparing for a forthcoming Board meeting at which the corporate dividend policy for the next four years will be decided. He has been advised he must cover three points of view in his briefing paper. Firstly, the chairman believes that annual dividends should be a constant proportion of the annual reported profits (ie a constant payout ratio); secondly a group led by a non-executive director believes that dividends should increase annually at a constant rate of 15% p.a., regardless of the level of profit achieved. The financial directors own view is that dividends are the residual payment from earnings after retaining all that is needed for the next years re-investment. The financial director has made the following predictions for profits and dividends for the next five payments under the three alternative views. The past years profits (year 0) and the dividend paid there from will be the same regardless of the dividend policy chosen.
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Alternative views 1 and 2 (Constant dividend payout ratio (50%) and constant dividend growth (15%)) Year Profit after tax Dividend proposed 0 100 50 1 120 2 ( millions) 150 140 180 3 4
Alternative View 3 (NB Profit shown incorporates the additional profit arising from the extra investment made compared to Alternatives 1 and 2.) Profit after tax Investment proposed Dividend proposed 100 (50) 50 125 (70) 162 (50) 157 (60) 203 (50)
At the end of year four it is predicted that the ex div market value of the company is 14 times the after-tax profits. The companys cost of equity is 12% net per annum. REQUIRED i) Prepare a schedule for the Board Meeting showing value to the shareholder under each of the three alternatives using the information given above and assuming that the presentation is from the viewpoint of a shareholder with 1% of the total equity of Sugary Plc. (15 marks) ii) Write a discussion paper for the Board meeting using the information calculated in i) above, discussing the theories and rationales of each of the three alternatives proposed and end with your recommendation for the preferred alternative. (10 marks) 4. Arras plc, a recently listed company, has just announced its annual results, stating that its profit before interest and tax was 2.0 million. It expected future profits to be roughly in line with this years amount. Arras is an all-equity financed company with a market value of 12 million. To improve the potential for returns to the shareholders it has decided to borrow 6 million @ 5% (gross) over a long term and use the money to repurchase 6 million of its equity (at market value). Bonn plc is in the same industry, and thus same business risk class, as Arras with a total market value of 25 million. It is financed by 70% equity and 30% debt based on market values. The value of its equity is given at 1.4 times, whilst its debt has a zero value. The pre-tax rate of return for the market as a whole is 8% and the risk free rate is 4%. Corporation tax is 30%. Bonn plc, subsequent to Arras share repurchase, has decided to extend its business by acquiring Chicki Ltd which is in a very different business risk class and has an asset of 0.7. The total value of the investment in Chicki is 12.5 million and it will be financed in the same proportions of debt and equity as the existing capital structure. REQUIRED a. Compute the asset for Arras plc. b. Compute the debt and equity values for Arras plc. c. Compute the weighted average cost of capital for Arras. (3 marks) (6 marks) (6 marks)
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d. Compute the revised weighted average cost of capital for Bonn and the new asset for Bonn after it has taken over Chicki. (6 marks) e. Briefly describe what discount rate Bonn should use in future investment appraisals giving reasons for your suggestion(s). (4 marks) See VLE for solution
Problems
Attempt the following problems in BMM: pp. 44748, numbers 6, 11, 14 and 15. Attempt the following problems in BMA: pp. 46769, numbers 6 and 18.
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Notes
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Chapter 8: Financial analysis, methods and uses, and financial planning

Aims of the chapter
This chapter has two parts, the first half dealing with the technique and application of financial analysis and the second half concerned with financial planning. Alternative names are often used for each of these parts, ratio analysis and financial budgeting. In each case the alternative titles are more restrictive in what they encompass. Course 25 Principles of accounting will have given you a solid grounding in each part, but particularly so in the financial analysis. Remember, as one learns the basic analytical techniques and ratios, that they can be used in many different contexts. Potential and existing investors, potential lenders, customers and creditors all are interested in a companys position and performance. A companys management is also interested because the ratios computed can be used for benchmarks, targets, and for review and critical assessment of performance measures. First learn the computational technique then learn how to interpret the messages they are giving or the possible questions they are posing that will require further investigation.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and activities, you should be able to: compute appropriate financial ratios to enable a set of accounts to be interpreted satisfactorily interpret part or all of a set of financial reports describe and evaluate the means and the limitations of ratio analysis describe and discuss the requirements for strategic financial planning construct a simple financial plan or model.
Essential reading
Brealey, R.A., S.C. Myers and A.J. Marcus Fundamentals of Corporate Finance. (McGraw-Hill Inc, 2007) Chapters 17 and 18.
Further reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (McGrawHill, 2008) Chapter 29. Atrill, P Financial Management for Decision makers. (FT Prentice Hall Europe, . 2005) Chapter 3.
Statement analysis
A companys set of accounts, its profit and loss account, cash flow statement and balance sheet are only of limited value when read in isolation and without analysis and evaluation. Therefore it is important to give meaning to the results portrayed by the accounts via analysis and interpretation. The analysis of financial information can perhaps be best
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broken down into two elements each with their own parts. These are the process and the context elements and each influences the other. The process of analysis will be heavily influenced by the mode and needs for its use. The structure, depth and detail of work undertaken will be influenced similarly. A very detailed review will start by strategically analysing the company and then using the ratios to address strategic elements within each area of enquiry. Most books delineate four areas: profitability, liquidity and solvency, activity and efficiency and financial structure. Each of these areas can be broken down further, for example with profitability it can cover trading profitability, the margin on sales, the proportions of sales taken by the different types of costs. Profitability also includes the return on the investment made. As to what constitutes investment depends on the reviewers perspective. Is it the return on the long term funds invested capital employed, or is it the return on the total assets used to generate the profit or the return to the ordinary shareholders for their investment in the company? Each of the areas has its own family of ratios each providing information for answers to the appropriate strategic questions. Remember the process is generally to prepare a set of ratios, analyse them, and use them for a review of the past performance with the view of helping in the projections for the future. You will find the approach you need to take in numerous specialist books. An understanding of accounting principles learnt in 25 Principles of accounting will enable you to appreciate the effects of any changes a company has made in its reporting practices. Turn your attention to large and important items first. What is important depends on the circumstances. Small changes in large items are usually much more critical than large changes in small items. Look for trends over time, or changes from past trends; compare the results with targets set, benchmarks given, competitors results or industry means. Look for answers or interpretations from the questions posed by the results and then you have the basis for your report. The context of what ratios to compute will depend on the purpose of the analysis, but the calculation of a few well-chosen ratios is generally much more effective than calculating as many as you can think of. The subject guide for 25 Principles of accounting (2006) in Chapter 7 has the main ratios that you should know. To those should be added some cash based ratios which are now available internationally thanks to the new requirement that companies must provide an annual set of accounts including balance sheet, profit and loss account and cash flow statement. Because there is less scope for influencing cash based results it is argued that cash flow based ratios will become more important in both the analysis and projection of financial results.
Cash based ratios

Cash return on net assets (or cash = Net operating cash flow return on capital employed) Total assets less current liabilities Cash interest cover Cash dividend cover = Net operating cash flow Interest payment = Net operating cash flow less tax and interest payments Dividend payment = Net free cash flow Investment
Internally generated investment
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The Du-Pont system which is based on a pyramid of ratios, each level interlocking with the next, is helpful in providing pointers for investigation derived from the inter-relationships. For example return on net assets is the product of operating profit margin (return on sales) and net asset turnover. This causes the analyst to look at the profit margin change, say in a price war between competitors, and see if it has helped improve the net asset turnover enough to result in an overall improvement in return to the net assets employed.
Practical applications
There are various areas where ratios have been used in practical applications for commercial ends. Not all have been successful. There have been attempts to use models incorporating ratios to identify potential takeover targets, possible bankrupts, credit ratings, forecasting profits, and valuing shares. None has been wholly successful though the credit rating and corporate failure models have had the best success story. Consider the reasons why these attempts have not been very successful and this will ensure you understand the weaknesses underlying ratio analysis. This will also help you to understand why the interpretations and predictions are still very subjectively biased. Review question The accounts for Chemistrand plc for the two financial years ended 31 December 2008 are given below. CHEMISTRAND PLC Profit and loss account for years ended 31 December 2008 and 2007 2008 000 Turnover Variable cost of sales Fixed production costs Administration costs Selling and distribution costs Research and development costs Interest 12,000 5,700 1,320 1,020 1,320 300 108 9,768 Net profit before tax Taxation Net profit after tax Dividend paid (during years) Profit retained 2,232 642 1,590 900 690 2007 000 13,200 6,660 1,200 1,080 1,290 270 10,440 2,760 960 1,800 900 900
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Balance Sheets as at 31 December 2008 and 2007 2008 000 Fixed assets Leasehold property (note 1) Plant and equipment (note 2) 6,750 1,620 8, 370 Current assets Stock Debtors Bank Less Creditors due within one year Tax creditors Taxation Bank Net current assets Net assets Ordinary share capital (1 shares) called up Profit and loss account 6,000 2,880 8,880 Note 1 Leasehold property (cost) Accumulated depreciation Balance Note 2 Plant and Equipment (NBV) Additions Depreciation for year Closing balance (NBV) 7,200 450 6,750 1,080 720 (180) 1,620 6,000 2,190 8,190 7,200 300 6,900 1,140 60 (120) 1,080 600 630 720 510 8,880 540 1,470 210 8,190 1,140 1,320 2,460 1,020 1,140 60 2,220 6,900 1,080 7,980 2007 000
Note 3 No sales of assets took place during the year (NBV Net Book Value) Note 4 All dividends were paid during the financial year at the rate of 0.15 per share.
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Cash flow statement for the year ended 31 December 2008 2008 000 Cash flow from the operating activities Returns on investments and servicing of finance Interest paid Taxation Capital expenditure Equity dividends paid Management of liquid resources Financing Share issue Increase/(Decrease) in cash in the period (780) 3,000 (1,740) (108) (1482) (720) 120 (900) (780) (240) (6060) (3840) (900) (4740) 2,430 2007 000 2,460
The following information from a credit rating agency for the industry is also available for the two years 2008 and 2007. 2008 LQ Return on net assets (%) Net assets turnover (times) Current ratio (times) Acid test (times) Collection period (days) Total owing to total assets (%) Long term debt to capital employed (%) Return on sales 15.0 1.0 1.0 0.8 30 20 5 11.5 M 20.0 1.5 1.9 1.2 45 50 15 13.3 UQ 25.0 1.7 2.8 2.1 65 65 40 14.7 LQ 15.0 1.1 1.1 0.7 35 25 5 11.0 2007 M 20.0 1.5 2.0 1.2 50 49 15 13.3 UQ 25.0 1.7 3.4 2.0 70 67 35 14.7
LQ Lower Quartile (25% of group had ratios same as or lower than figure given) M Median (50% of group had ratios same as or lower than figure given) UQ Upper Quartile (75% of group had ratios same as or lower than figure given) Required: a. Compute a full set of basic financial ratios which will help give a rounded assessment of Chemistrands performance in 2008. b. Using a subset of the ratios calculated in (a) above, comment on the performance of Chemistrand plc in comparison with the statistics provided by the agency. c. Write a short commentary on what additional information has been obtained from the results of the computations in (a) which were not used in (b) above.
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Solution to review question a. Profitability 2008 Return on net assets Return on sales Net asset turnover Return on equity Gross profit margin 2,232 100 8,880 2,232 100 12,000 12,000 8,880 1,590 100 8,880 (12,000 7,020) 100 12,000 = 25.2% = 18.6% = 1.35 =17.9% = 41.5% 2007 33.7% 20.9% 1.61 22.0% 40.5%
Other ratios such as the various costs can be computed as percentages of turnover, or annual growth rates of turnover, profit etc. Divisional and regional breakdowns of profit, turnover and net assets can be evaluated similarly if itis useful to the task. Solvency and liquidity Current ratio Acid test (quick ratio) Activity ratios Debtors collection period Stock holding period Creditor payment period Financing ratios Long term gearing Total owing to Total Assets Interest cover Dividend cover Earnings per share (EPS) Dividend per share Cash based ratios Cash return on net assets Cash interest cover Cash dividend cover Internally funded investment
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2,460 1,950 1,320 1,950 1,320 365 12,000 1,140 365 7,020 600 365 7,020 0 100 8,880 1950 100 (8,370 + 2,460) (2,232 + 108) 108 1,590 900 1,590 6,000 900 6,000 2,430 100 8,880 2,430 108 840 900
= 1.26 = 0.68
1.10 0.60
= 40.2 days = 59.3 days = 31.2 days
31.5 days 47.4 days 25.1 days
= 0% = 18% = 21.7 = 1.77 = 0.265 = 0.15
0% 19.7% n/a 2.0 0.30 0.15
= 24.7% = 22.5 = 0.93 0%
30.0% n/a 23.6 21.8%
N.B. The above ratios incorporate many more ratios and computations than what you would be expected to compute in an exam answer. An appropriate number could be the eight to be analysed in b) below. b. The decline in the return on capital employed appears to have been caused by falling operating profit margins and the declining level of sales which is also reflected in the falling asset turnover. Even so Chemistrand is still in the upper quartile for its profitability both in its operations and on its capital base. However compared to the rest of the industry it is below average in turning its assets over, (i.e. its marketing activities perhaps need reviewing). Chemistrands solvency ratios are below average which could be due to efficient management of current assets. It could also be due to increasing current liabilities at a rate which could cause future problems. Since the collection period is below average(i.e. the Sales ledger) are doing a better than average job of getting in the money, and the overdraft has suddenly emerged and grown, then the companys liquidity and solvency is perhaps to be put under the spotlight. Note how over the past two years the cash flow statement shows significant outflows of cash. Turning to the financial structure, the two ratios, total owing to total assets and the long term debt to capital employed reinforce what is obvious from the balance sheet, namely that there is no long term debt. The company is distinctly under geared compared with its competitors. Not knowing what the future holds, or what the present lending situation is like, one can probably still recommend that the company takes out a long term loan. This would improve the gearing, probably cost less than short term borrowing and reduce the risk of financial distress. Given the asset cover and the fact that the assets are recent acquisitions bankers would, in the light of the companys overall profitability, be more than willing to make a medium or long term loan to the company. c. To complete the analysis and interpretation this section was added to give the reader further insight into interpreting the accounts. Additional operating profitability ratios indicating how different types of costs have changed in proportion to turnover would have been useful. Note that gross profit had actually improved so perhaps the company has some internal strengths and some weaknesses, since return on sales had declined (i.e. could it be that production had become more efficient, but the administration and selling etc. had got less effective?). The increase in collection and inventory periods reinforces this point though the financial effects of this are lessened by the effects of increasing the creditor period. The shareholders will not be pleased, as return on equity and earnings per share declined, not something you wish to see when a company has just doubled its called up share capital. So even though the cash dividend cover hinted at insufficient funds to maintain the dividend level it was probably felt necessary in order to steady the share price. Notice how the introduction of the cash based ratios has provided much more meaningful information on interested dividend cover. The cash interest cover highlights the security lenders can feel over sufficient cash for the payment of interest. N.B. Note when answering these sorts of questions you may have to make some reasonable assumptions in order to make your interpretations. If so, state the assumptions. Do remember when you are asked to interpret, do not just describe a change or an event, try to give the actual, or a possible, reason for it.
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Financial planning introductory comments

This is a topic which tends to get a ponderous and generalised treatment in the textbooks. Do not be deceived, because for corporate managers it is very important. Businesses which do not undertake financial planning and control more often than not end up in liquidation, with serious consequences for those connected with the business. Financial planning is necessary because of the interaction between corporate investment and financing decisions. These decisions should not be undertaken independently and, if done correctly, provide an end result where the sum is greater than the parts. Financial planning helps avoid the nasty surprises, helps to prepare managers and the businesses to deal with those awkward occurrences that can, and do, occur so that the outcome is more favourable for the business, causes managers to think ahead and not just act on a day to day basis or even on a simple reaction basis only (e.g. contingency plans made to cover the possibility of the government introducing a new sales tax, or a competitor introducing a new product). Financial planning helps ensure a more measured response to events and provide motivation for managers through the establishment of agreed goals. Therefore it is important to learn why it is necessary to plan and how to do it.
Financial planning process

