Kwame Nkrumah University of

Science & Technology, Kumasi, Ghana

ACF 366: FINANCIAL MANAGEMENT

Kwasi Poku
Accounting and Finance
KNUST School of Business
College of Humanities and Social Sciences
 Course Outline:
1. An overview of Financial Management
• The flow of funds within a firm

• Role of financial management

• Financial Decision and forms of Business

Enterprise

• The goal of the firm and the agency problem

• The financial system in Ghana

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2. Determining the cost of capital
using the Dividend Based Approach
• Ordinary Shares
• Preference Shares
• Loan Capital
• The Weighted Average Cost of Capital
(WACC)
• Limitations of the WACC
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3. Introduction to the Capital
Structure Debate
• The Traditional View of Capital Structure

• Implications of the traditional View

• The Modernist view of the Capital

Structure and its implication(M&M view)

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4. An introduction to the Dividend
Policy Debate
• Dividend Policy and Shareholders Wealth
• The Traditional View of Dividend Policy

• The Modernist (M&M) view on Dividend

policy

• The importance of dividends

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5. Mergers and Takeovers ( Acquisitions)

• Rational for mergers

• Forms of purchase consideration

• Assessing Vulnerability to takeover

• Resisting a takeover bid

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6. Capital Asset Pricing Model (CAPM)

• The relationship between risk and return

• Using the CAPM to estimate the required
returns to ordinary shareholders

• Estimating the variables in the CAPM

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 Recommended Reading
1. Atrill, P. (2003). Financial Management for
Non-Specialists. 3rd edition. Pearson Education
Limited, Essex, U.K.

2. Arnold, G. (2002). Corporate Financial

Management. 2nd Edition. Financial Times/
Prentice Hall/ Pearson Education. Essex, U.K.

3. Brealey, R.A, Myers S.C and Allen F. (2006).

Corporate Finance. 8th Edition. McGraw Hill.
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Cont’d
4. Watson, D. and Head, A. (2010). Corporate
Finance: principles and practice. 5th Edition.
Financial Times/ Prentice Hall/ Pearson
Education Limited. Essex, U.K.

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 CHAPTER ONE

An overview of Financial
Management

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 INTRODUCTION
• This course focuses on the management
of the financial resources of a business
firm.
• Financial management in a business
setting or corporate finance means the
efficient management of the flow of
funds within a business enterprise.

• The key aspects of the definition are

“efficient” and “flow of funds”.
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Cont’d
FLOW OF FUNDS
➢Firms receive funds from various sources
and allocate the within the firm.

➢Inflows include cash flows from:

• Investors in company’s share
• Creditors who lend money
• Earnings
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Cont’d
➢Outflows: if the financial officer of a
large corporation has excess cash, he will
in all probability be looking for the best
way of using the excess cash.

➢Among the possibilities you might

consider:
• Invest in new project or expand/upgrade
• Invest in financial assets (e.g. treasury
bills)
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Cont’d
• Repay debt
• Pay a dividend

Outflows represent the use of funds for:

1. Acquisition of Fixed Assets
2. Working Capital (stocks, debtors accounts
receivables, short-term investments)
3. Dividends, loan repayments and interest
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Cont’d

➢From a balance sheet perspective,

corporate finance is about managing the
“sources” (primary liabilities and
shareholders equity and the “uses” (the
asset side of the balance sheet)

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Cont’d
➢Cash received by selling securities (bonds
and shares) to investors. (source)

➢Cash invested in the firm’s operations and

used to purchase assets. (use)

➢Cash generated by the firm’s operations.

(source)
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Cont’d

➢Cash reinvested .(source)

➢Cash returned to investors. (use)

➢Cash paid in taxes. (use)

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 ROLE OF FINANCIAL MANAGEMENT
➢Three principal tasks of the financial
manager:
• Analyze and plan the company’s
performance;
• Acquire the funds the company needs;
• Allocate funds to acquire the most
profitable assets.

➢These responsibilities are called the

three As of financial management.
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 ANALYSE AND PLAN

➢It is important for management to know

where the company is now and where it
wants to be in the future.

➢The financial manager gives management

and investors an assessment of the
company’s current position and the
financial consequences of alternative
courses of action.
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Cont’d

➢This involves analytical work that leads

to:
• Income statement

• Balance sheet

• Pro-formal financial statements

• Capital budgeting
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 ACQUISITION OF FUNDS
➢This is also called the “financing
decisions”. Acquiring funds involves the
complex question:

➢What are the appropriate proportions of

debt and shareholders equity in the
capital structure of the firm?

➢This is called the optimal capital

structure. www.knust.edu.gh
Cont’d

➢The financial manager needs to know the

principal securities that may be used
(shares, debt, preference shares) and the
condition under which any particular mix
of financing instruments is optimal.

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 ALLOCATION OF FUNDS
➢Allocation of acquired funds require that
the financial manager make investment
decisions. This include:
• Capital budgeting- investment in long-
term assets such as buildings and
equipment

• Working capital management

(management of short-term assets –
stocks, debtors, cash and short-term
securities) www.knust.edu.gh
 FINANCIAL DECISIONS AND FORMS OF
BUSINESS ENTERPRISE
➢The financial management function is
performed in all organizations, regardless
of the form of organisation or size.

➢However the scope of the financial

management function changes significantly
from one form of business organisation to
another.
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 Three main forms of business
organization:

1. Sole Proprietorship

2. Partnership

3. Limited Liability Company

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Factors that differ among the forms
of business organization are:

a) How the firm is taxed

b) The liabilities of the owners

c) The degree of control that owners may

have on the on the decisions of the firm

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Cont’d

d) The ease with which ownership interest

may be transferred

e) The ability to raise additional funds

f) The longevity of the business

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Cont’d
1. Sole proprietorship
➢A business that has a single owner who
usually provides all the capital from
personal resources.

➢Banks, friends and relatives are the

primary sources available to the sole
proprietor for raising borrowed funds.

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Cont’d
2. Partnership
➢An agreement between two or more
persons to operate a business.

➢The partners are ‘jointly’ and ‘severally’

responsible for the debts of the
partnership.

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Cont’d
3. Limited Liability Company
➢An independent legal entity.

➢It can enter into contracts and carry out

business under its own name
independently of the owners of the
business.

➢Ownership interest is called equity.

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Cont’d
➢As a firm grows and needs to access
capital markets to raise funds, the
advantages of the limited Liability
company begin to dominate.

➢Because of the ease of transferring

ownership through the sale of shares and
the flexibility in dividing the shares,…

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Cont’d
➢…the limited liability company is the
ideal business entry in terms of raising
new capital.

➢In contrast, the unlimited liabilities of

both the sole proprietorship and
partnership are deterring to raising
equity capital.

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 Finance in the organizational
structure of the firm
➢ How is the firm organized to carry out the
finance function?

➢ As financial markets develop, the functions

of the financial manager change.

➢ In the future, as financial markets develop,

finance will play an ever more strategic role
within corporations in Ghana.
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Cont’d
➢The Chief Financial Officer (usually with
the title of Director of Finance) is likely
to emerge as a team player in creating
value for shareholders.

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THE GOAL OF THE FIRM AND THE AGENCY
PROBLEM

➢A financial decision is efficient if it is

consistent with the goals of a firm.

➢Identifying the appropriate goal of the

firm will help us to better understand the
role and significance of financial
decision-making within the firm.

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Cont’d
Goal of the firm include:
• Shareholder wealth maximization

• Profit maximization, etc.

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Cont’d
➢The profit maximization objective,
however, create an unrealistic picture of
the real world. In particular, it leaves out
the following key factors:
• Uncertainty of returns

• The timing of returns

• The role of dividends

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Conclusion:
➢ The maximization of shareholders wealth
involves a modification of the profit
maximization motive to reflect the
complexities of the real world.

➢ It captures the effects of all managerial

decisions.

➢ Shareholders react to poor investment

decisions by selling their shares (causing
market value to fall) www.knust.edu.gh
Cont’d
➢ They also react to good decisions by buying
more shares (causing prices to rise)

➢ Thus, the market price of shares reflects

the value of the firm as seen by owners.