You should learn the six key elements of financial planning which are the setting of financial goals, forecasting, the analysis, evaluation and selection of possible strategies and finally the comparison of subsequent performance with the original plan. There should be added to this list the elements that complete the planning and control cycle, namely the investigation of the deviations from plan, the review of the reasons for the deviations which are then used as bases for appropriate amendments to a revised plan. Planning for the short term will be dealt with in the next chapter. Here the emphasis is on long term which means probably looking up to 10 years ahead, with the amount of detail diminishing over time. It is important to know the detailed requirements and possible approaches for each phase of the planning and control processes. Bear in mind, when learning and applying these points, that in a practical scenario, the strategic and operating implications of the plans are very important.
Technical aspects of financial planning

The setting of the objectives of a business will include financial objectives such as growth rates in earning per share, sales, or absolute values for profits or sales, or rates of return on investment etc. Learn the types of ratios that can be used as either long or short term objectives. Ratios will and should be used additionally to help prepare the financial plan by acting as the structural links between items in the plan (e.g. using an agreed return on sales to arrive at a projected profit given a predicted sales outcome); the level of debtors and stock can be predicted by using debtor days or inventory period with the predicted level of sales and purchases. Learn how to build simple models using equations comprising these ratios. Learn how to consider the financing and the investment aspects of the future which are to be combined together in the plan and link those financing or investment requirements in with the short term aspects.
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Learn the ways in which the planning process can be supported by the use of a financial model, whether one uses a simple approach to review a series of options (much easier these days thanks to the advent of spread sheets), or one attempts to use an optimisation model based on some form of linear or integer programming. Whichever form the model takes it will require exogenous and endogenous inputs. The former can be bought in sometimes from a consultancy, the latter developed in house.
Planning outputs
Learn the three major groups of outputs: the forecast statements of profit flows, cash flows and balance sheets, the strategic investment and financing plans. In the strategic investment plan the investments to be undertaken will be broken down by category replacement, expansion, new products, etc. The further into the future the more likely the project is to be as yet unsanctioned and just a sum of money earmarked for a particular subgroup of investments. A similar approach should have been used in preparing the financing plan. Naturally the detailed short term plans (budgets) will dovetail into the long term ones, with the long term ones being updated at least annually. Review question Plantree plc prepares long term financial plans. In order to achieve its long-term financial objectives the planning team will be faced with decisions on investment policy, financing policy and dividend policy. Required: 1. Comment on the nature of these three types of decisions. 2. Comment on the interrelationship of these three types and how they will be affected by the choice of the long term financial objective(s) of the business. 3. Describe briefly some of the main examples of forecast information needed for each type of decision. Solution to review question 1. a. Investment policy decisions This type of decision requires an understanding of the corporate strategy as to how the funds should be apportioned between the strategic groupings replacement needs, new product investments, expansion investments etc. The levels of required return from the investments and their risk levels must be considered. The potentially different cash flow patterns of returns from existing and new investments may need assessment; similarly what effects will the withdrawal or sell off of a major investment produce. b. Financing decisions The amount and type of funds required will be dependent not only upon the selection of investments made, but also the financial market place conditions and availability, combined with the present situation of the business. Possible types of finance will include new equity, retained earning, loans, leasing and sales of assets. The different costs of funds and their characteristics will also be of relevance here in the selection. c. Dividend decisions Whether or not to pay, if so how much, when and how are all very important and relevant decisions here since they reflect the returns to the shareholders, the owners of the business. They also provide the market place with information on one of its major decision criteria.
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2. Interrelations The three types of decisions are interrelated. People making decisions whether to invest require the opportunity cost of funds for final evaluation, they also need to know the availability of funds. In reality, these are not always available precisely when investors want them. The amount of dividend paid per share, the size of the earnings per share and the annual growth rate of these variables along with the size of profit and its return on investment will influence the availability and cost of funds. Thus one can see some of the interrelationships amongst the three decision types. Likewise, theory would suggest businesses should be aiming to maximise share price, while practice might add some other objectives like profit, profit growth, sales, market share, earnings per share, dividend per share etc. Whatever a businesss objective(s), whether it be one or all of those listed, it will influence the plan. For example, profit growth and thus dividend payment may be targeted at the expense of cash flow in order to influence equity market perceptions if the finance plan requires a share issue as the next major source of long term capital. Increasing dividend payout may, in the shorter term, reduce availability of funds perhaps restraining or deferring new investment. 3. a. Main forecast needs of investment decisions will include: predictions of cash flows, their timings and the influence of inflation the degree of variability in the cashflow estimates the opportunity cost of capital to be used that is appropriate for the business risk of the project the impact on the accounting profit profile the interactions (if any) with existing or new projects. b. For financing decisions the main forecast needs are: predictions of funds available and type of source equity, debt, etc. the trend of costs of funds increasing costs of loans or equity market perceptions of gearing, present corporate position vis--vis target gearing level, share price, risk classification for loans cost of raising different forms of capital. c. For dividend decisions the business needs predictions on: the level of profits available for distribution over the planning period the markets expectations of the business the expectations of the payout behaviour of competing businesses internal sources should provide estimates of the needs for retained profits along with the cashflow predictions of the business.

By the end of this chapter, and having completed the Essential reading and activities, you should be able to: compute appropriate financial ratios to enable a set of accounts to be interpreted satisfactorily interpret part or all of a set of financial reports describe and evaluate the means and the limitations of ratio analysis describe and discuss the requirements for strategic financial planning construct a simple financial plan or model.
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Practise questions
1. Describe the general uses of ratio analysis and discuss the limitations of the results obtainable. 2. Describe some of the practical applications where ratio analysis has been used and comment on the effectiveness of such applications. 3. The speed of change increases over time, making financial planning of little value. Describe and discuss what you understand by the term financial planning. Incorporate comments on the quotation into your overall discussion. See VLE for solution
Problems
Answer the following problems in BMM: Chapter 17, number 1, 14 and 18; Chapter 18, numbers 2 and 12. Answer the following problems in BMA: pp.81014, numbers 1, 5, 6, 12 and 24.
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Notes
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Chapter 9: Short-term finance and asset management

Aims of the chapter
This is quite a lengthy topic area as can be seen by the number of chapters listed below; however you are not required to learn the detail in the text on cash and inventory models or the management processes described. Rather you need to know the main outlines and characteristics of the sources and the processes of managing the current assets. You also need to know the basic evaluation techniques for choice between sources. This chapter starts by making the links between long and short-term financing and moves on to reviewing the features of various short-term sources. A problem is then provided to give an example of how and what to do in the choice between different forms of finance, some of which are long and some short. The second part of the chapter considers the management of working capital, the establishment of optimal levels of inventory, debtors and cash and then some techniques for managing those items.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and activities, you should be able to: explain the rationales supporting the financing mix of short and long term funds for an entity describe the major short-term sources of funds, their characteristics, costs and the providers requirements evaluate different possible short-term sources to meet the corporate needs discuss how to manage the major current assets including the knowledge of the basic models used in attempting to optimise their levels make a strategic assessment of the effects of the uses of changes in current asset levels.
Essential reading
Brealey, R.A., S.C. Myers and A.J. Marcus Fundamentals of Corporate Finance. (McGraw-Hill Inc, 2007) Chapters 19 and 20.
Further reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (McGrawHill, 2008) Chapters 30 and 31. Atrill, P Financial Management for Decision makers. (FT Prentice Hall Europe, . 2005) Chapter 10.
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Long- versus short-term finance

The mix of finance used to acquire the total assets of a firm is a very company specific and time specific selection. BMM go through the rationale behind the matching of maturities of assets and liabilities. Since a firms asset base grows irregularly over time one would expect the mix also to vary. Generally, though, firms will attempt to choose whether they will be conservative and predominantly financed by long-term sources or more aggressive and have a much higher proportion funded with shortterm sources. The level of financial distress will be greater the higher the proportion of short terns funds, since of necessity they will be interest bearing and not equity. However, they can be repaid more easily and quickly. No period of notice or penalty would normally be attached to repayment which can be done to best advantage.
Trade credit
This is an extremely important source of finance for small businesses in particular. It can be described as a spontaneous source of finance as it results from normal business operations (i.e. increases in sales lead, in turn, to increases in purchases on credit from suppliers). Trade credit can be a free source of finance to a business providing the goodwill of the trade supplier is maintained and providing discounts for prompt payment are taken. Failure to maintain supplier goodwill, however, can lead to a reduced level of service in the future and failure to take advantage of discounts can have a high implicit annual interest cost. Suppose trade suppliers offer a 2% discount for invoices paid within seven days and, if payment is not made within seven days, the payment period for invoices is 28 days (with no discount being allowed). The implicit annual interest cost of a business paying at the end of 28 days rather than at the end of seven days is:
We can see that the cost of foregoing discounts can be very high and, therefore, other forms of short-term finance may prove to be cheaper. You should note in particular when reading the relevant sections on trade credit, the four factors which determine the length of the credit period given to customers.
Debt factoring
When reading the relevant sections on debt factoring note the services offered by a factor and the fee structure employed. You must be clear about the distinction between debt factoring and invoice discounting. Debt factoring is often a long-term arrangement because of the administrative arrangements required to deal with the transfer of the sales ledger accounting function. Invoice discounting, on the other hand, may be a temporary arrangement. Factoring can prove to be expensive and so it is important to identify the relevant costs and benefits before entering into such an arrangement. Study the worked example below.
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Worked example 9 Aztec Electronics Ltd has an annual turnover of 25 million of which 0.2 million prove to be bad debts. Credit controls within the business have been weak in recent years and the average settlement period for its trade debtors is currently 70 days. All sales are on credit and turnover has been stable in recent years. The business has been approached by a debt factoring business which has offered to provide an advance equivalent to 80% of its debtors (based on an average settlement period of 30 days) at an annual interest charge of 14%. The factor will take responsibility for the collection of credit sales and will charge a fee of 2.5% of sales turnover for this service. The use of a factoring service is expected to lead to cost savings in credit administration of 120,000 per annum and will reduce bad debts by half. The settlement period for debtors will be reduced to an average of 30 days which is in line with the industry norm. The business currently has an overdraft of 6.2 million and pays interest at the annual rate of 15%. Required: Calculate the net annual cost or savings resulting from a decision to employ the services of the factor. Solution to Worked example 9 000 Existing investment in trade debtors {(70/365)25m} Expected future investment in trade debtors {(30/365)25m Reduced in investment Factor costs 2.5% of sales turnover Interest charge on advance {(2,055,000 80%)14%} 625 230 855 Factor savings Bad debt savings (0.2m 0.5) Credit admin savings Reduction in trade debtors (2,740,000 15%) Reduction in overdraft interest through advance {(2,055,000 80%)15%} Net annual savings 100 120 411 247 878 23 000 4,795 2,055 2,740
We can see that, in this case, the employment of a factor will lead to net savings for the business.
Bank borrowing
You should note the kind of loans that the clearing banks and merchant banks are prepared to make. When making a decision concerning a business loan application, a bank will take a number of factors into account. These include: the quality and integrity of the management of the business the quality of the case made in support of the loan application the period of the loan and the security being offered the nature of the industry in which the business operates the financial position and performance of the business.
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Specialist finance
There are numerous short and medium term sources available which are only provided with a specific end in view. For example there are a number of ways of getting money to support exports, or finance for specific projects, or the more general hire purchase. General knowledge of their existence is all that is required.
Leasing
When reading these sections you should note carefully the distinction between an operating and a finance lease and the reasons put forward to explain the growth of this form of financing in recent years. In addition, you should study carefully the techniques of lease evaluation. Sale and lease back arrangements offer an opportunity for a business with valuable property to raise new finance. You should compare the advantages and disadvantages of this form of financing with that of a mortgage.
Evaluation of sources of finance

When considering an appropriate form of finance for a particular business, internal sources of finance as well as external sources of finance should be considered. Consider the worked example below: Worked example 10 L C Conday Ltd is a family owned business which operates as a wholesaler of garden products. During recent months its trade creditors have been pressing for more prompt payment of amounts owing. In order to deal with this problem, the directors of the business have agreed to reduce the level of trade creditors by keeping to an average settlement period for creditors of 30 days. To finance this policy, the directors intend to ask the bank to increase the businesss overdraft by the necessary amount. The current annual interest charge on the overdraft is 14%. This is considered the opportunity cost for short-term funds. The profit and loss account and balance sheet of the business for the year ended 31 July 2008 is as follows: Profit and loss account for the year ended 31 July 2008. m Sales Cost of sales Opening stock Purchases Closing stock Gross profit Administration expenses Selling and distribution expenses Finance charges Net profit before taxation Corporation tax Net profit after taxation Dividend payable Retained profit for the year
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m 29.4
6.7 16.5 23.2 7.9 6.3 4.4 2.8 13.5 0.6 0.2 0.4 0.2 0.2 15.3 14.1
Balance sheet as at 31 July 2008 m Fixed assets Freehold land and buildings Fixtures and fittings Motor vans Current assets Stock Trade debtors Less: creditors amounts falling due within one year Trade creditors Dividend payable Bank overdraft Creditors amounts falling due beyond one year 10% debentures (secured on freehold) Capital and reserves 0.50 ordinary shares Retained profit 3.0 4.6 7.6 Notes 1. 2. 3. All sales and purchases are on credit. Freehold land and buildings are shown at valuation and the other fixed assets are shown at their net book value. No dividends have been announced in the preceding four years. 7.8 7.6 3.9 0.2 8.1 12.2 3.2 15.4 7.9 7.5 15.4 9.2 1.6 1.4 12.2 m m
The profit for the year to 31 July 2009 is expected to be similar to that for the year to 31 July 2008. Required: a. Calculate the amount of finance required to reduce the level of creditors in line with the proposed policy b. State what you believe the reaction of the bank would be to an approach to finance the proposed policy. c. Evaluate four other methods of financing the proposed policy and state, with reasons and supporting calculations, which you consider to be the most suitable.
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Solution to Worked example 10 a) m Trade creditors at balance sheet date Trade creditors representing 30 days outstanding (16.5m 30/365) Finance required 3.9 1.4 2.5
b) The bank is unlikely to provide the necessary finance for the proposed policy. The effect of increasing the overdraft by the amount required will be to increase interest charges by 350,000 per annum. Unless the ability to pay more promptly results in discounts being received from suppliers, the effect will simply be to depress profits (from an already low base) by the amount of the additional interest charge. The interest cover is already low at 1.2 times (i.e. 3.4/2.8) and the effect of increasing the overdraft could be to push the interest cover below 1.0. The overdraft is already large in relation to other forms of finance employed by the business (including the equity capital) and it is not clear from the information provided how, or even if, it is secured. To increase the overdraft further will make the bank even more vulnerable to the risk of default. The finance will not be employed to generate further income for the business but simply used to repay other creditors. The overdraft will not therefore be self-liquidating indeed, it is not clear how the overdraft will be repaid. The bank is likely to feel that the equity shareholders should contribute more to the financing of the business. At present, it appears that the creditors are bearing a large amount of the risk associated with the business. c) Four possible sources are: Equity shares: lenders are likely to look to equity shareholders for reasons mentioned above the total owing to total asset ratio is currently 72.5% (20.0/27.6 100) which is very high; however, equity shareholders may see little investment potential in the business as the return to equity for the year is only 5.3% (0.4/7.6 100) and the dividends seem sporadic. As the purpose of the finance is not to generate profits the effect of a new share issue will simply be to reduce equity returns further; however, the survival of the business could be at stake and so investors may respond to additional calls for funds. We are informed that this is a family-owned business and this may raise issues concerning the amount of capital available and the prospect of dilution of control. Debentures/loans: this form of finance is not a strong possibility; the business is already highly geared and there is already a debenture issue which is secured on the freehold land. From the information available there does not appear to be any other attractive form of security for prospective lenders the interest cover ratio is low, as stated earlier, which will give cause for concern. Invoice discounting: this will enable the business to convert trade debts outstanding into cash; however, like debt factoring, it is a costly form of financing a business and is often viewed by outsiders as an indication of financial weakness a financial institution may expect the debt to be insured before considering an application.
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Reduce stocks/debtors: it may be that an internal source of funds offers the most suitable means of dealing with the financing problem at the balance sheet date stocks represented more than six months cost of sales (7.9 12/15.3 = 6.2) this seems very high indeed a reduction in stock levels by one third would release the necessary funds to pay the trade creditors. Where stock management is weak and inefficient it may be, however, that there are many items which are obsolete or slow moving; hence, it may not be very easy to
make the stock reductions required. At the balance sheet date trade debtors represented more than three months sales (7.5 12/29.4 = 3.1) which again seems to be very high a reduction in this level by one third would again be sufficient to finance the payment of trade creditors.
Management of short-term assets