➢ It reflects uncertainty, timing, dividends

and any other factors that are of interest to
shareholders
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 THE AGENCY PROBLEM
➢ In a corporate setting, the shareholders are
the “principals” because they actually own
the firm.
➢ The board of directors, managing
directors, corporate executives and all
others with decision-making power are
agents of shareholders.

➢ In finance, the risk that management may

not act in the interest of shareholders is
called “principal-agent” or… www.knust.edu.gh
Cont’d
… “agency” problem.

➢ When managers subordinate the objective of

maximizing shareholder wealth to other
objectives, they create additional
monitoring expenditures such as:

i) Auditing systems to limit management

behaviour
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Cont’d
ii) Change in organizational systems to limit
ability of managers to engage in
undesirable practices (e.g. shuffling of
positions)

➢ The costs associated with managerial

behaviour that is against the interest of
shareholders are called “agency costs”.

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THE FINANCIAL SYSTEM IN GHANA

➢ The financial environment in Ghana changed

dramatically in the 1980’s and accelerating
rapidly, we have seen deregulation of the
financial services industry in Ghana.

➢ Removal of interest rate controls and

sector allocation of lending has increased
competition among banks and other
suppliers of capital.
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Cont’d
➢ At the same time, we are experiencing for
the first time, an environment characterized
by considerable volatility interest rates.

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 IMPORTANCE OF FINANCIAL
MARKETS
➢ Financial markets are the institutions and
procedures that companies use to raise
monies for investment.
➢ The market brings together savers and
users of funds

➢ For example, an individual whose income

exceeds his expenses in any particular year
is a net saver.
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Cont’d
➢ To obtain funds, a firm must offer the
provider of funds a rate of return that is
competitive with the next best alternative.

➢ The rate of the next best investment

alternative is the supplier’s opportunity
costs of funds.
➢ That is, the funds provider would not lend
to a firm at 12% if they could buy a Ghana
Government Stock for 28%. Therefore, the
opportunity cost is 28%.
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 FINANCIAL INTERMEDIATION
➢ Institutions or companies that act as a link
between surplus and deficit units are
collectively known as financial intermediaries.

Such financial intermediaries include:

a) Commercial banks
b) Merchant banks
c) Insurance companies
d) Pension Trusts
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Cont’d
e) Discount houses

➢ Other financial intermediaries existing in

Ghana include:
• Mortgage finance companies

• Leasing companies

• Finance houses
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Cont’d
➢ Role of financial intermediaries in
channeling funds from cash surplus to cash
deposit organizations are:
a) Allocation of resources

b) Signals and targets for financial managers

etc.

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 EFFICIENT MARKET AND THE
DETERMINANTS OF SHARE PRICE

➢ In an efficient capital market, information is

quickly and accurately reflected in security
prices so that share prices reflect the
expected earnings and the risk of the firm.

➢ By this, the market is protected from the

activities of speculators and arbitragers.

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Cont’d
➢ Items of information that affect share
prices in an economy:
a) The government announces new tax
measures

b) A company announces a new products

c) A company releases a new product

d) A company announces higher dividends

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 Cont’d
➢ Factors that affect efficiency of markets
include:
a) Rules and regulations

b) Trading arrangements

c) The technology of information dissemination

competitiveness of the brokerage/dealer/issue

house industry
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Cont’d
➢ The share price of a company is the result of
the interaction of 3 basic forces that
operate on the cash flows of a firm.

➢ These include:
a) Size

b) Risk

c) Timing
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 Example:
➢ At the end of Dec. 1997, Guinness Ghana
Limited shares closed at ¢650 per share.
During 1998, the co. paid dividends of
¢39.94 per share. The share price at the end
of 1998 was ¢800. If you bought Guinness
shares in Dec. 1997 and sold them in Dec.
1998, your one-year return is 29.22%.

➢ Formula; rate of return = selling price –

buying price + dividends
buying price www.knust.edu.gh
 END OF CHAPTER ONE

Lecture notes compiled by: K. Poku

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 CHAPTER TWO

Determining The Cost of Capital

Using The Dividend Based
Approach

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 THE COST OF CAPITAL
Introduction:
➢ When appraising investment opportunities,
the cost of capital has an important role to
play.

➢ As we saw in our Business Finance lessons,

the cost of capital is used as the
appropriate discount rate for NPV
calculations.

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Cont’d
➢ In this lesson we will examine the way in
which the Cost of Capital may be computed.

➢ After this examination, we will then look at

the factors that should be taken into
account when making Capital Structure
Decisions, and in particular, the impact of
gearing on the risks and return to the
shareholders.

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Cont’d
➢ As investment projects are normally
financed from long–term capital, the
discount rate that should be applied to new
investment projects should reflect the
expected returns required by the providers
of the various forms of capital.

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Cont’d
➢ From the view point of the business, these
expected returns by investors will
represent the cost of capital that it
employs.

➢ This cost is an opportunity cost as it

represents the return that investors would
expect from investments with a similar level
of risk.
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Cont’d
➢ The main forms of external long- term
capital for business as follows:
a) Ordinary shares

b) Preference shares

c) Loan capital

➢ In addition, an important form of internal

long- term capital is:
• Retained profit
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 COST OF EQUITY:
ORDINARY SHARES
➢There are two major approaches to
determine the cost of Ordinary Shares to
a business:

i) Dividend Based Approach

➢Investors hold assets (including Ordinary
Shares) in the expectation of receiving
future benefits.
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Cont’d
➢ In broad terms, the value of an asset can be
defined in terms of the stream of future
benefits that arise from holding that asset.

➢ When considering Ordinary Shares, we can

say that the value of an Ordinary share can
be defined in terms of future dividends
that investors receive by holding the
share.

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Cont’d
➢ To be more precise, the value of an
Ordinary share is equal to the Present
value of future dividends discounted at
the shareholders’ rate of return.

➢ Share Price = Present Value of the Future

Dividend Stream.

➢ In mathematical terms, the value of an

Ordinary Share (Po) can be expressed as
follows;
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Cont’d
Po= D1 + D2 + D3 + ……. Dn
(1+Ko ) (1+KO)2 (1+Ko )3 (1+Ko)n

Where:
Po= the current market value of the share
D= the expected future dividend in years 1 to n
n = the number of years over which the business
expect to issue dividends
Ko= the cost of Ordinary Shares to the business
(that is the required returns for investors).
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Cont’d
➢ Assuming we know the value of an ordinary
share and the expected future dividends,
the cost of the Ordinary Share will be the
discount rate when applied to the
stream of the expected future
dividends, will produce a present value
that is equal to the current market
value of the share.

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Cont’d
➢ Thus the required rate of return for
Ordinary Share investors (that is the cost
of Ordinary Shares to the business) is similar
to the Internal Rate of Return (IRR) that is
used in evaluating investment projects.

➢ Problems arise when trying to predict the

pattern of future dividend stream from an
Ordinary Share. As a result of these
problems, two simplifying assumptions are
employed:
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Cont’d
a) The first assumption is that dividends will
remain constant over time. With this
assumption , the fairly complicated equation
above can be reduced to:
Po= Do
Ko
➢ This equation can be rearranged to provide an
equation for deducing the cost of ordinary
share to the business. Hence:
Ko = D o
Po
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Cont’d
Key:
Do= Constant Dividend from year 1 to infinity.

Po= Share Price now/ year 0

Ko= Shareholders required return, expressed as

a decimal.

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Cont’d
Example 1:
• A company has paid a dividend of 20Ghp for
many years. The company expects to
continue paying dividends at this level in the
future. The company’s cost of equity is
12%. Calculate the market value of the
share.

• Solution
Po= Do = 0.20 = Ghc1.67
Ko 0.12
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Cont’d
Example 2:
• OWADSS investments plc has Ordinary Shares
in issue that have a current market value
of Ghc2.20. The annual dividend to be paid
by the business in future years is expected
to be 40p. What is the cost of Ordinary
Shares to the business?
• solution
Ko = Do
Po
Ko = 0.40 = 0.182 or 18.2%
2.20
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Cont’d
b) The second simplifying assumption that
can be employed is that dividends will
grow at a constant rate over time.

➢ Where dividends are expected to have a

constant growth rate, the equation to
deduce the current market value of a share
shown above can be reduced to:

Po = D1 or Po = Do(1+g)
Ko-g Ko- g
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Cont’d
➢ Where g is the expected annual growth
rate. This equation can also be re-arranged
to provide an equation for deducing the cost
of Ordinary Share Capital.

➢ Hence:
Ko = D1 + g or Ko = Do (1+g) + g
Po Po

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Cont’d
Key:
g = constant rate of growth in dividends,
expressed as a decimal

Do= Current Dividend or dividend to be paid

shortly
D1 = Do × (1+g) dividend at the end of year 1.

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Example 3:
• KSP plc has ordinary shares in issue that
have a current market price of GHc 1.50.
The dividend expected for next year is
20Ghp per share and future dividends are
expected to grow at a constant rate of 3%
per year. What is the cost of the ordinary
shares to the business?

• Solution

Ko = D1 + g = 0.20 + 0.03
Po 1.50
= 0.163 or 16.3%
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 PREFERENCE SHARES
➢Preference Shares may be either
redeemable or irredeemable.

➢The annual dividends paid to Preference

Shareholders do not represent a tax
deductible expense for the business.

➢Thus the full cost of the annual dividend

payments must be borne by the business.
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Cont’d
➢ Where the rate of dividend on preference
share is fixed (that is, there is no right to
participate in additional profits), the
equation used to derive the value of
irredeemable preference share is again
similar to the equation used to derive the
value of Ordinary Shares where the
dividends remain constant over time.

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Cont’d
The equation for Irredeemable Preference
Share is:
Pp = Dp
Kp
Where;
Pp = the current market price of the
preference shares
Kp = the cost of preference shares to the
business
Dp = the annual dividend payments
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Cont’d
➢ This equation can be rearranged to provide
an equation for deducing the cost of
irredeemable preference shares.

• Hence, Kp = Dp
Pp

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Cont’d
Example 4
➢ K. Poku plc has 12% preference share in
issue with a nominal (par) value of Ghc1.
The shares have a current market price of
Ghc0.90 (excluding dividends). What is the
cost of the preference shares?

• Solution

Kp = Dp = 12 = 13.3%
Pp 90
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 COST OF DEBT
a) Loan Capital
➢Loan capital may be redeemable or
irredeemable i.e. the business is not
expected to repay the principal sum and
so interest will be paid indefinitely.

➢ Where the rate of interest on the loan is

fixed, the equation used to derive the value
of irredeemable loan capital is similar…
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Cont’d
• ...to the equation used to derive the value
of Ordinary Shares where the dividends
remain constant over time.

➢ The equation for the value of irredeemable

loan capital is: Pd = I
Kd

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Cont’d
Where:
Pd = the current market value of the loan
capital

Kd = the cost of loan capital to the business

I = the annual rate of interest

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Cont’d
➢ This equation can be re-arranged to provide
an equation to deducing the cost of loan
capital.

Hence: Kd = I
Pd

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Cost of Debt to the Company
➢ Companies get tax relief on their interest
payments, therefore the true cost to a
company is the after tax cost of debt.

➢ The after tax cost of loan capital will be:

KdAT =I(1-t)
Pd
Where t is the rate of corporation tax payable.
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 TECHNICAL SPEAK

1.The terms debentures, bonds, loan stock

and marketable debt, are used
interchangeably.

➢ Gilts are debts issued by government.

2. Debt is always quoted in 100 nominal

value blocks.
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Cont’d
3. Interest paid on debt is stated as a
percentage of the nominal value.

➢ That is the coupon rate, e.g. an 8% coupon

rate means that Ghc8 of interest will be
paid on Ghc100 nominal value block of debt.

➢ The coupon rate is fixed at the time of

issue, in line with the prevailing market
interest rate.
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Cont’d
4. The coupon rate is not the current cost of
debt.

5. The market value of debentures may

change daily.

➢ The main influence on the price of a

debenture is the general level of interest
rates, for debt of that risk and maturity.
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 TYPES OF DEBT
a. Fixed
1. Irredeemable (perpetuity)
2. Redeemable
b. Floating

Example 5
➢ Jalil and company plc has irredeemable loan
capital outstanding on which it pays an
annual rate of interest of 10%.
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Cont’d
➢ The current market value of the loan
capital is Ghc88 per Ghc100 nominal value
and the corporation tax rate is 20%.

➢ What is the cost of the loan capital to the

business?

Solution
Kd = I(1-t) Kd = 10(1-0.20) Kd = 9.1%
Pd 88 www.knust.edu.gh
Cont’d
Example 6
➢ A company has just issued an 8%
irredeemable debt. The required return by
the providers of debt is 10%. What is the
market value of the debt?

Solution
Pd = I = 0.08 Pd = 80
Kd 0.10
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Cont’d
Example 7
➢ A company has in issue 10% irredeemable
debt quoted at Ghc80 ex. interest. What is
the return required by the debt providers?

Solution
Kd = I = Ghc8 = 10%
Po 80

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Cont’d
Example 8
➢ PK plc has Ghc20m (i.e. total nominal value
from the balance sheet) irredeemable 12%
loan stock valued at Ghc90 ex. interest.
➢ The corporation tax rate is 31%. What is the
cost of debt and the total market value of
the debt?

Solution
Kd =I (1-t) = 12 (1-0.31) = 12(0.69) = 9.2%
Pd 90 90
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 Cont’d
b) Total Market Value of Debt
Total nominal value × Market value per Ghc100
block
100
Solution
20m × 90 = 18m
100

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 BONDS
➢ There are two types of bonds; irredeemable
and redeemable bonds.

➢ The cost of irredeemable bonds is

calculated in a similar way to that of
irredeemable loan capital. Since the interest
payment made on irredeemable bonds are
subjected to tax deductions, it will have
both a before and after tax cost of debt.
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• The before tax cost of irredeemable bonds
(Kib) can be calculated as follows; Kib = I
P
Where;
I =interest payment on irredeemable bonds
P= current market price of irredeemable
bonds.

The after tax cost of debt is then easily

obtained as; Kibt = I (1-t)
P
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Cont’d
➢ The cost of redeemable bonds can be
calculated using the bond yield
approximation model developed by
Hawawini and Vora (1982).

➢ Krb = I + (P – NPD)/n
P + 0.6(NPD – P)

www.knust.edu.gh
Cont’d
Where;
I = annual interest payment
P = face value
NPD = net proceeds from disposal (market
price of bond)
n = number of years to redemption

The cost of redeemable bonds after tax will

be; Krbt = Krb (1 – t)
www.knust.edu.gh
 WEIGHTED AVERAGE COST OF
CAPITAL (WACC)
➢ Once the costs of a company’s individual
sources of finance have been found, the
overall weighted average cost of capital
(WACC) can be calculated.

➢ In order to calculate the WACC, the costs of

the individual sources of finance are
weighted according to their relative
importance as sources of finance.
www.knust.edu.gh
Cont’d
➢ If we accept that a business will maintain a
fairly stable capital structure over a period
for a project, then, the average cost of
capital can be calculated by:
a) taking the cost of the individual elements
and then

b) weighing each element in proportion to

the target capital structure.
www.knust.edu.gh
Cont’d
➢The WACC is calculated by using this
formula:
WACC = K e × E + KdAT × D
E+D E+D
Where;
Ke = cost of equity
E = value of equity
KdAT = after – tax cost of debt
D = value of debt
www.knust.edu.gh
Cont’d
➢ This equation will expand in proportion to
the number of different sources of finance
used by a company.