Now we turn to the management of the assets matched with the shortterm finance, the management of a companys working capital. This is concerned with the establishment of optimum levels of investment in the current asset as well as the decisions concerning their finance. The chapters listed above in general give greater detail of the concepts and techniques employed in managing each element, cash, trade debtors and inventory, than the course requires. So ensure you understand the principles of the basic approaches along with the strengths and weaknesses of the models described.
The management of cash

Cash has been described as the lifeblood of a business. In order to survive a business must retain an uninterrupted capacity to pay its maturing obligations. The efficient management of cash is, therefore, of critical importance to a business. When reading the relevant chapters you should note the importance of controlling the cash collection and payments cycle and the cash transmission techniques available. Cash flow forecasts are a valuable tool in the management of cash. They can reveal to financial managers the effect of planned events on the liquidity of the business. In the event that a cash surplus is forecast, financial managers can plan for either its short-term or long-term reinvestment. Where a cash deficit is forecast, plans must be made for either the financing of the deficit or for changes in the timing of receipts or payments so as to avoid the forecast deficit. Note the general pattern of a cash cycle, the influence of investment funding, the timing of finance, the requirements of the different stages of the product life cycle; all these must be reflected in the cash flow projections. When preparing a cash flow statement it is important to consider the timing of cash receipts and payments and to avoid the inclusion of items which do not involve either inflows or outflows of cash. Cash management models are available which seek to minimise the cost of holding surplus cash balances and to maximise the returns from the re-investment of these funds. The management of the treasury function is dealt with in the next chapter and should be linked with the critical appraisal of the cash models such as Miller-Orr etc. These models, thanks to the variability in the cash flow patterns, have not been overly successful in their applications. Hence the need for other approaches to managing the riskiness of the flows.
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Activity 9.1 List the key concepts of the classical static model for cash and inventory. State the square root rule. For cash and inventory separately consider the elements in an uncertain world that will affect the static model and its usefulness. See VLE for solution
The management of trade debtors

The credit policy of a business has three major elements. These are: credit terms offered to customers this includes the credit period and discounts allowed to credit customers analysis of creditworthiness credit customers should be investigated to assess the risk of non-payment collection policy efficient procedures must be in place for the prompt collection of amounts owing. When reading the relevant chapters you should note carefully the ways in which each element can be managed. It is important to appreciate that changes in credit policy are likely to result in both benefits and costs for a business. Thus, if a business decided to insist on more prompt payment from debtors, this might produce improved cash flows and a reduction in bad debts. However, it might lead to additional credit collection costs and lost sales from customers. The decision rule to be applied when considering proposed changes is that they should be introduced only where it is expected that the marginal benefits will exceed the marginal costs. Learn the simple approach to a practical derivation of an optimal credit policy. A review problem is shown at the end of this book to which you can apply a critique and so use that as a base for criticisms of such models. Worked example 11 Pinewood Supplies Ltd produces a pine bookcase which is sold to retailers throughout Scotland. The accountant of Pinewood Supplies Ltd has provided the following information concerning the product: Selling price Variable costs Fixed cost apportioned Net profit 42 6 48 22 70
The annual turnover of the business is currently 1.4m and it is believed that this can be increased in the forthcoming year by increasing the time given for trade debtors to pay. All sales are on credit and the average collection period for the business is 40 days. The business is considering an increase in the average collection period by 15 days, 30 days or 45 days. The effect on sales from adopting each option is as follows: Option 1 Increase in average collection period (days) Expected increase in sales (,000) 15 120 2 30 150 3 45 325
The cost of capital to Pinewood Supplies is 12% per annum.

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Required: Explain, with supporting calculations, which credit policy option should be offered to customers. Solution to Worked example 11 The profitability of each option can be determined by weighing the costs of the additional investment in debtors against the benefits from the expected sales. Contribution per unit Selling price Less Variable cost Contribution per bookcase Rate of contribution 28/70 = 40% Option 1 Projected sales (m) Projected debtor period (days) (40 + 15) Projected debtors 1.52m 55/365 1.55m 70/365 1.725m 85/365 Less: Current debtors 1.4m 40/365 Increase projected Cost of additional investment in debtors (12% increase) Increase in contribution (40% sales increase) Increase in profits 48,000 38,926 60,000 42,740 130,000 100,206 (9,074) (17,260) (29,794) 153,425 75,616 153,425 143,835 153,425 248,287 229,041 297,260 401,712 1.52 55 2 1.55 70 3 1.725 85 70 42 28
The calculations shown above indicate that extending the credit limit by 45 days provides the most profitable option. The expected profit of 100,206 is considerably higher than the other two options. The choice of options based on these figures is, therefore, unlikely to be very sensitive to any inaccuracies in the underlying assumptions and estimates.
The management of stock-in-trade

A number of techniques and procedures may be used when seeking to manage the stock-in-trade of a business. These include: Producing sales forecasts stocks are held in order to meet future requirements; hence, it is important to try and establish what the future requirements are likely to be. Producing reliable sales forecasts will provide a basis for ordering and drawing up production schedules aid will help in identifying the optimum level of stocks to be held. Financial ratios the stock turnover ratio, which has been dealt with in your previous studies, can provide an insight into the speed with which stocks are moving through the business. This ratio can be applied to each line of stock for control purposes.
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Stock re-order level the point at which stock is re-ordered will depend on the rate of demand during the period between ordering and receiving the stocks and the lead time. A safety (buffer) stock may be held in order to deal with the risk of stock-outs. Stock management models various decision models may be used to help determine the re-order points, and the optimum order quantity the major models are dealt with in the texts of BMM and PA the ABC classification system, also mentioned, can help management ensure the costs of exercising control are commensurate with the expected benefits. Stock checks the business should undertake physical stock checks to ensure the stock levels are consistent with the recorded levels the existence of slow-moving and obsolete stocks may be detected where stock checks are made on a regular basis. Clear authorisation procedures authority for the purchase of stocks should be confined to a few key personnel within the businesses and the ordering process should be clearly set out failure to do so may result in duplication of orders, the loss of bulk discounts, etc. The relevant readings in BMM and PA on this topic provide a good coverage of the stock management models available and should be studied carefully. Note also the just-in-time (JIT) approach to stock management, which has attracted considerable interest in recent years.
Working capital and the problem of overtrading

Overtrading will arise where the level of working capital and fixed assets employed by a business is insufficient for its level of operations. Overtrading often occurs when a new business expands its trading operations quickly but is unable to find the necessary finance to invest in fixed assets and working capital. The consequences of overtrading are liquidity problems and difficulties in supplying customers (through an inability to purchase the unnecessary stock). At the extreme, a business may be forced to cease trading because it lacks the cash to meet maturing obligations. Financial ratios may help detect the symptoms of overtrading. The financial statements of a business which is overtrading may reveal low liquidity ratios, high asset/sales ratios and a poor average creditors payment period. Overtrading is a reflection of weak financial management. It may arise through such factors as poor forecasting of profits and cash flows, failure to control costs or a failure to attract finance at the appropriate times. To deal with the problem of overtrading it is necessary to bring the level of operational activity into line with the level of finance available (even if this does lead to the rejection of profitable opportunities in the short-term). Careful monitoring and control of fixed asset utilisation and working capital is essential. Revision question Danton Ltd began trading recently on 1 April 2008 with a balance at the bank of 300,000. The business is both a wholesaler and retailer of carpets and floor coverings. During the first month of trading the business will make payments for fixtures and fittings of 15,000 and 8,000 for motor vehicles. In addition, the business will acquire an initial stock on credit costing 24,000. The business has agreed with its bank an overdraft facility of 20,000 to cover the first year of trading.
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Danton Ltd has provided the following estimates: i) The gross profit percentage on all goods sold will be 25%. ii) Sales during April are expected to be 10,000 and to increase at the rate of 4,000 per month until the end of July. From August onwards, sales are likely to remain at a stable level of 24,000 per month. iii) The business is concerned that supplies will be difficult to obtain later in the year and so, during the first six months of the year, it intends to increase the initial stock level of 24,000 by purchasing an additional 2,000 worth of stock each month in addition to the monthly purchases required to satisfy monthly sales. All stock purchases, including the initial stock, will be on one months credit. iv) 60% of sales are expected to be on credit with the remainder being for cash. Credit sales will be paid two months after the sale has been made. v) Administration expenses are likely to be 1,000 per month and selling and distribution expenses will be 700 per month. Included in the administration expenses is a charge of 200 per month for depreciation and included in selling and distribution expenses is a charge for 300 per month depreciation. Administration expenses and selling and distribution expenses are payable in the month incurred. vi) The business intends to buy more fixtures and fittings in June for 8,000 cash. vii) The initial bank balance arose from the issue of 60,000 ordinary shares payable in instalments. The second instalment of 0.50 per share is payable in September 2008. Required: a. Prepare a cash flow forecast for the six months ended 30 September 2008 showing the cash balance at the end of each month. b. State what problems the business is likely to face in the forthcoming six months and how might these be dealt with? Solution to revision question a) Cash flow forecast for the six months to 30 September 2008 Apr 000 Receipts Share issue Credit sales Cash sales Payments Fixtures Motor vehicles Initial stock Purchases Admin expenses Selling expenses Cash surplus /(deficit) Opening balance Closing balance 0.8 0.4 24.2 (20.2) 30.0 9.8 15.0 8.0 24.0 9.5 0.8 0.4 34.7 (29.1) 9.8 (19.3) 12.5 0.8 0.4 21.7 (8.5) (19.3) (27.8) 15.5 0.8 0.4 16.7 0.5 (27.8) (27.3) 18.5 0.8 0.4 19.7 0.7 (27.3) (26.6) 20.0 0.8 0.4 21.2 31.6 (26.6) 5.0 8.0 4.0 4.0 5.6 5.6 6.0 7.2 13.2 8.4 8.8 17.2 10.8 9.6 20.4 30.0 13.2 9.6 52.8 May 000 June 000 July 000 Aug 000 Sep 000
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Notes: 1. Purchases represent 75% of the sales for the relevant month plus an extra 2,000 for stockbuilding. 2. Depreciation is a non-cash item and therefore is excluded from the relevant expense figures. b) The cash flow forecast above reveals that the agreed overdraft limit of 20,000 will be exceeded in three consecutive months. However, the proceeds of the second instalment of the share issue will bring the business into cash surplus by the end of the six month period under review. It may, therefore, be possible to negotiate an increase in the overdraft limit to deal with this short term problem. If this is not possible the business must consider other options. For example, it may be possible to defer the purchase of the fixtures and fittings in June until a later date. (It is this purchase which pushes the business over its overdraft limit.) However, if this is not possible, then the business might consider other options such as the deferring of payments to trade suppliers, reducing the credit period to customers, and reducing the level of credit sales. These options, however, may involve some cost to the business. Though this problem and its solution are relatively straightforward they nevertheless encompass a number of important ideas and concepts, which must be understood both from the practical viewpoint and as a basis for the chapters that follow on treasury management and currency management.

By the end of this chapter and having completed the essential reading and activities, you should be able to: explain the rationales supporting the financing mix of short and long term funds for an entity describe the major short-term sources of funds, their characteristics, costs and the providers requirements evaluate different possible short-term sources to meet the corporate needs discuss how to manage the major current assets including the knowledge of the basic models used in attempting to optimise their levels make a strategic assessment of the effects of the uses of changes in current asset levels.
Practise questions
1. Consider the advantages and disadvantages of funding all of a companys current assets from bank advances or other short-term sources. 2. How might a firm go about determining its target cash balance? Evaluate the model(s) you have recommended. 3. Consider the derivation and implementation of an optimal trade credit policy. Discuss. See VLE for solution
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Problems
Attempt the following problems in BMM: Chapter 19, numbers 6 and 7; Chapter 20, numbers 12 and 15. Attempt the following problems in BMA: pp.84647, numbers 11 and 19; p.875, numbers 3 and 4.
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Notes
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Chapter 10: Treasury management and international aspects of financial management

Aims of the chapter
There is an ongoing expansion of overseas trade by companies which means that they need to keep abreast of the changing international foreign exchange markets. Thus this chapter describes various forms of financial derivatives such as options which companies can use to help manage their foreign exchange exposure. The chapter starts with describing types of options and their valuations and then moves on to their use in hedging against foreign currency risk. Other methods of hedging such as futures and forward contracts are described and then incorporated into examples showing how the currency risk is minimised. There is a section on the interrelationships between the variables that affect currency exchange rates in the marketplace. The three types of currency exposure, translation, transaction and economic are explained.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and activities, you should be able to: discuss what derivatives are and how they work describe the types of options and also the factors which affect them explain the theory underpinning basic option valuation explain the application of option pricing theory to corporate finance explain why financial managers are concerned with international financial management describe the basic definitions associated with foreign exchange transfers explain the various theories that underpin the activities in the foreign currency markets explain how financial managers can manage the three major types of currency exposure.
Essential reading
Brealey, R.A., S.C. Myers and A.J. Marcus Fundamentals of Corporate Finance. (McGraw-Hill Inc, 2007) Chapters 22, 23 and 24.
Further reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (McGrawHill, 2008) Chapters 27 and 28.
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Introduction
In this chapter we provide an introduction to both the basic instruments of treasury management and how companies manage foreign exchange risk. At first glance, this chapter may seem very long and daunting, but you are asked, first to attempt the section on options and basic treasury management techniques and, secondly, to proceed to aspects of international financial management. The aim of this chapter is to provide you with a basic appreciation of option valuation; and not to turn you into Wall Street option specialists overnight. Keep in mind that Chapter 23 in BMM only provides an introduction to options whereas Chapter 24 in BMM broadly covers risk management techniques in particular, hedging.
Why should financial managers of firms be concerned with options and other financial instruments?
The opportunity to buy or sell an asset in the future can be expressed using options whereby the opportunity to buy an asset known as a call option and to sell a put option. The price at which the purchase of the option is made is known as the exercise price and as to the date of exercise this can be a specific date such as 25th March, 20X7, as in the case of European options or they may be exercised any time up to and including the exercise date, an American option. First, most capital budgeting projects will have options embedded in them; as these options will allow the company to profit if things go well but also provide downside protection should profits go down. Downside risk is associated with the probability of failure for a business. Second, many of the securities that firms issue will include an option. For example, many companies issue convertible bonds whereby the buyer has the option to exchange the bond for ordinary shares at a certain date in the future. Third, financial managers will invariably use currency, commodity and interest-rate options to protect the firm against a variety of risks and therefore provide the firm with a degree of flexibility (such as unpredictable changes in raw material costs, tax rates, technology, etc.) The purpose of this chapter is to provide an introduction into how companies provide flexibility in managing risk by using options and how they use other financial instruments to offset risk a process commonly referred to as hedging.
Calls and puts

Call option gives you the right to purchase an asset at a fixed exercise price on or before the exercise date. For instance, you would need to pay 5 for an option to buy British Airways shares (call option) in January 2008 at 40 (exercise price) any time until the exercise date which is December 2008. In all instances the movements in the price of the option (between January and December) will reflect movements in the share price of the company. Therefore, if the share price for British Airways shares was greater than 40 in December, then you would want to exercise your right to purchase the share at the 40; as the market price exceeds the price that you must pay to buy the share. On the other hand, if the share price is below 40 then you would not exercise the right to purchase the option and you would only lose 5 (the value you paid for the option in January).
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Share price as option expires: i. exceeds exercise price ii. less than exercise price
Value of call option on expiration: share price minus exercise price zero as option is NOT exercised
Put option gives you the right to sell an asset (which you may not necessarily own) at a fixed exercise price on or before the exercise date. For instance, you would need to pay 3 for an option to sell British Airways shares at 40 (exercise price) any time until the exercise date which is December 2008. Therefore, if the share price for British Airways shares exceeded 40 in December, then you would not want to exercise your put option as you would need to purchase the share at a price greater then 40 and then have to sell at 40, incurring an overall loss; in passing you would only lose 3 for the original price of the option. However, should the price of British Airways shares be below the exercise price of 40 then you would want to purchase the shares at a price below 40, and then get a guaranteed price of 40 thus making a gain between the current share price and the exercise price. Share price as option expires: i. exceeds exercise price ii. less than exercise price Value of put option on expiration: zero as option is NOT exercised exercise price minus share price
Selling calls and puts