➢ For a company using ordinary share,

preference shares and both redeemable and
irredeemable bonds, the equation will
become;

www.knust.edu.gh
 Cont’d
➢ WACC = Ke × E + Kp × P + Kibt × Dib + Krb× Drb
(E +P + Dib +Drb) (E +P + Dib +Drb) (E +P + Dib +Drb) (E +P + Dib +Drb)

➢ Where P, Dib and Drb are the market values of

preference shares, irredeemable bonds and
redeemable bonds respectively

www.knust.edu.gh
Cont’d
• Market value = nominal value × current market price
Block (if any)

• Note that shares and bonds are sometimes

issued in blocks of hundred.

• In situations where they are not, the market

value will be obtained by multiplying their
nominal values with the current market
prices.
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Example 9:
• Danton plc has 10 million ordinary shares in
issue with a current market value of
GH₵2.00 per share. The expected dividend
for next year is 16p per share and this is
expected to grow each year at a constant
rate of 4 per cent. The business also has
GH₵20 million of irredeemable loan capital
in issue with a nominal rate of interest o f
10 per cent and which is quoted at GH₵80
per GH₵100 nominal value. Assume a rate of
corporation tax of 20 per cent and that the
current capital structure reflects the target
capital structure of the company. What is
the weighted average cost of capital of the
company? www.knust.edu.gh
Cont’d
➢ The first step is to calculate the cost of the
individual elements of capital. The cost of
ordinary shares in Danton plc will be
calculated as follows:
➢ Ko = D1 + g
Po
= 0.16 + 0.04 = 12%
2
➢ Note that although we have used the
dividend valuation model to calculate the
cost of ordinary shares in this case, the
CAPM model could have been used if
relevant information had been available.
www.knust.edu.gh
Cont’d

• The cost of loan capital will be calculated as

follows;
Kd = I (1- t),
Pd
= 10(1 - 0.2)
80
= 10%

www.knust.edu.gh
 Cont’d

• The second step is to find the current market values

of each element;
Market value = nominal value × current market price
Block (if any)
• Market value of equity = 10m × GH₵2 = GH₵20m

• Market value of loan capital = GH₵20m × 80

100
= GH₵16m
www.knust.edu.gh
Cont’d
• Having calculated the cost of the individual
elements, we can now calculate the WACC
of these elements;
• WACC = Ke × E + Kdat × D
(E +D) (E +D)

• E +D = 20m +16m = GH₵36m

= 12× 20 + 10 × 16 = 6.67 + 4.44
36 36
= 11.11%
www.knust.edu.gh
Cont’d
• Example 2;
Billy Boat Plc is calculating its current weighted average cost of capital. You
have the following information;
Financial position as at 31 December; GH₵
Non-current assets 33 344
Current assets 15 345
Current liabilities (9 679)
5% bond (redeemable in 6 years) (4 650)
9% irredeemable bonds (8 500)
Bank loans (3 260)
22 600
Ordinary share (GH₵ 1 par value) 6 400
8% preference share (GH₵ 1 par value) 9 000
Reserves 7 200
22 600

www.knust.edu.gh
Cont’d
• The current dividend, shortly to be paid, is 23p per share.
Dividends in the future are expected to grow at a rate of
5% per year.
• Corporate tax currently stands at 30%.
• The interest rate on bank loans currently stands at 7%.
• Stock market prices as at 31 December ( all ex-dividend
and ex-interest);

Ordinary shares GH₵ 4.17

Preference shares 89p
5% bonds GH₵96 per GH₵100 bond
9% irredeemable bonds GH₵108 per GH₵100 bond
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SOLUTION
Step 1; calculate the cost of the individual
sources of finance
Cost of equity; using the dividend valuation model
Ko = Do (1+g) + g
Po
= 0.23 (1 + 0.05) + 0.05 = 10.8%
4.17

Cost of preference shares;

Kp = Dp = 0.08 = 9%
Pp 0.89
www.knust.edu.gh
Cont’d
Cost of redeemable bonds (after tax) ; using
the Hawawini-Vora bond yield approximation
model;

Krb = I + (P – NPD)/n = 5 + (100 – 96)/6

P + 0.6(NPD – P) 100 + 0.6(96 – 100)

= 5.8%
Then Krbt = Krb (1 – t)
= 5.8 (1 – 0.3) = 4.1%
www.knust.edu.gh
Cont’d
Cost of bank loans after tax;
Kd = I (1- t),
Pd
= 7(1 - 0.3) = 4.9%
1
Cost of irredeemable bonds (after tax;
Kibt = I (1-t) = 9 (1-0.3)
P 108
= 5.8%
www.knust.edu.gh
Cont’d
Step 2; calculate the market values of the
individual sources of finance;
Market value = nominal value × current market price
Block (if any)

GH₵
Market value of ordinary shares (E) = 6 400 × 4.17 = 26 688
Market value of preference shares (P) = 9 000 × 0.89 = 8 010
Market value of redeemable = 4 650 × 96/100 = 4 464
Market value of irredeemable bonds = 8 500 × 108/100 = 9180
Market value of bank loans = 3 260
51 602
www.knust.edu.gh
Cont’d
Step 3; Calculate the WACC
= Ke × E + Kp × P + Kibt × Dib + Krb × Drb
(E +P+ Dib +Drb +Dd) (E +P +Dib +Drb +Dd) (E + P + Dib +Drb +Dd) (E +P + Dib +Drb +Dd)
+ Kd × Dd
(E + P + Dib +Drb + Dd)

E + P + Dib +Drb + Dd = 26 688 + 8 010 + 4 464 +

9180 + 3 260

= GH₵51 602
www.knust.edu.gh
 Cont’d

= 10.8 × 26 688 + 9 × 8 010 + 4.1 × 4 464 + 5.8 × 9 180 + 4.9 × 3 260

51 602 51 602 51 602 51 602 51 602

= 5.5856 + 1.3970 + 0.3547 + 1.0318 + 0.3096

WACC = 8.3786 ≈ 8.4%

www.knust.edu.gh
Example 10
L plc
Balance sheet as at 31st December 2007
GHcm
Net Assets 50
Capital reserves:
Ordinary Share Capital (50p shares) 15
Reserves 25
10% Redeemable Debenture 10
50
www.knust.edu.gh
N.B:
a)The current share price is GHc1.50 Cum
Div. and a dividend of 20p has been paid for
many years. The debentures are trading at
90 ex. interest; the corporation tax rate is
31%.
Required:
1) Calculate the WACC as at 31st December
2007.
Solution:
a) Ke = d = 20 = 15.38%
(Ko) Po 130
www.knust.edu.gh
Cont’d
b) KdAT = I(1-t) = 10 (0.69) = 7.67%
Po 90

c) Market Value:
Equity = 15 ÷ (0.5) × 1.3 = 39m

Debt = 10 × 90 = 9m
100
www.knust.edu.gh
Cont’d

d) WACC = 15.38 × 39 + 7.67 × 9

39 +9 39+9

= 13.93% ≈ 14%

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 LIMITATIONS OF WACC

ASSIGNMENT TWO
Find five limitations of the Weighted
Average Cost of Capital (WACC).

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 END OF CHAPTER TWO

Lecture notes compiled by: K. Poku

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 CHAPTER THREE

Introduction to the Capital

Structure Debate

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Objectives:
➢ When you have completed this chapter, you
should be able to describe:

• The traditional View of Capital Structure

• Implications of the traditional View

• The Modernist view of the Capital Structure

and its implication(M&M view)

• Importance of the capital structure

www.knust.edu.gh
 Introduction
➢ There is some controversy over whether the
‘mix’ of long term funds employed by a
business can have an effect on the overall
cost of capital of a business (WACC).

➢ If a particular mix of funds can produce a

lower cost of capital, then the way in which
the business is financed is important as it
can affect its value.

www.knust.edu.gh
Cont’d
➢ (in broad terms, the value of a business can
be defined as the net present value of its
future cash flows) .

➢ By lowering the cost of capital, which is

used as the discount rate, the value of the
business will be increased.

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 TWO SCHOOLS OF THOUGHT

➢ There are two (2) schools of thought;

1) The traditional view

2) The modernist view

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 THE TRADITIONAL VIEW
a) The capital structure decision is very
important.

b) They point out that the cost of loan capital is

cheaper than ordinary share(equity) capital.

c) This difference in the relative cost of finance

suggests that by increasing the level of
borrowing, (or gearing), the over all cost of
capital of the business can be reduced.
www.knust.edu.gh
 DRAWBACKS TO ADDITIONAL
BORROWING
1. As the level of borrowing increases,
ordinary shareholders will demand
higher levels of return on their
investments to compensate for the higher
levels of financial risk that they will have
to bear.

2. Existing lenders will also require higher

levels of return.
www.knust.edu.gh
Cont’d
➢ The traditionalists argue that at fairly low
levels of borrowing , the benefits of raising
finance through the use of loan capital will
outweigh any cost that arise.

➢ This is because ordinary shareholders and

lenders will not view low levels of borrowing
as having a significant effect on the level of
risk. As a result, they will seek
compensation for this higher level of risk
in the form of higher expected returns.
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This situation just described is shown in
the diagram below:

Fig. C.S.1 Cost of Ordinary Share

Capital
Cost of
Overall Cost of Capital
Capital

Cost of Loan Capital

Optimal Level of borrowing

(That is, point at which
overall cost of capital is
minimized)
Level of Borrowing
www.knust.edu.gh
Cont’d
➢ Figure C.S.1, above, depicts the traditional
view of the relationship between levels of
borrowing and expected returns.

➢ This figure assumes that at low levels of

borrowing, ordinary (equity) shareholders
will not require a higher level of return to
compensate for the higher risk incurred.

www.knust.edu.gh
➢ As loan finance is cheaper than ordinary
share finance, this will lead to a fall in the
overall cost of capital.

➢ However, this situation will change as the level

of borrowing increases.

➢ At some point, the increased returns required

by ordinary shareholders will begin to outweigh
the benefits of cheap loan capital and so the
overall cost of capital will start to rise.
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RELATIONSHIP BETWEEN THE LEVEL OF BORROWING,
THE COST OF CAPITAL AND BUSINESS VALUE: THE
TRADITIONAL VIEW

Fig. C.S 2 Fig. C.S 3

Value of
Cost of business
Capital

Level of borrowing Level of borrowing

www.knust.edu.gh
Cont’d
➢ The first graph plots the cost of capital
against the level of borrowing.

➢ We saw earlier that the traditionalist view

suggests that in the first instance, the cost
of capital will fall as the level of borrowing
increases.

➢ However, at higher levels of borrowing, the

overall cost of capital will begin to increase.
www.knust.edu.gh
Cont’d

➢ The second graph plots the level of

borrowing against the value of the business.

➢ This is the inverse of the first graph.

➢ As the cost of capital decreases, so the

value increases and vice –versa.

www.knust.edu.gh
 IMPLICATIONS OF THE TRADITIONAL
VIEW:
➢ Management of the business should try to
establish the mix of loan/equity finance that
will minimise the overall cost of capital.

➢ At this point, the business will be said to

achieve an optimal capital structure.

➢ By minimising the overall cost of capital in

this way, the value of the business will be
maximised. www.knust.edu.gh
 THE MODERNIST VIEW (1958)
➢ Franco Modigliani and Merton Miller (M&M),
who represent the modernist school,
challenged the traditional view by arguing
that the required returns to shareholders
and the lenders will not follow the pattern
as set out in the traditional view.

www.knust.edu.gh
a) They argued that shareholders in a
business with financial gearing will
expect a return that is equal to the
returns expected in investing in a similar
ungeared business plus a premium which
rises in direct proportion to the level of
gearing.

b) Thus, the increase in returns required for

ordinary shareholders as compensation for
increased financial risk, will rise in
constant proportion to the increase in the
level of borrowing over the whole range of
borrowing. www.knust.edu.gh
Cont’d
➢ This pattern contrasts with the traditional
view of course, which displays an uneven
change in the required rate of return over
the range of borrowing.

c)The M&M analysis also assumes that the

returns required from borrowers would
remain constant as the level of borrowing
increases.

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This position is set out in figure Fig. C.S.4 below

THE M&M VIEW OF THE RELATIONSHIP BETWEEN

LEVELS OF BORROWING AND EXPECTED RETURNS

Fig. C.S.4
Cost of Ordinary share Capital
Cost of
Capital

Overall Cost of Capital

Cost of Loan Capital

Level of Borrowing
www.knust.edu.gh
Cont’d
➢ The M&M view assumes that the cost of
capital will remain constant at different
levels of gearing.

➢ This is because the benefit of cheap loan

will be exactly offset by the increased
returns required by ordinary shareholders.

➢ Thus, there is no optimum level of gearing.

www.knust.edu.gh
RELATIONSHIP BETWEEN THE LEVEL OF BORROWING,
THE COST OF CAPITAL AND BUSINESS VALUE:
THE M&M VIEW.

Cost of
Cost of
Capital
Capital

Level of borrowing Level of borrowing

www.knust.edu.gh
Cont’d
➢ The first graph shows that, according to
M&M, the cost of capital will remain
constant at different levels of borrowing.

➢ The second graph shows the implication of

this for the value of a business.

➢ As the cost of capital is constant, the net

present value of future cash flows from
the business will not be affected by the
level of borrowing.
www.knust.edu.gh
Cont’d

➢ Hence, the value of the business will remain

constant.

➢ Although the views of M&M were first

published in the late 1950’s, they are often
described as modernists because they base
their position on economic theory.

www.knust.edu.gh
 IMPLICATION OF M&M VIEW
➢ The financing decision is not really
important. As the cost of capital remains
constant, a business does not have an
optimal capital structure as suggested by
the traditionalists.

➢ This means that one particular capital

structure is no better or worse than any
other and so managers should not spend
time on evaluating different forms of
financing mixes for the business.
➢ www.knust.edu.gh
Cont’d
➢ Instead, they should concentrate their effort
on evaluating and managing the investment
of the business

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 ASSUMPTIONS
a) Perfect Capital Markets:
➢ This assumption means that there are no
share transaction costs and companies can
borrow unlimited amounts at the same rate
of interest.

b) No bankruptcy costs:
➢ This assumption means that, if a business
were liquidated, no legal and
administrative fees would be incurred and
the business assets could be sold at a price…
www.knust.edu.gh
Cont’d
…that would enable shareholders to receive
cash equal to the market value of their
shareholding prior liquidation.

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c) Risk:
➢ It is assumed that businesses exist that have
identical operating risks but which have
different levels of borrowing.

d) No taxation:
➢ A world without corporate or personal
income tax is clearly an unrealistic
assumption.
• Individuals can borrow and lend at the same
rate as giant corporations
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 M&M AND THE INTRODUCTION OF
TAXATION
➢ M&M were subjected to considerable
criticism for not dealing with the problem of
taxation in their analysis, this led them to
revise their analysis and include taxation.

➢ They acknowledged in their revised analysis

that the tax relief from interest payments
on loans provide a real benefit to ordinary
shareholders.
www.knust.edu.gh
➢ The more the level of borrowing increases,
the more tax relief the business receives
and so the smaller the tax liability of the
business will become.

➢ Tax relief on interest should therefore,

represent an additional benefit to
shareholders.

➢ As the amount of tax relief increases with

the amount of borrowing, the overall cost of
capital (after tax) will be lowered as the
level of borrowing increases.
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IMPLICATIONS OF M&M WITH TAX
➢ There is an optimum level of gearing and it
is at 100% gearing.

➢ The M&M view of the relationship between

levels of borrowing and expected returns
(including tax effects)

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 IMPLICATION OF M&M VIEW TAX -
illustration

Cost of Ordinary Share Capital

Cost of
Capital
Overall Cost of Capital
Cost of Loan Capital

Level of Borrowing

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Relationship Between the Level of Borrowing,
the Cost of Capital and Business Value:
The M&M view including tax effects.