If you decided to sell the December 2008 call on British Airways shares, the buyer would pay you 5. However, in return you must promise to sell British Airways shares at a price of 40 if the call buyer decides to exercise his option. The option sellers obligation to sell British Airways is just the opposite to the option holders right to buy the shares. If the share price is below the exercise price of 40 when the option expires in December 2008, holders of the call will not exercise their option and you the seller will have no further liability. On the other hand, if the price of British Airways shares is greater than 40, the option will be exercised and you will have to give up the shares for 40 each. You will therefore lose the difference between the share price and the 40 that you receive from the buyer. The general rule is that the sellers loss is the buyers gain.
The rights and the obligations of buyers and sellers of calls and puts
These are as follows: Buyer Call option Put option right to buy asset right to sell asset Seller obliged to sell asset obliged to buy asset
What the value of a call option depends upon

To exercise the option the holder must pay the exercise price. Therefore, with other factors remaining constant, the less you are obliged to pay the more you are likely to gain. Therefore, the value of the option will be lower when the exercise price is high relative to the share price. Investors who purchase shares by the way of a call option are purchasing on instalment credit. They pay the purchase price of the option today but delay payment of the exercise price until the option is exercised. The higher the rate of interest and longer the period to the expiration date, the higher this free credit will be worth.
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The owner of a call option cannot lose more than the price of the call irrespective of how far the share price falls. On the other hand, if the share price rose above the exercise price, the holder of a call would benefit when the option is exercised. Thus, the option holder in reality should not lose the total amount as a result of increased variability (share price volatility) if things were to go wrong; on the other hand the option holder would gain if things were to go right. Obviously, the value of the option increases with (a) the variability of share returns and (b) the longer the period to the final exercise date, as this will provide a greater opportunity for the share price to be volatile. In summary, what the price of a call option depends upon: If the following indicators increase The value of thecall option will Exercise price Share price Time to expiration Share private volatility Interest rate Activity 10.1 Why should financial managers be concerned with using options? What does the value of a call option depend upon? See VLE for solution Drop Rise Rise Rise Rise
Option valuation model

The Basic approach to option valuation relies on finding a balance between a combination of borrowing and investment in a particular share that mimics the option. Worked example 12 Suppose it is January and you are contemplating the purchase of a call option on British Steel shares. The call has a December exercise date and exercise price of 40. The current market value of a British Steel share is 30; thus the option will be valueless unless the share price rises by 10 over the 12-month period. The outlook for British Steels share price is uncertain and all you know is that at the end of the year, the price will be either 10 or 70. Finally, the rate of interest on a bank loan is 10 per cent a year. You are required to calculate the value of a British Steel call. Here are the cash flow projections for the alternatives which are currently available: Here are the cash flow projections for the alternatives which are currently available: British Steel shares Jan Outcome 1 Investment Outcome 2 30 70 Dec 10 ? 30 Call option Jan Dec 0 100 110 Bank loan Jan Dec 110
Note: when the call expires in December, the option will be valueless if the share price falls to 10 and it will be worth 70 40 = 30, if the price rises to 70.
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Now consider the two investment strategies that are available: Strategy I Strategy II 9.09 buy 2 call options (adopt a strategy to profit from volatility). buy 1 British Steel share and then borrow the present value of 10 is Cash flow in Jan Strategy I Buy 2 calls Strategy II 1 British steel share Borrow PV (10) 30 +9.09 20.91 +10 10 0 +70 10 +60 ? Payoff in Dec if share price is equal to 10 +0 70 +60
You will notice that, irrespective of whether the share price falls to 10 or rises to 70, the payoffs from Strategy I and Strategy II are identical. Therefore, to calculate the value of the call you can replicate a call by combining a bank loan and an investment in the same share. If the two investments give the same payoffs in all circumstances, then their value must be the same today. In other words, 2 call options = 309.09 = 20.91 thus the price of 1 call = (309.09)/2 = 10.46. The two strategies require a computation of the number of shares per call option to ensure equality between the strategies. The formula for the number of shares per call option is: Spread of possible share prices Spread of possible options prices = 70 10 = 60 = 2 30 0 30
Therefore 2 shares need to be bought to replicate one call option. Black and Scholes (1973) came up with a similar formula which showed that you could price calls by replicating the investment in the call by performing a series of investments in shares and partly funded by borrowing. Chapters 22 and 23 in BMA illustrate advanced calculations of option values using put-call parity, binomial and Black Scholes option valuation models. This level is not required here.
Using options to allow the expansion or abandonment of real assets

You have seen the need to allow for flexibility in investment projects in Chapter 4 of this guide; in this section we extend our current understanding of allowing for flexibility with the aid of options. For example, many capital investment projects on real assets provide flexibility to expand capacity should it be found that demand turns out to be more buoyant than expected. These projects are in fact, providing the firm with a call option (for the future) on getting additional capacity. In contrast, firms may also consider the position concerning the alternative uses for their assets, for instance, if the firm suddenly realised that demand was not as high as they had anticipated. This would in theory be the complete opposite to the option to expand which utilised a call option and therefore would make use of a put option (to abandon in the future). Therefore, the put options exercise price would be the value of the projects assets if shifted to an alternative use.
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Options on financial assets

When companies issue securities, they often include an option in the package. Here are a few examples of the options that are associated with new financing: Warrants allow the right to buy shares in a company at a stipulated price on a set date(s) (long-term call option). Convertible bonds are bonds that the holder may exchange for a specified number of shares (give the investor the option to buy the firms shares in exchange for the underlying bond). Callable bonds are bonds that may be repurchased by the firm before the maturity date at a specified call price (gives an option to the firm to buy the bond back at a specified price, should interest rates decline and the value of the bond rise).
Why do companies hedge?

Most companies hedge (using treasury management techniques) to reduce risk rather than make money. By reducing the risk of a project the financial planning of it becomes easier and therefore the likelihood of an embarrassing short-fall is also reduced (in extreme cases the short-fall could even trigger off bankruptcy). Hedging is also a technique which may be able to help the directors of a firm assess the performance of their top management; for instance, if a firms profits grew by 30% the directors can decide how much the increase is due to a shift in the exchange rate and how much it is due to good managerial decision-making. Finally, hedging certain likely events such as foreign exchange movements by companies which import or export goods reduces the currency exposure risks these companies are open to. Dramatic changes in interest rates, exchange rates and commodity prices can make planning difficult for financial managers. They can adopt the use of a number of specialised financial instruments known as derivative instruments (derivatives) which allow them the opportunity to manage these risks. As already discussed, options are often used by firms to limit their downside risk. Other derivatives include futures contracts, forward contracts and swaps which have been regarded as some of the great success stories in finance.
Futures contracts
These are agreements made today to purchase or sell an asset in the future. The price is usually fixed today, but the final payment for the asset does not occur until the delivery date. Futures contracts tend to come in a standardised format and tend to be traded on formal exchanges. In essence there are two broad types of futures: financial futures to help firms to defend themselves from unseen movements in interest rates, exchange rates and share prices commodity futures to allow companies to fix the future price that they pay for a wide variety of agricultural commodities, metals and oil.
Forward contracts
These are usually bespoke (specially made) futures contracts. They are essentially agreements to buy or sell an asset in the future at an agreed price
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Activity 10.2 Describe in what circumstances are companies likely to hedge: illustrate your answer with an explanation of two derivative instruments. See VLE for solution
International financial management

Introduction
When a business goes international it adds many new dimensions to the analysis and actions undertaken by its financial managers, compared with the environment faced by them solely operating in the domestic market place. It is to these new dimensions that you need to address yourself. Unfortunately, there is only a brief outline in the BMM textbook on this subject but more can be found in Chapters 27 and 28 in BMA. However, you will be required to know the basic definitions associated with foreign exchange transfers, exchange risk exposure and management of foreign exchange exposure.
Foreign exchange market

It is always worthwhile to learn not only the terminology associated with this topic but also the mechanics of the foreign exchange markets before learning the theories and some of the primary management techniques of dealing with currency risk. The foreign exchange market enables the transfer of purchasing power denominated in one currency into another currency by providing a market place and acting as an intermediary. The market clearing price, which balances demand and supply for a currency today is called the spot rate, and for a future date is called the forward rate. Each of the quotes (examples of which are found in the respective chapters of BMM and BMA) are in pairs bid and ask. The difference between the bid and the ask is called the spread, the extent of which is influenced by the level of risk, the volume of deals and the type of the market. Rates per 1 (Sterling) Bid F Francs HK $ 8.28 12.77 Ask 8.30 12.80 Spread 0.02 0.03
Thus HK$12.77 or Euros 1.28 is the amount the bank will give you for 1, whilst it would ask $12.80 or Euros 1.30 before giving you (i.e. selling you) 1. The forward rate incorporates the markets expectation of the future movement in the currency, so if the value of 1 is expected to fall over the month then the HK$ will be trading at a small forward premium to the spot rates since it takes less HK$ to acquire 1. Trading at a discount means the points would be added to the spot to get the forward rates because the 1 is expected to appreciate. In the example HK$ is trading forward at a premium as sterling is expected to weaken.
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Forward and spot rates per 1 for Hong Kong $

Bid Spot rate ($) Points Forward rate (30 days) ($) 12.77 (0.23) 12.54 Ask 12.80 (0.20) 12.60 Spread 0.03 (0.03) 0.06
Remember that the concepts of market efficiency and arbitrage are also applicable here in the international foreign exchange market as they were in the capital market.
Interrelationships between variable affecting exchange rates

Learn the five basic interrelationships that affect the exchange rate between two currencies. Bear in mind the objective of maintaining as efficient a market as possible, on the one hand and the desire for traders to profit through arbitrage which, if the market is operating effectively, will enhance efficiency. If this happens the relationships, shown below, will move closer and closer to the equilibrium positions presented here. But, by the same token, if there are some inefficiencies, then the traders will be looking to test the relationships in order to generate trading profits.
Figure 10.1 Interrelationships between variables affecting exchange rates Figure 10.1 attempts to show the theoretical links between differences in interest rates in different countries (A&B), differences in inflation rates and the resultant expected parity with differences between the present spot rates, and the market forward rate and the expected spot rate which should be identical. If they are different then the traders should buy or sell appropriately until equilibrium is achieved.
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Worked example 13 The following exchange, lending and borrowing rates were quoted on 30 March for the US$, sterling in the USA and UK. Bid Spot ($ per 1) 30 day forward 90 day forward 2.0615 2.0552 2.0511 Ask 2.0645 2.0587 2.0551
Interest rates (annualised) USA Lend 30 days 90 days Required: a. evaluate the above situation in terms of pure interest arbitrage; take as your example borrowing for 30 days in USA and investing in UK and b. discuss whether the interest rate parity equilibrium is holding; would you comment differently if the transaction costs were 0.25%? Solution to Worked example 13 a. Let us assume we can borrow $10 million for the benefit of our answer (but we could have used $1 just as easily). Borrow $10 million at 10.35% p.a. Repay it with interest after 30 days. Having borrowed $10 million, convert it into sterling at the spot rate of $2.0645 and invest the proceeds in the UK at 11.9% p. a. (The difference in annual interest rates of 1.55 p.a. suggests it might be a worthwhile operation). Buy a forward contract to convert the sterling investment proceeds back to dollars. With dollars in hand pay back loan and outstanding interest. If the market is in complete equilibrium the dollar proceeds exactly pay off borrowings plus interest. $ Capital and interest due for repayment in 30 days Borrow Lend 11.90% 11.40% 10.15% 10.35% 10.40% 10.60% UK Borrow 12.10% 11.60%
Take, convert and invest $10 million loan in UK. Sterling value at end of 30 days:
Buy $ forward contract to convert to to $ for the expected proceeds of 4,891,822: 2.0552 4891822 = $10,053,673 Loss on deal = 10,053,673 10,086,250 = $ 32,577 If the mechanism was operating perfectly there would be zero loss or gain. b. This approach can be repeated for the three other alternatives, borrow in USA and invest in UK for 90 days and borrow in UK and invest in USA for either 30 or 90 days. Try this for yourself using easy amounts like $10 million or 10 million, or just $1 or
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1. The losses or gains you will derive will tell you in theory whether it is a worthwhile trade. The larger the loss or gain the less the market is in equilibrium and the more likely the arbitrageurs will move in and, by their actions, influence currency and interest rates to make it less rewarding for those that follow. In practice, traders may have to pay some transactions costs which if they amounted to 0.25% would increase the loss shown in (i) above and obviously affect the figures you have calculated for the other possible deals. Any transactions costs influence operating efficiency and the movements towards equilibrium.
Exchange risk exposure

A business is exposed to exchange risk when a movement in a currency would change for better or worse the parent businesss home currency value of any of the businesss assets, liabilities, cashflow or expected profit streams. You will be expected to describe the three main categories of exposure: translation, transaction and economic exposure. Some texts may call economic exposure by another name, operating exposure, as well as treating transaction exposure as a subset of economic exposure. You are only required to learn the basics of translation exposure as an advanced financial accounting course would cover the topic in greater depth. Translation exposure arises from the need to consolidate overseas subsidiary balance sheets and profit and loss accounts into the one set of accounts for the group in one currency. This consolidation requires the translation of foreign currency valued assets etc. into the home-currencyvalued assets etc. on a particular date. The choice of exchange rate can have a material effect on the consolidation figures. For this paper we concentrate on the problems faced by management of actual or potential cashflows. When a debt is payable or receivable, in a foreign currency, this gives rise to transactions exposure, while economic exposure relates to the exposure of potential cashflows For example, if a steel manufacturer tenders a contract to make and supply large steel pipes to an oil drilling company, then the steel business will have a potential (economic) exposure during the tendering process and period which becomes an actual (transaction) exposure once the contract has been accepted with delivery and payment dates agreed.
Management of foreign exchange exposure

You will be expected to discuss the internal techniques a holding company can use to manage and minimise foreign currency exposure such as netting, matching, leading and lagging and asset and liability management. In addition, you will also be required to explain the mechanics of hedging, the use of options and swaps. (you will not be required to do worked examples of these.) Worked example 14 hedging question Lee Ltd import goods to the UK from Singapore. At the end of December the business has just signed a contract requiring a payment of $ (Singapore) 586,000. The business is considering the cost of three possible ways of hedging the foreign exchange risk arising from the contract: forward contract, money market hedge or the acquisition of foreign currency options. The various rates and prices at the time of signing are given below:
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Exchange rates (London Market) Singapore $/ Spot 3 months forward 6 months forward Interest rates (annual) Six months $ Sterling Singapore $ Borrowing 12.5% 9.0% Lending 9.5% 6.0% 3.4212 3.4280 1.64 1.54 cents premium 2.78 2.68 cents premium
Foreign currency option prices (LIFFE Market) (Prices are cent per contract size 12,500) Put option Exercise price ($) 3.40 3.60 June 13.80 18.64
(Note: If the forward contract is undertaken then cash will be paid in six months time, as it will if the option is taken up.) Required: 1. Calculate the cost of the three possible ways of hedging the foreign exchange exposure open to Lee Ltd; identify the extent of the exposure. 2. Evaluate the three possibilities and make a recommendation to the business. Solution to Worked example 14 1. a. Forward exchange marketforward contract Use forward rates for six months. Use the bid rate because you are buying S$ Remember it is the cost to Lee in Sterling that matters (i.e. required as the answer). Forward rates = Spot premium = (3.4212 0.0278) (3.4280 0.0268) = $3.3934 3.4012 Cost of forward contract to buy S$586,000 = 586,000 3.3934 = 172,688 b. Money market hedge S$586,000 to be paid in six months Borrow now, convert immediately to S$ and invest it so it becomes $586,000 in 6 months. Singapore lending rate 6.0%, sterling borrowing at 12.5% Amount needed for investment: = 586,000 1+[0.06 (16/12)] = S$568,932
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Amount if required at spot to provide S$568,932 = 586,000 3.4212 = 166,296 Amount required in six months to repay sterling loan and accumulated interest: = 166,296 [1 + 0.125 (16/12)] = 176,690 Cost of money market hedge: 176,690 c. Currency option Choose option rate, note price per . Calculate required number of option contracts of 12,500. If option to be exercised calculate net S$ flow, convert to . Sum sterling flows.
Assume buy put option at S$3.60. It gives Lee the right to sell 1 at S$3.60 in June. Price per =18.64 cents. value of debt owed at option rate: = 586,000 360 = 162,778 Number of option contracts (to next whole number): = 162,778 12,500 = 13.02 = 14 contracts Cost of 14 option contracts: = 14 12,500 0.1864 = S$32,620 Amount required in six months to repay sterling loan and accumulated interest. If exercised, 14 contracts provide: S$(14 12,500 3.60) = S$630,000 Net S$ cashflow in June: = 630,000 32,620 586,000 = S$11,380 inflow Net inflow must be converted at forward rate to sterling (As an inflow use ask rate, for outflow use bid rate). Total sterling outflow in June = (14 12,500) 11,380 3.4012 = 171,654 (Note: If Lee Ltd had chosen to buy options at S$3.40 rate it would have required 14 option contracts, produce a net S$ outflow on conversion, which when translated at the forward bid price plus sterling outlay for the contracts of 175,000 would show a total cost of 179,465. You can give yourself some practice by reworking the option section using the information for S$3.40 options, the guidance in this paragraph and then checking your answer.) d. The extent of the exposure is the amount due S$586,000. 2. The cheapest possibility is to buy 14 put options at S$3.60 per . This method costs 171,654, 1034 cheaper than the simpler, easier method of buying a forward contract at S$3.3934 per . However, if the spot bid price in June rose above S$3.6039 then Lee Ltd could dispense with using the options and buy S$ in the market to cover the combined cost of the outstanding debt and option purchase cost (586,000 + 32,620) [N.B. The cut off spot price of S$3.6039 comes from dividing the sterling cost (171,654) into the combined S$ cost of S$618,620], the more the future spot price exceeds S$3.6039. The more the future spot price exceeds S$618,620, the cheaper the cost of paying off Lees debt becomes. The exposure risks are covered in all three methods but in the money market hedge there is an
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added practical risk that interest rates might change during the six months thus not completely wiping out the exposure risk using this method.