Cost of Value of
capital business

Level of borrowing Level of borrowing

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 END OF CHAPTER THREE

Lecture notes compiled by: K. Poku

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 CHAPTER FOUR

An Introduction to the Dividend

Policy Debate

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DIVIDEND POLICY AND SHAREHOLDER
WEALTH
Objectives:
➢ When you have completed this chapter, you
should be able to:

• Describe the nature of dividends and the

way in which they are paid

www.knust.edu.gh
Cont’d
• Explain why dividends should have no effect
on shareholder wealth in a world of perfect
and efficient markets

• Discuss the factors that influence dividend

policy in practice

• Discuss the alternatives to cash dividends

that may be used.
www.knust.edu.gh
 Introduction
➢ Dividends represent a return by a business
to its shareholders.

➢ The return is normally paid in cash,

although it would be possible for it to be
paid with assets other than cash.

➢ The law states that dividends can only be

paid to shareholders of private limited
companies out of realized profits.
www.knust.edu.gh
Cont’d
➢ Much of the interest surrounding dividend
policy has been concerned with the
relationship between dividend policy and
shareholder wealth.

➢ Put simply, the key question to be answered

is:
“Can the pattern of dividends adopted by
a business influence shareholder wealth?”
www.knust.edu.gh
Cont’d
➢ Note that it is the pattern of dividends
rather than the dividends themselves which
is in issue.

➢ Shareholders must receive cash at some

point in order for their shares to have any
value.

➢ Various dividend valuation models suggest

that dividends are important in determining
share price. www.knust.edu.gh
Cont’d
➢ One such model, you may recall, is the
dividend growth model which is as follows:
Po = D1
Ko-g
Where;
D1 = expected dividend for next year

g = a constant rate of growth

Ko = the expected return on the share

www.knust.edu.gh
Cont’d

➢ Looking at this model, it may appear that by

simply increasing dividends (D1) there will
be an automatic increase in share price (Po)

➢ However, the relationship between

dividends and share price is not likely to be
as straightforward as this.

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 SCHOOLS OF THOUGHT

There are two (2) schools of thought on

Dividend Policy;
1. The Traditional View Of Dividend Policy

2. The Modernist (M&M) View On Dividend

Policy

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 TRADITIONAL VIEW OF DIVIDEND
POLICY
➢ The early finance literature accepted the
view that dividend policy was important to
shareholders.

➢ It was argued that a shareholder would

prefer to receive GHc1 today rather than
to have GHc1 reinvested in the business,
even though, this might yield future
dividends.
www.knust.edu.gh
Cont’d

➢ The reason for this was that future

dividends (or capital gains) are less certain
and so will be valued less highly.

➢ The saying ‘a bird in the hand is worth

two in the bush’ is often used to describe
this argument.

www.knust.edu.gh
Cont’d
➢ Referring back to the dividend growth
model, the traditional view suggests that
Po will rise if there is an increase in D1, as
dividends received later will not be valued
so highly.

➢ If this line of reasoning is correct, the effect

of applying a higher discount rate of
future dividends will mean that the share
of businesses that adopt a high retention
policy will be adversely affected. www.knust.edu.gh
 THE IMPLICATION FOR CORPORATE
MANAGERS
➢ That, corporate managers should adopt as
generous a dividend distribution policy as
possible, given the investment and financing
policies of the business, as this will represent
the optimal dividend policy for the business.

➢ In view of the fact that the level of payout

will affect shareholder wealth, the dividend
payment decision will be an important policy
decision for managers. www.knust.edu.gh
THE MODERNIST (M&M) VIEW ON DIVIDEND
POLICY

➢ Modigliani and Miller (M&M) have challenged

this view of dividend policy.

➢ They argue that, given perfect and efficient

markets, the pattern of dividend payments
adopted by a business will have no effect on
the shareholder wealth.

www.knust.edu.gh
Cont’d

➢ Where such markets exist, the wealth of

shareholders will be affected solely by the
investment projects that the business
undertakes.

➢ To maximize shareholders wealth, therefore,

the business should take on all investment
projects that have a positive Net Present
Value (NPV).
www.knust.edu.gh
Cont’d

➢ The way in which the returns from these

investment projects are divided between
dividends and retention is unimportant.

➢ Thus, a decision to pay a lower dividend will

simply be compensated for by an increase in
share price.

www.knust.edu.gh
Cont’d
➢ If a business does not pay a dividend, the
shareholder can create ‘homemade’
dividends by selling a portion of the shares
held.

➢ If, on the other hand, a business provides a

dividend that the shareholder does not wish
to receive, the amount can be reinvested in
additional shares in the business.
www.knust.edu.gh
Cont’d
➢ In view of this fact, there is no reason for an
investor to value the shares of one business
more highly than another simply because it
adopts a particular dividend policy.

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 IMPLICATIONS FOR CORPORATE
MANAGERS
➢ The M&M view suggest that there is no such
thing as an optimal dividend policy, and that
one policy is as good as another. That is, the
dividend decision is irrelevant to shareholder
wealth

➢ Thus, managers should not spend time

considering the most appropriate policy to
adopt, but should, instead, devote their
energies to finding and managing profitable
investment opportunities. www.knust.edu.gh
 THE M&M POSITION EXPLAINED
➢ M&M believe that dividends simply represent
a movement of funds from inside the
business to outside the business.

➢ The change in the location of funds should

not have any effect on shareholder wealth.

➢ The problem with the traditional argument

is that it is based on a misconception of the
nature of risk.
www.knust.edu.gh
Cont’d
➢ The risks borne by a shareholder will be
determined by the level of business
borrowing and the nature of the business
operations.

➢ These risks do not necessarily increase over

time and are not affected by the dividend
policy of the business.

www.knust.edu.gh
Cont’d
➢ Dividends will only reduce risks if the
amount received by the shareholder is then
placed in a less risky form of investment
(with a lower level of return).

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 THE M&M ASSUMPTIONS
➢ The logic of the M&M arguments has proven
to be unassailable and it is now widely
accepted that, in the world of perfect and
efficient capital markets; dividend policy
should have no effect on shareholder
wealth.

➢ The burning issue, however, is whether or

not the MM analysis can be applied to the
real world of imperfect markets.
www.knust.edu.gh
 Cont’d
➢ The assumptions are, in essence, that we live
in a ‘frictionless’ world where there are:
1. No share issue costs
2. No share transaction costs
3. No taxation

➢The first assumption means that money paid

out in dividends can be replaced by the
business through a new share issue without
incurring additional costs.
www.knust.edu.gh
Cont’d
➢ The second assumption means that investors
can make homemade dividends or reinvest in
the business at no extra costs (or no barriers
for investors to pursue their own dividend
and investment strategies).

➢ The third assumption concerning taxation

is unrealistic and, in practice, tax may be an
important issue for investors.
www.knust.edu.gh
➢ The three assumptions discussed
undoubtedly weaken the M&M analysis when
applied to the real world.

➢ However, this does not necessarily mean

that their analysis is destroyed.

➢ One direct way to assess the validity of

M&M’s arguments, in the real world, is to
see whether there is a positive
relationship between the dividends paid
by businesses and their share price.
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 THE IMPORTANCE OF DIVIDENDS
➢ Whether to accept the M&M analysis, there
is little doubt that, in practice, the pattern
of dividends is seen by investors and
corporate managers as being important.

➢ Dividends are important due to the following

reasons;
1. The clientele effect
2. The information signaling effect
3. The need to reduce agency costs
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 FACTORS DETERMINING THE LEVEL
OF DIVIDENDS
1. Investment and financing opportunities

2. Legal requirements: Company law

restricts the amount that a business can
distribute in the form of dividends. The
law states that dividends can only be paid
to shareholders out of realized profits.

3. Loan covenants
www.knust.edu.gh
Cont’d
4. Profit stability: Businesses that have a
stable pattern of profits over time are in a
better position to pay higher dividend
payouts than businesses that have a
volatile pattern of profits.