By the end of this chapter, and having completed the Essential reading and activities, you should be able to: discuss what derivatives are and how they work describe the types of options and also the factors which affect them explain the theory underpinning basic option valuation explain the application of option pricing theory to corporate finance explain why financial managers are concerned with international financial management describe the basic definitions associated with foreign exchange transfers explain the various theories that underpin the activities in the foreign currency markets explain how financial managers can manage the three major types of currency exposure.
Practise question
1. Sugarloaf Tea Importers Ltd. is a British tea-importer importing teas from various foreign countries. It is required to make a 20 million rupee payment in six months time for a shipment of tea just received. The treasury department of the company is reviewing its general strategies for hedging foreign currency payments as well as trying to decide how to hedge against the foreign exchange risk associated with this payment. In this situation, the two person department is split equally, in that one member believes that shortly the 1 will weaken to 65 rupees per 1, while the other member believes it will strengthen to 75 rupees. The department is considering four options. They are: i. Do nothing and pay the bill when it falls due in 6months time. ii. To take out a forward exchange contract. Currently the exchange rates are: /rupees spot 70.100 rupees 70.2657 6 months forward (rupees) 0.60 0.150 premium iii. Via the bank use a money market hedge. At present, annual interest rates are UK 5% India 10%. In addition the bank would charge 0.5% on the sterling value as administration expenses. iv. To take out an over-the-counter currency option via the bank at an exercise price of 1 = 69 rupees, the premium cost would be 0.05 per 100 rupees. REQUIRED: a. Separately set out the financial implications of each of the four options for each of the two exchange rate expectations, of 75 and 65 rupees, of the treasury department members. (10 marks) b. Outline the strengths and weaknesses of the hedging methods used in the four options above. Using the figures calculated in (a) review your
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results and make a recommendation as to the hedging option to be used for making the payment, giving your reasons. (12 marks) c. Briefly discuss whether the treasury department should maintain a general rule as to which hedging method to use, and if so, which one; or should they treat each transaction on its merits. (3 marks) See VLE for solution
Problems
Attempt the following problems in BMM: Chapter 22, numbers 9, 10 and 18; Chapter 23, numbers 1, 3, 4, 5 and 12; Chapter 24, no. 7. Attempt the following problems in BMA: p.750, number 16; p.781, numbers 19 and 20.
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Chapter 11: Mergers, corporate restructuring and off-balance sheet funding

Aims of the chapter
Most companies are involved in either a merger or a takeover sometime during their corporate existence so understanding the motives and tactics behind them is very important. There are waves of merger activity and an explanation is put forward for this before describing the motives and theories behind mergers and takeovers. To achieve success in taking over a company requires a knowledge of appropriate tactics, as does a knowledge of defence tactics should a company not wish to be taken over. These are explained. A section then looks at corporate restructuring and divesting. Finally off balance sheet financing and leasing is introduced and explained.
Learning outcomes
By the end of this chapter and having completed the essential reading and activities, you should be able to: explain the reasons why companies may decide to merge with another firm describe the factors that may give rise to merger waves explain the motives underlying individual mergers (including economic theories) explain the role that takeovers play in removing inefficient management describe the rules governing takeovers in the UK describe takeover defences and any advantages and disadvantages they may have describe the theory and evaluate the methods of company restructuring and refinancing explain both the types and reasons underlying leasing.
Essential reading
Further reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (McGrawHill, 2008) Chapters 32 and 33. Atrill, P Financial Management for Decision makers. (FT Prentice Hall Europe, . 2005) Chapter 12.
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Introduction
This chapter focuses on trying to explain the motives and tactics involved in merger and acquisition activity. Chapter 21 in BMM gives a predominantly US perspective on the topic whereas Chapter 12 in PA though very detailed, gives a UK perspective on merger activity. During periods of intense merger activity, financial managers spend a great deal of time searching for firms to acquire or they spend time worrying about firms which are likely to take their firm over. When one firm buys another, it is exactly the same as undertaking any ordinary investment. Therefore, from our earlier studies of financial management we will know that the investment should only proceed if there is going to be a net contribution to shareholder wealth. The only problem is that mergers are very difficult to evaluate because the benefits and costs may not be easy to measure and also they are more complicated than, say, buying a machine, due to the tax, legal and accounting regulations that need to be followed. The terms mergers and takeovers are used interchangeably. This is because in many instances it is not clear whether one or the other is occurring. Strictly, a merger is when two companies of equal size come together and continue to have an interest in the combined business. This supports the idea of the combination while, when a large company makes a bid for a smaller company, and the directors of the smaller company do not recommend shareholders to sell their shares to the purchaser and neither the pre-bid shareholders nor the directors of the company have any interest in the combined firm, then this is an acquisition or takeover. In a merger, the accounting rules emphasise the continuity of ownership and in takeovers the emphasis is rather on a purchase and discontinuity of ownership; the main differences between the accounting rules are concerned with the treatment of goodwill, value of shares exchanged and pre-acquisition profits.
Merger waves
In the UK, there was a takeover boom between 1984 and 1989, but this boom had been driven largely by a small number of very large acquisitions; in general, there was increased expenditure on acquisitions which coincided with a general increase in capital expenditures by industrial firms. It was also a period when company profits and liquidity in general were relatively high and large funds were available to perform takeovers. This was not only the case in the UK Germany, France and the US also experienced a similar trend in merger activity. Several reasons have been advanced for these so called merger waves: during the 1960s boom conglomerate mergers became fashionable and during the 1980s boom the UK was preparing itself for the single European market in 1992. One of the most popular reasons advanced for waves of merger activity suggests they are associated with booms and slumps in the economy and stock market prices; this situation is also referred to as the economic disturbance theory of mergers. The only problem with the notion of the economic disturbance theory of mergers is that we do not understand the economic forces that underlie the pattern of merger activity. Many academics believe that the reasons for merger waves may not be economic but behavioural.
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What causes merger waves: high merger activity when share prices are low (firms are bought at a bargain) high merger activity when share prices are high (the stock market allows a firms management to finance takeovers through equity issues) high merger activity in certain economic situations (especially prevalent in technology driven industries).
Motives for individual mergers

Before the motives are discussed, it is important to point out that, when a firm decides to merge with another, it is the management of the firm who make the decision. The management of the firm should be acting in the interests of their shareholders (we discuss managerial motives for takeovers in a later part of this chapter). If company A decides to take over company B then their reasons for the attempt would be either: if they believed the value of the two firms together exceeds the value had they remained separate entities; this is commonly referred to as a synergistic effect (the simplest explanation is that the combined firms resources increase the potential for future growth and make it possible to utilise each firms relative advantage), or if they can buy company B at a price below the present value of its future cash flow. For example: PVab = PVa+ PVb + Gain If company A decided to bid for company B (the target), it could end up paying a price above the PVab; in which situation the shareholders of company B would gain. If we assume: PVab = 100,000, PVa = 50,000, PVb= 20,000 then PVab = PVa + PVb + Gain 100,000 = 50,000 + 20,000 + Gain Here the relative gain would be 30,000, but the gain would be much smaller if 40,000 was paid for company B, as the shareholders of company B would then receive two-thirds of the gain (30,000 20,000 = 10,000 Gain; and 20,000/30,000 = 2/3 gain to shareholders of company B). Note: if PVab is the value placed on the consideration by company As management then (PVab PVa) equals the maximum value they will pay for company B.
Economic theories of mergers

Economies of scale Internationalisation of transactions Market power Entry into new markets/industries Elimination of misguided management Free cash flow (trapped equity) Undervalued shares
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Tax advantages High prices/earnings rations (bootstrapping) Risk diversification
Economies of scale
The topic economies of large scale production should have been adequately covered in your earlier economic studies, but to revise the concept we provide a brief explanation of economies of scale in finance which arise where administrative costs per unit raised are less with large issues of finance than with small issues.
Internalisation of transactions
This usually occurs when firms vertically integrate (vertical integration backwards occurs by the acquisition of firms that supply raw materials and vertical integration forwards occurs when firms are acquired nearer the selling of the product). It is an important form of merger as it eliminates transaction costs when firms have to deal with each other. One drawback is that by merging two large firms, extra costs may result. For example, suppliers may be less inclined to compete with one another leading to higher prices paid by the merged entity.
Market power
During the boom of 197985, it was estimated that 3% of assets in the UK changed hands as a result of vertical integration while 57% were a result of horizontal integration (horizontal integration occurs where firms acquired are at the same stage of the production process, and the merger leads to a greater share of a particular market). This is an attractive feature for firms as it has been shown that a concentration in an industry leads to a greater level of profit.
Entry into new markets/industries

Entry into areas where an expanding firm lacks the know-how. As the growth through a takeover is quick, it can provide almost instantly the necessary size for a firm to be an effective and formidable competitor.
Elimination of misguided management

There is a substantial separation between the ownership and management of large firms. Shareholders do not appoint or supervise the firms management; they only elect directors who are agents responsible for the choosing and monitoring of top management of the firm.
What then happens if managers are inefficient?

Inefficient managers can exist for a limited time period, but if markets are efficient then over the longer period, they will be identified and the market mechanism should ensure that they are replaced, this general process is referred to in the academic literature as the market for corporate control. In some instances, it may only be that the interests of managers differ from those of the shareholders; this is commonly termed the agency problem.
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How then do takeovers perform the disciplining function on inefficient management?

For example, if company A has inefficient management or they are neglecting the interests of shareholders then the managers of another firm, company B will make a takeover bid for company A, promising the shareholders of company A that they will be able to manage the assets of the firm better than the present managers, which would ultimately raise shareholders wealth in the future.
Free cash flow (trapped equity)

Michael Jensen (1986) suggested that managers with cash flows in excess of those required to finance all positive NPV projects within a firm would use the excess resources to finance takeovers. The same would apply if profitable growth opportunities were limited, and rather than distribute the excess cash to the shareholders, they would use the funds to acquire other firms. Two benefits to shareholders were identified by Jensen concerning the free cash flow theory. First, there would be tax benefits and second, if the excess cash was used to finance a takeover in preference to a dividend, then the stock market value of the shareholders investments would increase more than if the money was distributed to shareholders.
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Jensen, M.C. Agency Costs of Free Cash Flow, Corporate Finance and Takeovers, American Economic Review 26 (May 1986) pp. 32329.
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Undervalued shares
An acquisition can also occur when the stock market is underestimating the real value of a firm. For instance, if a firm is not too familiar with its stock market valuation and its share price is low in relation to its actual potential, then this may make it an ideal takeover target. The point here is that the victims of takeovers are not necessarily the firms failing to make the most efficient use of their resources. The victims could actually be firms using assets to their best advantage but their share price may not fully reflect the true value of the firm and its assets.
Tax advantages
The crucial point is whether or not the losses of one company can be used to offset the profits of another in the group; so as to reduce the overall groups taxation liability. In the UK, the law is more restrictive with regard to these considerations than in the US.
High price/earnings ratios (bootstrapping)

This was particularly important during the conglomerate merger booms of the 1960s. If company A possesses a high stock market rating relative to another company B; then the former company is able to purchase the latter firm on advantageous terms, as banks and financial institutions are more likely to support a takeover bid from a company with a better stock market rating.
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Worked example 15 If an acquisition is valued at 1,000 and the present market price of company A (purchaser) shares is 1, then 1,000 shares would need to be exchanged for the takeover. If company As share price fell to 0.5 then 2000 shares would be needed; therefore, the lower the share price of the acquirer, the greater the number of shares (proportion of the acquirer) need to be exchanged, which would not be in their interest. The key to this type of problem lies in the earnings per share (EPS), as a firm can raise its EPS by merely acquiring other firms and not by normal trading. Companies A and B each have 1,000 shares outstanding Company A Total earnings EPS Share price P/E ratio 100 0.10 2.00 20:1 Company B 100 0.10 1.00 10:1
Company A has a higher P/E ratio because it is assumed to have a higher prospect of future growth. If company A purchases company B, then the market value of company B is 1,000 (1,000 shares at 1) and 500 shares of company A (500 shares at 2) will need to be offered. The position of company A after the purchase is as follows; Total earnings Number of shares EPS 200 1,500 0.13
The EPS has increased due to purchasing company B. If the same P/E ratio is maintained for company A, the share price will be 2.67; showing a gain for shareholders of company A of 0.67. The shareholders of company B will also have benefited as prior to the merger they held 1,000 shares priced at l, valuing the company at 1,000 but after the takeover they hold 500 shares at 2.67 each giving a total value of 1,333. This is because they hold shares in company A which now has higher growth prospects.
Risk diversification
During the conglomerate merger boom of 197985, the rationale for the mergers was said to be diversification, which would eventuate in the stability of future cash flows. As firms in different industries experience booms and slumps in their profits and cash flows at different times, it was felt safer for firms to conglomerate to reduce this volatility. From this point of view takeovers reduce risk for companies. Activity 11.1 Discuss how merger waves may occur. Briefly describe the benefits and limitations of four different economic theories of mergers. See VLE for solution
Management motives
In the traditional theory of takeovers it is assumed that one company (bidder/purchaser) seeks to acquire another company (target). It is in reality the management who initiate the bidding for the target on behalf
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of the shareholders of the bidding firm. The bidding management will make an offer to the target companys shareholders, with or without agreement from the target companys management. As already mentioned, 2 Jensen and Ruback (1983) referred to the takeover market as creating the market for corporate control, in which alternative managerial teams compete for the rights to manage corporate resources. It will obviously be the target companys shareholders who will ultimately decide whether to sell their shares to an acquirer. The bidding companys managers cannot diverge too much from shareholder wealth maximisation but they can and do take their own interests into account (i.e. higher status and remuneration). Another motive for management might concern their own survival, the reduced risk of losing their job. Unlike shareholders, managers are unable to diversify their risk, as they are tied to one firm usually. Thus by pursuing an active takeover strategy they are less likely to offer themselves as targets for takeover predators. This theory moves the emphasis from shareholders to the management of the company, who are regarded as the activists in the takeover. Activity 11.2 Explain the role that takeovers play in disciplining inefficient management. Can you think of real examples that you have read about in the newspaper. See VLE for solution
Jensen, M.C. and R.S Ruback The Market for Corporate Control; The Scientific Evidence Journal of Financial Economics 11 (April 1983) pp. 5-50.
Takeover tactics
Rules governing takeovers in the UK Bidding tactics Market raids Concert parties The offer
Rules governing takeovers in the UK

Rules are self-regulatory and statutory: the self-regulatory rules are known as the City Code on Takeovers and Mergers the City Code is designed to protect shareholders the City Code does not have the force of the law but all stock exchange listed firms must follow it the major problem with the Code is that it cannot reverse events (impose sanctions after the event) the statutory rules are governed by the Companies Acts, Fair Trading Act and the Monopolies and Mergers Act the objective of the Monopolies and Mergers Commission is to promote competition and prevent takeovers that reduce competition and are against the interest of the public an EU takeover code and a statutory harmonisation code still needs to be developed. The rules will vary between countries.
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Bidding tactics
Having decided to purchase a company, the problems that arise are: what is the value of the company and how to finance the purchase. The offer can be financed by the purchasing companys equity, debentures, cash or other security. The idea is to make the offer as attractive as possible to the target companys shareholders. Almost always, the bidding firm has to offer a premium to the targets shareholders; this is the difference between the value of cash and securities being offered and the pre-bid market price of the target company. The factors which have been most commonly found to influence the size of the premium are: a. whether there are any other firms keen to bid for the target b. the levels of cash flow for the target and c. the value of the targets assets.
Market raids
Market raids occur when a person or a company acts with speed of action in buying shares of a target company. The raider achieves their acquisition objectives before they have to notify the target company of the acquisition. Dawn raids are ones which take place at the early minutes/hour after the stock exchange has opened. The disadvantage with raids is that the initial high price offered at the outset of the raid is not usually offered to all the shareholders and, usually, only informed brokers acting on behalf of large institutional shareholders are quick enough to benefit from any market raids. However, recently in the UK the city code has been revised to strengthen the restrictions prior to the announcement of an offer in an effort to achieve equity between shareholders.
Concert parties
Concert parties occur where several persons act together to buy shares in a particular company, so that no one individual owns or has an interest exceeding 5%; thus they do not need to notify the company of their holding. In the UK, both the stock exchange and the city code require concert parties to disclose any holding greater than 5% in total within 36 hours of an action.
The offer
The acquiring company first announces its intention to make an offer disclosing its terms to the board of the target firm. Within a few days, the offer is posted disclosing the terms to the shareholders of the target. In the meantime, the board of the target must circulate its own view of the offer and suggest whether shareholders should accept the offer. The bidding company may have to obtain approval from its shareholders before the bid for the target can be made. The offer only becomes unconditional (win/accepted) when the bidder has acquired over 50% of the voting equity. When only between 3050% of the shares can be acquired, the consent of the targets board and the takeover panel may be required. If the purchaser fails to acquire all the shares from the target firms shareholders then the remaining shareholders will become minority interests who will be entitled to receive dividends on their shares until they are sold.
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Activity 11.3 Under what circumstances are the rules and regulations which govern takeovers in the UK likely to prevent a takeover from occurring? Explain the following terms: market raids the offer.
Takeover defences
The directors of a company that is the subject of a takeover bid should act in the best interests of the shareholders. The city code on takeovers and mergers requires certain principles that must be met. In most takeover cases, professional advisors are recruited in the preparation of any documents relating to bids and defences. If directors decide to fight the bid, there are many defences open to them. Before they decide to defend a bid, they need to convince their shareholders of the benefits associated with the defence. If directors find a bid financially unattractive to their shareholders then in defence they may try to convince their shareholders that: at the current market price, the purchasers shares are overvalued or the current market price offered by the purchasers is undervalued. In addition to these suggestions, the board of the target company may also offer future incentives to their shareholders such as higher future dividends/profits or even changing the management team.
Glamorous defence tactics

White knights Poison pills Crown jewels.
White knights
One defence the directors of the target company may employ is to offer the ownership of their firm to a more friendly outside interest (defensive merger); in this case the friendly acquirer is termed the white knight. It is a very successful strategy but should only be used as a last resort. The city code makes it clear that shareholder approval is usually required before any approach to an outside party can be made.
Poison pills
Another defence occurs where a company takes steps before a takeover bid has been made to make it less attractive to a potential bidder. Usually, shareholders are given the right to convert loan stock/preference shares into ordinary equity on the announcement of a takeover bid.
Crown jewels
This defence involves a tactic of selling off certain highly-valued assets of the company subject to a bid: the intention being to put off any acquirer, as the value of the firm will be substantially reduced with the crown jewels sold off.
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Other tactics which you may be asked to discuss can be found in BMA chapter 32 are: golden parachutes pac-man greenmail producing a revised profit forecast ESOPs shark repellents. In concluding, mergers seem to generate economic gains. Typical mergers seem to realise positive net benefits for the shareholders of the acquiring firm, but competition between bidders and active defence strategies by the target firms management may push most of the benefits to the selling shareholders.
Company restructuring
In the previous section of this chapter, several aspects of mergers have been discussed. However, mergers are only one form of company restructuring, probably the form which attracts the greatest media attention. In this section, we briefly outline other forms of corporate restructuring in addition to mergers and acquisitions, namely divestments. You should be aware that this section only briefly outlines corporate divestments, and you should read about and understand the motives and methods behind the other forms of change in Chapter 33 of BMA. These include: demergers (spin-offs); going private; buy-outs/buy-ins; premium buybacks; refinancing and reverse takeovers.
Divestments
During the 1980s and 1990s a new trend in corporate restructuring was evidenced, namely a move towards company management adopting strategies of demerger or divestment. This came about partly due to the increased tendency of company management to concentrate on the strategic processes of the firm, especially to focus on the core-business activities. The term divestment, or divestiture, means the sale of either a subsidiary, division or product line by one business to another. Selling the parts of a business can be seen as similar to asset stripping, although this term is usually reserved for describing the practice of selling unwanted or unprofitable parts of a business following an acquisition. Divestitures, on the other hand, occur whether or not a company has been involved in takeover activity. A situation soon developed in the UK whereby conglomerates were seen as being risky and highly inefficient both from a managerial and an investors point of view. This increased competitive pressure encouraged firms to reorganise their group structure into more specialised and smaller manageable units and sell off aspects of the business which were not likely to be profitable in the future. Therefore, during the 1970s many conglomerates (such as Hanson plc and ICI in the UK) sold off assets that they thought were unprofitable to them. Practically, there are many problems involved in attempting to evaluate the results of divestment as the mechanics of divestment involve a number of important behavioural issues, in additional to the financial issues.
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Off-balance sheet funding

This subject guide is, in large part, about how to make investment and financing choices which add value. But, given that a firm has a mix of business activities, it can choose alternative ways of structuring its assets and liabilities to achieve the same business outcome. For instance, a firm may be able to achieve a better value position for itself when it is more tax efficient to lease rather than own an asset. But at other times the effect is merely cosmetic, to make the balance sheet look different. Therefore in this section we analyse the ways in which off-balance sheet financing may add value to a firm. In reality, off-balance sheet financing is undertaken so that its effects will not influence the markets view since it is not information that is publicly available and visible to investors and potential investors, yet it obviously contains information content. The most common example of off-balance sheet financing involves the decision to lease assets rather than purchase them outright.
Leasing
The topic of leasing is not covered in BMM but BMA (Chapter 26) provides too much material on the topic as you are only required to possess a general understanding of what leasing entails. There is a brief introduction in PA (pages 2268). Leasing has increasingly become a popular form of medium- or shortterm finance. The major advantage of adopting a lease in preference to buying an asset is that it allows one party (the lessee) the use of an asset for a specified period of time, while the supplier of the asset (the lessor) still retains legal ownership. The difference between hire purchase and leasing is that the former agreement the ownership of the asset at the end of the hire purchase period transfers to the party which had made the hire purchase payments, whilst, at the end of the period of the lease the ownership of the assets remains with the lessor. The lessee is usually the company making use of the equipment and in return paying a rental to the lessor. The lessor is usually a finance company, which purchases the asset and then leases it out for a period of time. There are two broad types of lease: namely, finance leases and operating leases. The distinction between the is concerned with the risks and rewards associated with the ownership of the asset. In the case of an operating lease (which is usually for a shorter period than a finance lease) it is the lessor who is usually responsible for the maintenance of the asset and it is the lessor who loses should the asset become obsolete before the end of its useful economic life. In contrast, a finance lease essentially passes the risks (maintenance) and rewards of ownership to the lessee over the useful economic life of the asset and who in turn agrees to pay fixed annual amounts.
Reasons for leasing

The main reasons for leasing are as follows: A company may not have the funds available to purchase the asset. There can be considerable tax advantage.
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A company may not wish to own a certain type of asset (such as a computer which may become out of date relatively quickly) It is often suggested that leasing does not interfere with other borrowing or credit facilities.

By the end of this chapter, and having completed the Essential reading and activities, you should be able to: explain the reasons why companies may decide to merge with another firm describe the factors that may give rise to merger waves explain the motives underlying individual mergers (including economic theories) explain the role that takeovers play in removing inefficient management describe the rules governing takeovers in the UK describe takeover defences and any advantages and disadvantages they may have describe the theory and evaluate the methods of company restructuring and refinancing explain both the types and reasons underlying leasing.
Practise questions
1. Suppose you are the financial manager in a large firm and have been asked by the board of directors who have been threatened by a takeover bid to describe some policies that the firm may adopt in defending the takeover bid. Prepare a report describing the takeover defence policies you are likely to suggest. 2. Jono plc is considering making an offer for Wilco plc. The abbreviated st financial accounts for the year ended 31 December 2008 for both
companies are as follows:
Balance Sheets as at 31 December 2008 Jono plc. million Fixed assets net Current assets Less Current liabilities Less Long-term liabilities Ordinary share capital Share Premium Profit and Loss Account (50p shares) 800 (300) 500 860 (200) 660 50 250 360 660 (1 shares) 360 200 (300) (100) 40 40 100 (60) 40 Wilco plc million 140
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Profit and Loss Accounts for year ended 31 December 2008 Rhy plc million Turnover Net Profit after tax Dividends proposed Profit Retained 2,000 100 50 50 Wilco plc million 500 1 1 0
Jono plc is a quoted public company with a price earnings (PE) ratio of 16x. Wilco plc. is not a quoted company; its ordinary share capital is 40% owned by a group of business angels and the majority, 60%, by the original owner and members of her family. The merchant bank advising Jono have indicated that if Wilco were a quoted company, in their view, the PE ratio for the company would be 5x, and that if the two companies were to merge, the combined company would have a PE ratio of 14x. The merchant bank report that the average net dividend yield for the market as a whole is 4% p.a., whilst the average net dividend yield for the industry is 3% p.a. Jono and Wilco are in the same industry. Jono and its advisors have just completed their due diligence investigation of Wilco and believe that if the two companies were combined then, even with no change in the annual turnover of Wilco or Jono, there would be considerable savings in administration and other fixed overheads. The after-tax profits of Wilco would increase to 10% of its turnover with no change in the after-tax profits of Jono. REQUIRED a. Provide valuations per share of both companies using three separate approaches: i. net asset value ii. earnings yield approach iii dividend approach. (10 marks) b. Calculate the maximum, in your view, that Jono could pay for a share in Wilco without loss of value to Jono shareholders. Give your reasons. (6 marks) c. Using the underlying rationale of the valuation methods to support your argument, provide a reasoned strategy for Jono to follow in bidding for the share capital of Wilco assuming they will only make a maximum of two offers, with the second expected to be successful if the first is not. (9 marks)
Problems
Attempt the following problems in BMM: Chapter 21, nos 6, 7, 8 and 11. Attempt the following problems in BMA: pp.91012, numbers 1, 3 and 12.
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Notes
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Appendix 1: Review questions

Read Chapter 26 in BMM. It will help you review and critique the subjects covered in this guide.
Question 1
Simat plc produces electrical and electronic components for the defence industry. Both the chairman and chief executive have recently expressed concern at the rising level of inflation within the economy and its implications for the financial management of the business. A board meeting has been arranged to discuss the issue. Required: Prepare a report for the board of directors which sets out the ways in which inflation may effect the financial management of the business.
Question 2
Modern Industrial Manufacturers plc (MIM) is a Stock Exchange listed company. MIM is all equity financed and generates a steady profit of 5 million a year. This level of profit is expected to continue indefinitely. MIM has 10 million shares in issue. It is the businesss policy to pay all of its annual profit as a dividend to the shareholders. Associated Industrial Producers plc (AIP) is another Stock Exchange listed company which is identical to MIM in every respect except that it is financed 50% (based on market values of debt and equity) from a debenture loan, which has a yield of 10% per annum, and the remainder from equity. AIP has 5 million shares in issue. The current market price is 4 per share. Jane is an individual who has 1,000 to invest and wishes to make an investment either in MIM or AIR She is able to borrow as much money as she wishes, within reason, at an interest rate of 10% per annum. Jane is contemplating two investment strategies: spend all of her 1,000 on shares in AIP; or make an investment in MIM which will provide her with an identical income, with identical risk. Required: a. Assess the position of Jane in respect of each of the two investment strategies, assuming that Modigliani and Miller were correct in their assessment of the effect of capital gearing on the value of a business and that there are no taxes. On the basis of your assessment of Janes position, what is the theoretical price per share of the shares of MIM? b. What will be the value of a share in MIM, again assuming that Modigliani and Miller were correct in their assessment of the effect of capital gearing on the value of a business, but that there is Corporation tax at 25%. c. Apart from the assumption of no taxes in part (a), above, what other assumptions have you made and how valid are they in real life?
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Question 3
Aspirations plc is an unquoted, medium sized business. The management is contemplating making an investment which will expand its existing business. The cash for the investment, should it go ahead, will come from debentures, which will be issued at par with a coupon investment rate of 12% per annum. Because of the size of the outlay the businesss management is keen to assess the investment as carefully as possible. Estimates have been made of the cash flows which will arise from the investment and the management is fairly confident of these estimates. A problem has arisen in selecting an appropriate cost of capital to apply to the cash flow estimates, particularly since the businesss shares are not traded on a Stock Exchange, nor has there been a recent sale of shares in the company. One of the staff of the business has recently complete an Economics degree, which included a course in Financial Management. He has been asked to look into the problem of finding an appropriate cost of capital figure. He has decided to select a business of similar size and activity to those of Aspiration plc and apply two approaches to deducing that businesss cost of capital. The chosen figure will then be used in the assessment of Aspiration plcs investment proposal. The business selected is James plc. The two approaches and the relevant data for use are as follows: 1. Dividend valuation model The Gordon growth model will be used. Dividends per share for James plc over the past six years have been as follows: Year 1988 1989 1990 1991 1992 1993 Dividend per share () 15.5 17.5 19.5 22.0 24.5 28.0
James plc cum-div share price is 3.47. 2. Capital asset pricing model Published sources reveal the following: James plc equity beta is 0.90 Average annual returns from Stock Exchange listed companies over the past 10 years have been 18%. Average annual returns from short term UK government stocks over the past 10 years have been 10%. Required: a. Use the information provided to deduce James plcs cost of capital on both of the suggested approaches. b. To what extent would the management of Aspiration plc be justified in using the figures calculated for James plcs cost of capital (part (a)) to apply to the estimated cash flows of Aspirations plcs investment proposal? Explain any reservations which you may have about using these figures.
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Question 4
Cameron plc, which sells all of its goods on credit, is currently reviewing its policy concerning trade credit. At present, 25% of trade debtors pay one month after the invoice date and the remainder pay two months after the invoice date. This pattern is expected to continue in the forthcoming year if the current trade credit policy continues. No cash discounts are currently offered to customers for prompt payment. However, to encourage customers to pay earlier, the business is considering offering a 2% discount for those paying amounts outstanding in one month or less. It is expected that this incentive will lead to 50% of customers paying one month after the invoice date and the remainder paying two months after the invoice date. The introduction of a cash discount scheme is likely to attract new customers and so a 10% increase in sales is predicted. The level of sales for the next 12 month is expected to be 4m if there is no change in credit policy. Whatever trade credit policy is adopted, the business will maintain a gross profit margin of 25% on all goods sold and will hold two months stock throughout the year. The business also intends to achieve a cash balance of 50,000 at the year end. The variable costs of the business (excluding cash discounts) are expected to represent 15% of sales and fixed costs are 20,000 per month. All expenses are paid one month in arrears. Trade creditors will represent two months cost of sales and the dividend payout ratio of the business is 60% of after tax profits. The rate of corporation tax is 30%. Required: a. Separately prepare a forecast profit and loss account for the business for the forthcoming year assuming: i. there is no change in credit policy, and ii. cash discounts are introduced. b. Separately calculate the investment in working capital at the end of the forthcoming year assuming: i. there is no change in credit policy, and ii. cash discounts are introduced. c. State, with reasons, whether or not the business should implement the proposed policy.
Question 5
a. Briefly describe how the equity ( of a publicly quoted company could be estimated. Address critically the assumptions underlying your proposed method and, in the light of those comments, interpret the possible empirical results you could have obtained. b. Having obtained the ( value for a businesss equity from a research source, discuss how and why it may have to be adapted if it is to be used by the business in evaluating a major investment. c. Describe and critically evaluate at least three methods of evaluating risk that might be used when a business is appraising a group of investments.
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Question 6
a. Discuss briefly four techniques available to a company to use in hedging against foreign exchange risk arising from overseas trading. b. You have been given a challenge as part of a competition to see who can make the most money through trading on the foreign exchange market. The bank which is sponsoring the competition will lend up to 100,000 units of the local currency at the going market rate. You are not allowed to borrow in the UK and invest the proceeds in Singapore, nor the reciprocal, borrow in Singapore and invest proceeds in UK. All other combinations are possible. Assume you can buy and sell the currencies at the same mid rate for the time period (i.e. there are no transactions costs). Foreign exchange rates Singapore $/US$ Spot 3 months forward 2.1378 2.0039 US$/ 1.4875 .5105
Fixed money market rates Lending Euro sterling () Euro dollar (US$) Singapore (S$) 6.0 7.5 4.0 Borrowing 11.0 11.0 7.0
i. Indicate with evidence whether the sterling and US$ are in equilibrium together. ii. Indicate with evidence whether the S$ and US$ are in equilibrium together. iii. Take up the competitions challenge and indicate your predicted maximum gain through your money market operations.
Question 7
Atlane Ltd has recently received an offer to produce a new type of synthetic fibre for a large international company. The offer is to produce 14,000 tonnes of the new fibre each year for a three-year period at a price of 44 per tonne. The directors of Atlane Ltd are currently considering the offer and have collected the following information: New equipment costing 85,000 will be required immediately in order to commence production. The equipment required is highly specialised and can only be used by the company for production of the new fibre. At the end of the three-year period the equipment will be sold for an estimated 6,000. Eleven new workers will be required to help produce the fibre. The wage costs for the additional workforce is expected to be 200,000 in the first year and will rise at a compound rate of 10% per annum. Recruitment and selection costs, to be paid at the outset, are expected to be 15,000 At the end of the three year contract the workers will no longer be required and redundancy payments of 2,000 per worker will be paid. Overheads relating to the contract are estimated at 60,000 per annum One third of this figure is arrived at by the reallocation of existing overheads to the contract.
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The production process requires the use of 6,000 tonnes of chemical XT3 each year in order to produce the required amount of fibre. The company already has 3,000 tonnes of this chemical in stock. The original cost of this stock was 16 per tonne, however if the contract is not undertaken the chemical could not be used in any other of the companys production processes or resold in the market. The directors have agreed that, if the new fibre is not produced, the existing stock of XT3 will be disposed of immediately at a cost to the company of 2 per tonne. The replacement cost of the chemical is 20 per tonne. The production process also requires the use of 8,000 tonnes of chemical ZF6 each year to produce the required amount of fibre. The company has 4,000 tonnes of this chemical already in stock. The original cost of this stock is 22 per tonne and the replacement cost is 25 per tonne. This chemical is widely used in other production processes of the company. The directors of Atlane believe that successful execution of the contract may result in further contracts being offered by the same company. Atlane has an estimated annual cost of capital of 12%. Ignore taxation. Required: a. Prepare a statement showing those incremental cash flows which are relevant to a decision concerning whether or not to accept the offer. b. Calculate the net present value of the offer. c. State whether or not you believe the offer should be accepted. d. Outline the basic principles to be applied when identifying relevant costs and benefits relating to the offer. Present value of 1 receivable in n years at 12%: n 0 1 2 3 12% 1.00 0.89 0.80 0.71
Question 8
Dewstone Ltd has received the following credit rating report on the customers in its industry. The total market is estimated at sales of one million units of which Dewstone has 25%. The report gives the points rating for customers and the cumulative percentage of sales in the market that fall in that category or worse. Points rating classes Cumulative percentage of market sales 11 40 82 95 100 Cumulative percentages of sales which turn out good 2 15 54 66 71 of sales that turn out bad debts 9 25 28 29 29
0 19 0 39 0 59 0 79 0 100
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In other words 40% of the markets sales are taken by customers with a rating of between 0 and 39. 15% of the total markets sales turn out good and the balancing 25% turn out to be bad debts. Of the years sales of 1 million units 29% turn out to be bad debts. Dewstone is considering restricting its sales personnel to making sales to customers with a credit rating of 60 or better. At present they estimate they will still only achieve success with 25% of the total market sales to customers with those ratings. The following profit estimate is based on that assumption. Any customer with a 059 rating is rejected. Selling price/unit 20. Sales (25% 1,000,000) 18% 20 Variable costs 45,000 11 Contribtion Fixed administration, etc Bad debt cost (25% 1,000,000) .01 20 Net profit Required: a. Assuming selling price and variable cost per unit are 20 and 11 respectively and fixed administration etc.costs are 175,000 for the year, check whether the predicted profit from the sales under the suggested credit policy are correct. b. Using the credit rating agency estimates and the above company costs show what is the optimal credit policy for the company to follow (show your workings). = = 900,000 495,000 405,000 175,000 50,000 225,000 180,000
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Appendix 2: Suggested solutions to review questions