5. Control: A high profit retention/low

dividend policy can help avoid the need to
issue new shares, and so control exercised
by existing shareholders will not be diluted.
www.knust.edu.gh
Cont’d
6.Threat of takeover: it has been suggested,
for example, that a high retention/low
distribution policy can increase the
vulnerability of a business to takeover.
Dividend policy may, however, help avert
the threat of takeover.

7.Market expectations: investors may have

developed certain expectations concerning
the level of dividend to be paid.
www.knust.edu.gh
Cont’d
• These expectations may be formed as a
result of earlier statements made by the
managers of the business.

• If these expectations are not met, there

may be a loss of investor confidence in the
business.

www.knust.edu.gh
Cont’d
8.Inside information: the managers of a
business may have inside information
concerning the future prospects of a
business that cannot be published but which
indicates that the shares are currently
undervalued by investors.

• In such a situation, it may be sensible to

rely on internal shareholder funds (that is,
retained profit) rather than issuing more
shares.
www.knust.edu.gh
Cont’d

• Although this may lead to lower dividends,

it could enhance the wealth of existing
shareholders.

9.The dividend policy of other businesses

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 ALTERNATIVES TO CASH DIVIDENDS

➢ In some cases, a business may decide to

make distributions to shareholders in a form
different from a cash dividend.

➢ The two (2) most important of these are

scrip dividends and share repurchase

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 SCRIP DIVIDENDS
➢ A business may make a scrip dividend ( or
bonus share dividend) rather than making a
cash distribution to shareholders.

➢ Thus, if a business announced a 20 percent

scrip dividend this would mean that each
shareholder would receive a 20 percent
increase in the number of shares held.

www.knust.edu.gh
 Cont’d
➢ Scrip issues (or bonus issues) do not result in
an increase in shareholder wealth as seen in the
earlier chapter.

➢ Making a scrip issue is, in essence, a

bookkeeping transaction that will not, of itself,
create value.

➢ Nevertheless, the market may respond positively

to a scrip dividend if it seen as a sign of the
directors’ confidence concerning the future.
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 SHARE REPURCHASE
➢ A share repurchase is a voluntary
agreement between the business and its
shareholders, which means that only those
shareholders wishing to receive cash
actually receive it.

➢ It is often used to return surplus cash to

shareholders.

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 Advantage Over Dividends:

a) It is regarded as a ‘one-off’ event and does

not imply a commitment to make regular
returns to shareholders.

➢ For this reason, businesses that have surplus

cash may prefer to repurchase their shares
rather than to distribute cash through higher
dividends.

www.knust.edu.gh
 Cont’d
b) It also has greater flexibility in so far that
the repurchase can be spread over a longer
period and, if the environment changes, it
may be less difficult for managers to change
their plans.

➢ Managers must take care to ensure equity

between shareholders during a share
repurchase.

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 END OF CHAPTER FOUR

Lecture notes compiled by: K. Poku

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 CHAPTER FIVE

Mergers and Takeovers

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 MERGER
• When two or possibly more businesses
combine, it can take the form of either a
merger or takeover.

• The term merger is normally used to

describe a situation where there are two
businesses of roughly the equal size and
there is agreement between the two
management and shareholder groups on the
desirability of combining them.
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 TAKEOVER
• The term takeover is normally used to
describe a situation where a larger
business acquires control of a smaller
business.

• When a takeover occurs, the shareholders of

the target business may cease to have any
further interest in the business and the
resources of the business may come under
entirely new ownership
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TYPES OF MERGERS AND TAKEOVER

• Horizontal merger occurs when two

businesses in the same industry and at the
same point in the production /distribution
process decide to combine.

• Vertical merger occurs when two businesses

in the same industry, but at different points
in the same production/distribution process,
decide to combine.
www.knust.edu.gh
Cont’d
• Conglomerate merger occurs when two
businesses in a unrelated industries decide
to combine.

• QUESTION; Can you think of an example

for each type of merger?

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WHY RECENT INCREASE IN MERGER
ACTIVITIES?
• The globalization of markets

• Improvement in communication,
transportation and technology

• Deregulation of industries such as gas,

electricity, water and telecommunications.

www.knust.edu.gh
Cont’d

• Restructuring of industries in the face of

increased competition and changes in
demand

• Rising share prices and relatively low

interest rates

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 THE RATIONAL FOR MERGERS
• In economic terms, a merger will only be
worthwhile if combining the two businesses
will lead to gains that would not arise if the
two businesses stayed apart.

• If a merger is to make economic sense, the

present value of the combined business
should be equal to the present value of
future cash flows of both the bidding and
target business plus any gain from the
merger. www.knust.edu.gh
a) Benefits Of Scale
• A merger or takeover will result in a larger
business being created that may enable
certain benefits of scale to be achieved.

• For example, a larger business may be able

to negotiate lower prices with suppliers in
exchange for larger orders.

www.knust.edu.gh
Cont’d

• QUESTION:
• Is it necessary for a business to merge
with, or take over another business in
order to reap the benefits of combination?
Can these benefits be obtained y any
other means?

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b) Eliminating Competition
• A business may combine with or take over
another business in order to eliminate
competition and to increase the market
share of its goods. This, in turn can lead to
increased profits.

• QUESTION:
• What kind of merger will achieve this
objective? What are the potential
problems of this kind of merger from the
consumer point of view?
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 c) Underutilized Resources
• A business may have poor management team
that fails to exploit its full potential.

• In this situation, there is an opportunity for a

stronger management team to be installed that
would exploit more fully the resources of the
business.

• This argument is linked to what is sometimes

referred to as the market for corporate
control.
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d) Complementary resources
• Two businesses may have complementary
resources that, when combined will allow
profits to be made which are higher than if
the businesses operate as single entities.

• By combining two businesses, the relative

strengths of each business will be brought
together and this may lead to additional
profits being generated.
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e) Surplus funds
• A business may operate within an industry
offering few investment opportunities. In
such a situation, the management may have
surplus cash that is not earning a reasonable
return.

• The business may decide to invest in a new

industry where there is no shortage of
profitable investment opportunities.
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f) Diversification
• A business may decide to invest in another
industry in order to reduce the level of risk.

• At first sight such a policy may seem

appealing. However, we must ask ourselves
whether diversification by management will
provide any benefit to shareholders that the
shareholders themselves cannot provide
more cheaply.
www.knust.edu.gh
Cont’d
• QUESTION:
• Who do you think might benefit from
diversification?

www.knust.edu.gh
g) Management interest and goals

• There is the argument that some mergers

may be undertaken to fulfil the personal
goals or interests of managers.

• Thus, managers may acquire another

business simply to reduce the risk that they
face. Managers may also acquire another
business to increase the amount of resources
that they control.
www.knust.edu.gh
Cont’d

• The size of the business will often influence

the status, income and power that managers
enjoy.

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FORMS OF PURCHASE CONSIDERATION

• When a business wishes to purchase the

shares of another, it can offer payment in
different ways.

• These are cash, shares in the bidding

business and loan capital.

• Some combination of these methods may of

course also be used.
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 Cash
• Payment by cash means the amount of the
purchase consideration will be both certain and
clearly understood by the target business’s
shareholders.

• This may improve the chance of a successful

bid.

• It will also mean that shareholder control of

the bidding business will not be diluted as no
additional shares will be issued. www.knust.edu.gh
• Raising the necessary cash, however can
create problems for the bidding business,
particularly when the target business is
large.

• It may only be possible to raise the amount

required by a loan or share issue or by
selling off assets, which the bidding
business’s shareholders may not like.

• On occasions, it may be possible to spread

the cash payments over a period.
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 Shares
• The issue of shares in the bidding business as
purchase consideration will avoid any strain
on its cash position.

• However, some dilution of existing

shareholder control will occur and there
may also be a risk of dilution in earnings per
share.

www.knust.edu.gh
Cont’d

• A substantial fall in share price will reduce

the value of the bid and could undermine
the chances of acceptance.

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 Loan capital
• Like the issue of shares, this is simply an
exchange of paper and so it avoids any
strain on the cash resources of the bidding
business.