Solution to Question 1
The major ways in which inflation can have an effect on the financial management of a business are as follows: Loan capital. A fixed loan will mean that inflation will erode the value of the amount owing in real terms. In effect, there will be a transfer of wealth from lenders to equity shareholders. However, lenders will normally expect to receive compensation for this in the form of a higher rate of interest. Investment projects. Rising prices may make it more difficult to forecast future receipts and payments during the period of an investment project. In addition interest rates are likely to increase making it difficult to estimate the correct discount rate. Some adjustment for inflation is required in order to ascertain the profitability of an investment proposal. Financial reports. Financial reports based on the historic cost convention produce distorted results during a period of inflation. Profits are understated and assets understated because of the time lag between acquiring and utilising resources. The effect will be to overstate the return on capital employed. In addition, gains and losses from holding monetary items during a period of inflation are not recorded. These may be important in the assessment of performance. Taxation and dividends. The effect of overstating profit may be to encourage the payment of higher dividends. If the dividends paid exceed the profit as measured in real terms the capital of the business will be eroded. Similarly, the overstatement of profit may lead to higher tax payments, which will reduce the amount available for retention or dividends and which may also result in the depletion of the capital base. Working capital. The value of stocks and debtors held will increase during a period of inflation, although this is likely to be offset by an increase in trade creditors to some extent. This means that increased investment in working capital may well be required. Gains and losses in holding the monetary elements of working capital must be taken into account when considering the appropriate level of investment. Pricing policy. Where prices have to be established some time in advance, inflation can complicate matters. Underestimating the rate of inflation may result in a lower than expected profit or even a loss. Conversely, overestimation may result in producing uncompetitive prices for goods and services which will again result in lower than expected profits. Escalation clauses may have to be built into long-term contracts in order to pass on the risk of price rises to the customer. However, there may well be some customer resistance to attempts to pass on price increases and so any policy on this matter should be considered carefully.
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a) If Jane has 1,000 to invest in AIP at a market price of 4 per share she can buy 250 shares, 0.0005 of the business. Thus: Total million Profit per annum of AIP Less: debenture interest (10% x 20m) Profit and dividend 5,000 2,000 3,000 Janes portion 250 100 150
In order to have the same income with the same level of risk, Jane could buy sufficient shares in MIM to gain an annual dividend of 250 and pay interest out of this of 100. This amount of interest (at 10%) would imply a loan of 1,000. This would mean a total maximum expenditure on MIM shares of 2,000. In order to generate a dividend of 250 Jane would need to buy 500 shares in MIM, because the business pays a dividend of 0.50 per share. Thus if Jane paid 4 per share, she would be exactly as well off in terms of income, both risk and return, as had she bought shares in AIR. Thus must be the theoretical price of MIM shares. If MIM shares cost less than 4, Jane (and others) could achieve a better return on her investment than by an investment in AIR If the price were above 4, investors could get better returns by an investment in AIR Market forces would drive the price of both shares to the same value. This means, on the basis of the assumptions stated below, the value of a share is independent of the level of capital gearing. b) Assuming a 25% rate of corporation tax, Janes portion of the profit of AIP would be as follows: Profit per annum of AIP Less: Debenture interest Corporation tax @ 25% Profit and dividend 250.00 100.00 150.00 37.50 112.50
Were Jane to buy shares in MIM Janes portion of the profit would be as follows: Profit per annum of AIP Corporation tax @ 25% Profit and dividend Less: interest on personal loan 250.00 62.50 187.50 100.00 87.50 If a share in AIP is worth 4, a share in MIM must be worth 3.11 (i.e. 4 87.50/112.50). Were this not the case it would be possible to earn higher returns for the same risk by buying one share rather than the other. Market forces should ensure that this cannot happen.
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The difference between the theoretical values of the two shares stems entirely from the greater tax efficiency of a business borrowing, where the interest is allowable for tax, as compared with personal borrowing, where the interest is not allowable for tax. c) The main assumptions on which the above analysis is based are as follows: There are no bankruptcy (liquidation) costs, thus the shareholders will not lose wealth as a result of the business being forced into liquidation because of the financial distress arising from capital gearing. This seems unlikely to be true in real life. Shares can be bought and sold without dealing costs. Unless this is valid the market forces necessary to drive share prices together, where there are identical returns, may not fully operate. This does not hold in real life. Interest rates are equal between individuals and businesses. If individuals have to pay more to borrow than does the business, corporate and home-made gearing are not perfect substitutes for one another. Generally, it is probably the case that businesses can borrow more cheaply than can the average individual. Borrowing and lending rates are the same.
a. Gordon Dividend growth model basis The annual rate of dividend growth (for the current year) is calculated as: (Dividend of current year dividend of previous year)/dividend of previous year. Using the assumption of a compound annual growth rate, as in Gordons model, then: DKNY = Dl(1+g)n1
According to the Gordon dividend growth model
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D1 = 0.28 (1 + 0.1256) 0.3152 (i.e. next years dividend) P0=3.47 028 = 3.19 (i.e. the current ex-dividend price per share) i = (0.3152/3.19) + 0.1256 = 0.2244 or 22.44% Capital asset pricing model basis Eri = rf + i (Erm rf) where Eri, rf, i(Erm rf) are respectively the expected return from a particular security i, the risk free rate, the beta of a particular security i and the expected return from the market portfolio Eri = 0.10 + 0.9(0.18 0.10) = 0.172 or 17.2% b. The fact that the figures obtained using these two bases are different should be a cause for concern. Both approaches are theoretically valid and should, therefore, produce the same result. This and other reasons, set out below, should cause management to view the results with some scepticism. Other relevant points include the following: The inputs, which have been used for both models, are based on historic data. The business is seeking a future cost of capital and should use estimates of the future in the analysis. The past may provide a useful guide as to that which is likely to happen in the future, but it is illogical to presume that the past will be precisely replicated in the future. Inflation is incorporated into the analysis, which makes the assumption that it will continue at the same rate as it has done historically. The annual figures for past dividend growth are a little erratic, which raises doubts about using them as a guide for the future. Is the quoted company (James plc) really comparable with Aspirations plc? They may operate in the same industry and be of similar size, but they could, nevertheless be profoundly different in other significant ways, for example the level of capital gearing. The rates used in CAPM look to be incompatible as regards the treatment of taxation, whereas the expected return from the market is almost certainly an after-tax figure, the risk free rate looks as if it is a gross figure.
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a. Forecast profit and loss accounts Current policy 000 Sales Cost of sales (75% sales) Gross profit (25% sales) Less Variable costs (15% sales) Fixed costs Discounts allowed [2%(50% 4.4m)] Net profit before taxation Corporation tax (30%) Net profit after taxation Dividend (60%) Retained profit b. Investment in working capital Current policy 000 Stock (3m 2/12) (3.3m 2/12) Trade debtors [25% 4m 1/12) + (75% 4 2/12) [(50% 4.4m 1/12) + (50% 4.4m 2/12) Cash Trade creditors (3m 2/12) (3.3m 2/12) Accrued expenses fixed variable (600 1/12) (660 1/12) Taxation due Dividends due Working capital 48 67 685 448 50 55 47 65 737 413 20 20 500 550 50 1,133 583 550 50 1,150 500 550 000 Cash discounts 000 000 600 240 840 160 48 112 67 45 660 240 44 944 156 47 109 65 44 000 4,000 3,000 1,000 Cash discounts 000 000 4,400 3,300 1,100
The calculations reveal that the proposed policy to introduce cash discounts will lead to a marginal decline in profitability in the forthcoming year. The benefits of increased sales to the business are more than offset by the cost of the cash discounts. The proposed policy leads to a slight reduction in working capital. This is largely because the increase in stocks are more than offset by the decrease
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in debtors and the increase in trade creditors. However, this change does not compensate for the decline in profitability. On the basis of the calculations above, it does not seem sensible to adopt the cash discount scheme.
a. To obtain the asset beta necessary for the calculation of the required rate of return to be used in the evaluation of a major physical investment requires a number of steps. The rate needed is that one appropriate for the risk class of the investment under investigation. Starting with the equity beta of a company; 1. Is the company a geared company? No, then equity beta is average asset beta for the company. Yes, Derive weighted average beta for the company using market values of debt and equity as weights for the debt and equity. To do that requires estimates of equity and debt betas. 2. Using the values for the market rate of return and the riskless rate, the equity and debt betas and the market values for the equity and debt the companys WACC can now be calculated. (See text) 3. If the company is a single industry company then its asset beta is the same as weighted average beta, thus WACC is the required rate of return. 4. If the company is investing in a new commercial area then it will have to go to the market and find a company with the appropriate beta and return for that risk class. Thus knowing its own equity values will be of no use. 5. If the company has a portfolio of investments in a different risk class then use the following formula to solve to find the required rate.
Where: rd id the desired rate of return, ri is the return of the risk class i of which the company has no divisions MVi is the market value of the ith division MVd is the market value of the division d which wants to make the investment TMV is the Firms total market value. b. So if the company is a single industry company then the WACC will be the asset beta, and thus the company will need to calculate its equity and debt betas and then weight them as above. The equity beta and debt beta can be calculated separately using regression analysis on time series data of the price relatives of the companys equity and debt with the market index movements. In practice they are available from brokers. There are weaknesses in the model used to derive the s and thus the cost of capital, but in general the rates obtained are accurate enough for practical use. Remember that the s are actually single period estimates, the quality of their estimates may be poor, (i.e. low r2) and the estimates
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could vary from one time period to the next. Then there is the decision of selecting the appropriate riskless rate and market index bearing in mind they vary daily and there is more than one market index. What this means is that there is a range of rates that one can choose from. The range is probably not too wide and is no more error prone than the figures estimated for the investments cash flows. c. The conceptually sound method of evaluating a group of investments is to use the portfolio approach where one combines the expected returns and standard deviations of the group of projects with those of the existing portfolio of assets. The optimal combination is the one that provides the highest return R at the companys risk level. If assessing the investments individually then one can compute their expected NPVs, standard deviations and coefficient of variations. This allows for risk but not the benefits arising from diversification. A third way is to use the three point estimate approach, where the NPV for each project is calculated under three environments, worst possible, most likely and best possible. Then one selects, using rule of thumb, since the projects results will not necessarily be straightforward to assess. Finally one can use sensitivity analysis which will give the company an indicator as to which of the variables, sales, costs, etc. are the most sensitive and thus the ones that need most careful management. Moving away from the world of certainty means that there are no hard and fast decision rules which will ensure you select the optimal mix of investments.
a. The following are techniques a company can use to protect itself from adverse foreign exchange movements. The simplest technique is for a company to trade solely in its own currency, so transferring the risks to its customers or suppliers. This depends on its competitive situation as to whether it can use that approach. The matching technique whereby assets and liabilities in a particular currency are netted off and any difference between the two kept as small as possible. The company can use the forward market contracts, either buying or selling the currency forward at the contracted rate, thus locking the company into a given future payment for the future contracted date. Buying foreign currency options is a fourth way, with the buyer acquiring the right to sell (put option) or buy (call option) a certain amount of a currency at a fixed rate on some future date. They are a form of insurance in that if the rates move favourably then the option can lapse and they can take advantage of the new favourable rate, otherwise the company avails itself of its option. The company can use the financial future exchange and buy foreign currency futures. Futures are effectively forward contracts in standard sizes with fixed maturity dates. They are usually sold before maturity since their prices move in response to forex price movements. The profit or loss on sale will correspond approximately to the loss or profit on the currency transaction they were hedging.
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A further way is to use the money market hedge. This is where one currency is borrowed, converted into another which is invested to earn sufficient by the end of the original period to pay off the due debt in that currency. The early conversion is undertaken to provide the protection against adverse exchange rate movements, with the cost of protection being the difference between the cost of borrowing in one and the returns of investing in the other currency. (Note: More than the requested four answers were given in order to provide an indication of the majority of options, rather than to provide an answer that precisely fits the requirements, since this is a subject guide.) The size of the debt, the frequency of the foreign trades, the degree of hardness in the currency of the trades, the variety and range of currencies used, as well as the level of market efficiency will influence the size and sophistication of the organisation used by a company; thus influencing the choice of techniques used. b. i. There are two ways to present the evidence on whether or not the market appears to be in equilibrium. One is to compute the values in accordance with the basic equations: whether or not
The second method, which will be used here since it helps with the answer to the second part of the question is to see if it pays to borrow a unit of currency in one country, convert it, invest the conversion then reconvert the accumulated principal and interest. The reconverted amount should just equal the amount to be repaid if equilibrium holds. 1. Borrow S$1 in Singapore and invest proceeds in USA, then repatriate. Proceeds of Investment Cost of Borrowing
= 0.9549 1.0178 = S$0.0629 (loss) 2. Borrow $1 in USA and invest proceeds in Singapore then repatriate.
= 1.0775 1.0275 = $0.05 (Gain) 3. Borrow 1 in UK and invest in USA then repatriate.
= 1.0307 1.0275 = $0.0032 (Gain) 4. Borrow $1 in USA and invest in UK then repatriate.

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=1.03071.0275 =$0.0032 (Gain)
The computations suggests that the market is close to equilibrium except when one borrows in the USA and invests in Singapore, since traders cannot make material gains through arbitrage except through that one combination. ii. If the bank will lend up to $100,000 then the gain to be made by borrowing $100,000, converting it at S$2.1378, investing at 4% p.a., for three months and selling forward the proceeds at the forward rate of S$2.0039 should give a $5,000 gain, a gain of 5%. From answer 2 above, gain for $1 = $0.05, therefore Gain 100,000 $0.05 = $5,000 Proof:
= $5,000 Gain
a. Incremental cash flows 0 000 Sales Equipment Wages Recruitment & selection costs Overheads Disposal cost savings Cost of chemical XT3 Cost of chemical ZF6 (94) b. Net present value 0 Incremental cash flows Discount factor (12%) Present value Net present value (94) 1.00 (94.00) 36.6 1 116 0.89 103.20 2 26 0.80 28.80 3 (2) 0.71 (1.42) 6 (60) (200) 116 (120) (200) 36 (120) (200) (2) (15) (40) (40) (40) (85) (200) (200) 1 000 616 2 000 616 3 000 616 6 (242)
c. The calculations in (b) above reveal that the offer has a positive net present value. Acceptance of the offer would, therefore, increase the wealth of shareholders in Atlanta Ltd. However, the margin of safety relating to the offer is relatively low and further analysis to deal with the problems of risk and uncertainty would be prudent before a final decision is made. d. When identifying relevant costs and benefits the following principles should be applied: Differential costs and benefits (i.e. those costs and benefits which vary as a result of the decision) should be taken into account whereas costs which are independent of the decision should be ignored. Thus, for example, the additional overheads (40,000) resulting from the decision to accept the contract will be included in the analysis whereas those overheads reallocated (20,000) will be ignored as they will have to be paid whether or not the offer is accepted.
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Past costs are irrelevant to the decision to accept the offer. No decision can be taken to alter the past and, therefore, only future costs are relevant. This means that the cost of stock already acquired by the company is irrelevant whereas the (future) replacement cost of the stock is relevant. Only costs and benefits which can be expressed in cash terms should be taken into account. Thus, the fact that successful execution of the contract may result in further benefits accruing to the company may be taken into account only if it is possible to quantify the expected benefits in cash terms.
1. Since only (100 82) (i.e. 18% of the market sales are purchased by customers with ratings of 60 and above) then, since Dewstone can only achieve 25% of that slice of the market, the Dewstone sales can only be .18 .25 1 million(i.e. 45,000 units). Contribution per unit is 20 11, 9. All bad sales (i.e. (29 28)% 25% of 1 million) will cost the company 20 per unit of lost revenue (i.e. 2,500 units). Thus 180,000 is the correct net profit. 2. By computing the profit before fixed costs we can assess the optimum credit policy. Points rating 019 039 059 079 01000 Cum. % sales 11 40 82 95 100 Dewstone Sales (000) 27.5 100 205 237.5 250 Good Sales Bad Sales (000) (000) 5 37.5 135 165 177.5 22 62.5 70 72.5 72.5 Contribution (000) 247.5 900 1845 2137.5 2250 Bad debt Expense (000) (450) (1,250) (1,400) (1,450) (1,450)
Net profit cum. (000) (202.5) (350) 445 687.5 800
Incremental profit/class (000) (202.5) (147.5) 795 242.5 112.5
Note that sales to customers of rating 39 and below make losses, and sales to customers in each of the three rating classes 4059, 6079, 80100 make incremental profits therefore the optimum credit policy is to restrict sales to customers with rating of 40 or better and a net profit of 975,000 will be achieved. Sales Less Less 150K units @ 20 variable costs @ 11 contribution overheads Administration, etc Bad debts (10K@20) 175,000 200,000 375,000 975,000 3,000,000 1,650,000 1,350,000
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Appendix 3: Sample examination paper

Important note: This Sample examination paper reflects the examination and assessment arrangements for this course in the academic year 20102011. The format and structure of the examination may have changed since the publication of this subject guide. You can find the most recent examination papers on the VLE where all changes to the format of the examination are posted. Time allowed: three hours Candidates should answer FOUR of the following NINE questions: TWO from Section A, ONE from Section B and ONE further question from either section. All questions carry equal marks. Workings should be submitted for all questions requiring calculations. Any necessary assumptions introduced in answering a question are to be stated. Extracts from compound interest tables are given at the end of Section A of the paper. 8-column accounting paper is provided at the end of this question paper. If used, it must be detached and fastened securely inside the answer book. A calculator may be used when answering questions on this paper and it must comply in all respects with the specification given in the Regulations. The make and type of machine must be clearly stated on the front cover of the answer book.
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SECTION A
Answer two questions from this section and not more than one further question. (You are reminded that four questions in total are to be attempted with at least one from Section B.) 1. Splott Engineers Limited manufacturers components for the car industry. It is considering automating its line for producing crankshaft casings. The automated equipment will cost $350,000. It will replace equipment with a scrap value of $25,000 and a book written-down value of $90,000. At present the line has a capacity of 650,000 units per annum but typically it has only been run at 80% of capacity because of the lack of demand for its output. The new line has a capacity of 750,000 units per annum. Its life is expected to be 5 years and its scrap value at that time $50,000. The accountant has prepared the following cost estimates based on output of 500,000 units per annum. Old line (per unit) c Materials Labour Variable overheads Fixed overheads Selling price Profit per unit 40 22 14 44 120 150 30 New line (per unit) c 36 10 14 20 80 150 70
Fixed overheads include depreciation on the old machine of $20,000 per annum and $60,000 for the new machine. It is considered that for the company overall, fixed overheads are unlikely to change. The introduction of the new machine will enable stocks to be reduced by $80,000. The company uses 10% as its cost of capital. You should ignore taxation. Required: a. Prepare a statement of the incremental cash flows arising from the project. (8 marks) b. Calculate the projects net present value. (2 marks) c. Calculate the projects approximate internal rate of return. (3 marks) d. Explain the terms net present value and internal rate of return. Discuss which method you consider to be preferable and under what sets of circumstances. (7 marks) e. Briefly describe one way how the above analysis could be extended to incorporate a treatment of risk. Give a brief critique of the method you have selected. (5 marks) 2. Your client is the owner of a small group of hotels. He is near retirement and he would like to sell some of his shares in the company and then also to raise further equity to reduce its gearing. He understands that one way to do this, is to seek a quotation on the unlisted securities market. An extract of some recent accounts of the company appear below.
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Profit and loss data 31.12.08 million Sales Profit before interest and tax Interest Profit before tax Taxation Profit after taxation Retained Balance sheet data Fixed assets Less: Depreciation Current assets Stock Debtors Cash Less creditors (Amount due in under 1 year) Trade creditors Taxation Dividends Net current assets Total assets less current liabilities Less: Loans (due in over 1 year) Net assets Capital and reserves Share capital* Reserves * 5p shares Profit before tax for 2009 is forecast at 6.1 million and after tax at 3.3 million. Similar hotel groups have price earnings ratios of approximately 17 times and dividend yields of approximately 4%. If the group went public, it would anticipate paying out 2/3rds its income as dividends. An analyst forecasts the free cash flow of the company to be: 2010 millions 6.9 2011 7.4 2012 7.8 2013 8.4 2014 8.7 201530 9.3 1.8 1.8 0.3 3.9 4.2 47.7 31.2 16.5 1.5 1.5 15.0 16.5 1.8 1.8 0.3 3.5 1.8 36.3 22.4 13.9 1.5 1.5 12.4 13.9 2.0 6.1 0.0 8.1 1.5 3.9 0.0 5.4 54.0 10.5 43.5 43.5 9.0 34.5 36.8 8.6 3.9 4.7 2.9 0.3 2.6 31.12.07 million 33.1 7.1 3.9 3.2 1.8 0.3 1.5
The companys cost of capital is 12% net of tax. A surveyor has recently valued the fixed assets of the group at 93 million.
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Required: a. Calculate the value of one 5p share in the company on each of the following bases, commenting on the practical and theoretical merit of each basis used. i. Net assets ii. Prospective price earnings ration iii. Dividend yield iv. Free cash flow (4 marks) (4 marks) (4 marks) (4 marks)
b. Select the share price from the above calculations at which the companys shares should be issued, with your reasons for selection. (6 marks) c. Calculate how many shares need to be issued to reduce the companys gearings so that it has the same amount of long-term debt as equity. (3 marks) 3. Osmond Limited is a small company to be formed by Conny and Winnie Bond to sell an exclusive range of furnishings from a boutique in a fashionable suburb of London. In January 2008 they plan to invest 100,000 cash to purchase 50,000 1 shares each in the company. Of this 60,000 is to be invested in new fittings in January. These fittings are to be depreciated over 3 years on the straight-line basis (their scrap value is assumed to be zero at the end of their lives). A half-years depreciation is to be charged in the first six months. The sales and purchases forecast for the company are as follows: Jan 000 Sales Purchases Other costs* 20.4 40.0 18.0 61.2 60.0 18.0 61.2 50.0 18.0 81.6 50.0 18.0 81.6 60.0 18.0 102.0 60.0 18.0 408.0 320.0 108.0 Feb Mar Apr May June Total
* These include wages but exclude depreciation. The sales will all be made by credit card. The credit card company will take one month to pay and will deduct its fee of 2% of gross sales before paying amounts due to Osmond Limited. One months credit is allowed by suppliers. Other costs shown above do not include rent and rates of 20,000 per quarter, payable on 1 January and 1 April. All other costs will be paid in cash. Closing stock at the end of June is expected to be 116,000. You should ignore taxation. For your convenience you are advised to work to the nearest 000. Required: a. Prepare a cash forecast for each of the six months to 30 June 2008. (8 marks) b. Prepare a forecast profit and loss account for the same period. (5 marks) c. Prepare a forecast balance sheet at 30 June 2008. (5 marks) d. Comment briefly on the financial prospects of Osmond. You should refer both to its profitability and liquidity. (7 marks)
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4. Trilley Building Supplies Ltd has an annual turnover of 25 million before taking into account bad debts of 150,000. All sales made by the company are on credit and, at present, credit terms are negotiable by the customer. On average. the settlement period for trade debtors is 60 days. The company is currently reviewing its credit policies to see whether more efficient and profitable methods could be employed. Two major proposals have so far been put forward concerning the management of trade credit. These are as follows: Proposal A The credit control department has proposed that customers should be given a 2.5% discount if they pay within 30 days. For those who do not pay within this period, a maximum of 50 days credit should be given. The credit department believes that 60% of customers will take advantage of the discount by paying at the end of the discount period and the remainder will pay at the end of 50 days. The credit department believes that all bad debts can be effectively eliminated by adopting the above policies and by employing stricter credit investigation procedures costing an additional 50,000 per annum. As less time will be spent chasing debtors, savings of 60,000 in the credit control administration can be made if the new policies are adopted. The credit department are confident that these new policies will not result in any reduction in sales. Proposal B The company is also considering whether it should factor its trade debts. The accounts department has recently approached a factoring company which has agreed to provide an advance equivalent to 80% of trade debtors (based on an average settlement period of 40 days) at an interest rate of 12%. The factoring company will undertake collection of the trade debts and will charge a fee of 2% of sales turnover for this service. The factoring service is also expected to eliminate bad debts and will lead to credit administration savings of 130,000. The settlement period for trade debtors will be reduced to an average of 40 days, which is equivalent to that of its major competitors. The company currently has an overdraft of 5.2 million at an interest rate of 14% per annum. The bank has written recently to the company stating that it would like to see a reduction in the overdraft of the company. Required: a. Calculate for each proposal the net annual cost (savings) to the company of changing its existing credit policies and either i. adopting the proposals of the credit control department (10 marks) or ii. factoring the debts of the company. (10 marks) b. Explain which of the two proposals (if either) you would support and why? (5 marks)
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SECTION B
Answer one question from this section and not more than one further question. (You are reminded that four questions in total are to be attempted with at least two from Section A.) 5. a. Securities can be issued using the following methods: i. Offer for sale ii. Rights issue iii. Tender issue Describe briefly each method and state where its use might be appropriate. (12 marks) b. Describe two methods whereby a company may estimate its costs of equity capital. What are the advantages and limitations of each method? (13 marks) 6. a. Some authorities maintain that the dividend payout ratio is unimportant. However press comments suggest otherwise. Discuss why these authorities believe the dividend payout ratio to be irrelevant and give your own views on this matter. (12 marks)
b. Accountants place considerable emphasis on profit when reporting results to shareholders. However for assessing the viability of capital projects cash flow forecasts are used. Explain and evaluate this apparent anomaly. (13 marks) 7. Assume a quoted British company wants to use the CAPM approach in deriving the hurdle rate (cost of capital) it will use in evaluating its major investments. Describe and discuss the problems the company faces in trying to achieve the use of a single period empirically determined and market based hurdle rate. (25 marks) 8. Describe and discuss the relevance of the Fisher Effect and the Purchasing Power Parity theories to a foreign currency dealer in a merchant back in London (25 marks) 9. Discuss why, in your view, the stockmarkets of the world will never achieve th strong fom of the efficient market hypothesis. (25 marks) END OF PAPER
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Financial Management Subject Guide

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Financial Management Subject Guide

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Financial management

J. Dahya, R.E.V. Groves

Undergraduate study in Economics, Management, Finance and the Social Sciences

Aims and objectives

Studying financial management

Online study resources

Making use of the Online Library

How to use the subject guide

Solutions to learning activities

Chapter 1: Introduction to financial management

Chapter 1: Introduction to financial management

Key tasks of financial management

Chapter 1: Introduction to financial management

Organisational forms of business

Conflicts of interest and their resolution

Chapter 1: Introduction to financial management

Financial management and risk

Financial management and accounting

Financial management and taxation

A reminder of your learning outcomes

Chapter 1: Introduction to financial management

Chapter 2: Basic investment appraisal methods

Chapter 2: Basic investment appraisal methods

Time value of money

Future value and compounding

Present value and discounting

is the discount factor.

Chapter 2: Basic investment appraisal methods

Interest rates, discount rates and real rates

Basic investment appraisal techniques

Total 17,500 4,000

Payback (Years) ARR(%)

Chapter 2: Basic investment appraisal methods

Application problems some considerations

Chapter 2: Basic investment appraisal methods

= (4.775/5) 100 = 95.5% = 0.28

Chapter 2: Basic investment appraisal methods

A reminder of your learning outcomes

Sample examination questions

Practise question 2.1

Chapter 2: Basic investment appraisal methods

Chapter 3: Introduction to risk and return

Chapter 3: Introduction to risk and return

Rate of return: a review

Chapter 3: Introduction to risk and return

Cash returns for investment

Cash to buy shares

Cash to undertake projects

See VLE for solution

Calculating expected return, variance and standard deviation

Equations Expected return = Variance = Standard deviation = variance.

Chapter 3: Introduction to risk and return

Risk and diversification

Return on share % Share A Share B

0.2 0.6 0.2

65 35 20 30 760 27.6 0.92

30 10 10 10 160 12.6 1.26

0.5(20) + 0.5(10) = 15.0 20 400 20 1.0

Chapter 3: Introduction to risk and return

Market risk versus unique risk

A reminder of your learning outcomes

Chapter 4: Capital budgeting risk and return

Chapter 4: Capital budgeting risk and return