• It has certain advantages over shares such as

the issue of loan capital involves no dilution
of shareholder control and the service costs
will be lower.
www.knust.edu.gh
Cont’d

• A disadvantage of a loan capita-for-share

exchange is that it will increase the gearing
of the bidding business and, therefore the
level of financial risk.

• When a takeover bid is being made,

convertible loan capital may be offered as
purchase consideration.

www.knust.edu.gh
Cont’d
• QUESTION:
• What is the attraction of this form of loan
capital from the point of view of the
target business’s shareholders?

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 ASSESSING VULNERABILITY TO
TAKEOVER
• When a business is taken over, all those
connected with the business are likely to be
affected.

• Shareholders, managers, employees,

suppliers and others all have a stake in the
business and may stand to lose or gain by a
change in ownership.
www.knust.edu.gh
Cont’d
• Predicting the likelihood of takeover should
therefore be of interest to these various
stakeholder groups.

• Financial ratios can be used to predict the

likelihood of a takeover.
• In recent years, various studies have been
carried out to identify the particular
characteristics that make a business
vulnerable to takeover and predict the
prospects of such an event.
www.knust.edu.gh
Cont’d
• In the USA, a study by Palepu:

a) Lower average shares return over the

four year period to takeover.

b) Higher ‘growth-resource mismatch’.

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• In the UK, Barnes developed a multivariate
model to predict vulnerability to takeover.

• The study found that the following five

ratios could be used to classify businesses as
either acquired or not acquired with a level
of accuracy of slightly more than 68%;
a) Acid test ratio
b) Current ratio
c) Return on shareholder funds
d) Net profit before tax and
e) Net profit after tax www.knust.edu.gh
 RESISTING A TAKEOVER BID
• Studies have found that those businesses
that successfully fended off hostile bid
have;
a) Lower profitability, that is lower ROCE,
ROSF and profit margin

b) Higher liquidity and

c) Higher dividend payout

www.knust.edu.gh
Cont’d
• Defending against a takeover bid need not
imply that managers and shareholders are
committed to maintaining the business as an
independent entity.

• It may simply be a tactic to increase the

premium bid, thereby, to increase
shareholder wealth.

www.knust.edu.gh
 TAKEOVER: WHO BENEFITS?
• Various economic benefits may be claimed in
support of two businesses combining.

• Which groups are most likely to benefit?

Various studies have shown that shareholders in
the target business are usually the main
beneficiaries.

• They are likely to receive substantial benefits

from a takeover through a premium on the
share price. www.knust.edu.gh
 DEFENSIVE MEASURES FOR A
TAKEOVER BID
• In some cases, a takeover bid will not be
welcomed by the directors of the target
business. Various defensive measures may be
used to reduce the risk of takeover.

• Some of these measures must be put in

place before receiving a hostile bid whereas
others can be deployed when the bid has
been made.
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a) Conversion to private company
status
• The directors of the target business may
recommend that the business converts to
private limited company status.

• This ‘pre-offer’ defense should make it

more difficult for a bidder to acquire the
shares of the target business.

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b) Employee share option schemes

• By encouraging employees to acquire shares

in the business, the proportion of
shareholders that are likely to resist
takeover bids will be increased.

• This is a further example of a pre-offer

defense.

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c) Circularizing shareholders
• When an offer has been received, the
directors of the target business will normally
circularize shareholders.

• In the circular, the directors might argue

that it is either not in the interest of the
shareholders to accept the offer, or that the
share price offered is too low.

www.knust.edu.gh
Cont’d

• In support of such arguments, the directors

may disclose hitherto confidential
information such as profit forecasts, future
dividend payments, asset valuation,
details of new contracts, and so on.

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d) Making the business unattractive
• The directors may take steps to make the
business unattractive to the bidder. This may
involve:
a) A poison pill through the sale of prized
assets of the business (the crown jewels).

b) Other tactics include agreements to pay

large sums to directors for loss of office
resulting from a takeover (golden
parachutes).
www.knust.edu.gh
Cont’d

c) The purchase of certain assets that the

bidding business does not want.

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e) Pac-man defense

• This involves the target business launching a

counterbid for the predator business.

• However, this tactic is difficult to carry out

where the target business is much smaller
than the predator business.

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 f) White knight
• A target business may avoid a takeover by an
unwelcome bidder by seeking out another
business (a white knight) with which to
combine.

• This tactic will normally be used only as a

resort, however, as it will result in the loss of
independence.

• There is also a risk that the white knight will be

less gallant after the merger than was hoped.
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g) White squire
• This is a variation of the white knight tactic
mentioned above.

• In this case, another business that is

regarded as supportive will purchase a block
of shares in the target business that is big
enough to prevent any real prospect of a
takeover but will not provide a controlling
interest.
www.knust.edu.gh
Cont’d

• The white squire will usually be given some

incentive to ‘ride to the rescue’ of the
target business.

• This might take the form of a seat on the

board or a discount on the price of the
shares purchased.

www.knust.edu.gh
 DIVESTMENT AND DEMERGERS

• Lately, there is been a number of businesses

divesting themselves of particular business
operations rather than acquiring them.

• Sometimes, it will arise in response to

particular problems experienced by the
business.

www.knust.edu.gh
Cont’d
• An example of this is where a business is
short of cash or too highly geared and
management decides to improve the
liquidity or gearing by realizing certain
assets.

• A further example is where a business is

vulnerable to a takeover and decides to take
pre-emptive action by selling its ‘crown
jewels’.
www.knust.edu.gh
Cont’d
• On some occasions, the decision to divest
may be taken because the business has
reviewed its strategic plans and has decided
that certain operations of the business are
no longer compatible with its objectives.

• When a sell-off is undertaken, the managers

of the particular business operations may
bid to become the new owners. If their bid
is successful, the purchase arrangement is
referred to as a management buy-out.
www.knust.edu.gh
Cont’d
• In some cases, a group of managers from
outside the business may make a successful
bid to become the new owners of the
business operations. When this occurs, it is
referred to as a management buy in.

• Rather than selling off business operations

to a third party, they may be transferred to
a new business.

www.knust.edu.gh
Cont’d

• The distribution of shares in the new

business is usually made in proportion to
shareholdings in the existing business.

• This kind of restructuring is referred to as a

demerger or spin-off.

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 END OF CHAPTER FIVE

Lecture notes compiled by: K. Poku

www.knust.edu.gh
 CHAPTER SIX

Capital Asset Pricing Model

(CAPM)

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 Introduction
• The Capital Asset Pricing Model (CAPM),
which is a development based on Harry
Markowitz’s portfolio theory, owes its
conception to William Sharpe.

• Sharpe developed this method of share

valuation in his 1964 seminal paper in which
he attempted to ‘construct a market
equilibrium theory of asset prices under
conditions of risk’.
www.knust.edu.gh
Cont’d
• Sharpe, like Markowitz, was in 1990 awarded
the Nobel Prize for Economics.

• While the CAPM is based on the foundations

provided by Markowitz, there are subtle
difference between the two.

www.knust.edu.gh
Cont’d
• Portfolio theory considers the total risk and
return of portfolios and advises investors
on which portfolios to invest in, whereas
CAPM uses the systematic risk of individual
securities to determine their fair price.

• In order to ignore the influence of

unsystematic risk on the valuation of
securities, it is assumed that investors have
eradicated unsystematic risk by holding
diversified portfolios.
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 ASSUMPTIONS OF CAPM
1. Investors are rational and want to
maximize their utility; they do not take risk
for risk sake.

2. All information is freely available to

investors and, having interpreted it,
investors arrive at similar expectations.

3. Investors are able to borrow and lend at

the risk free rate.
www.knust.edu.gh
4.Investors hold diversified portfolios,
eliminating all unsystematic risk.

5.Capital markets are perfectly competitive.

The conditions required for this are;
a. Large number of buyers and sellers.
b. No one participant can influence the market.
c. No taxes and transaction costs.
d. No entry and exit barriers to the market and,
e. Securities are divisible.
www.knust.edu.gh
Cont’d
6.Investment occurs over a single,
standardised holding period.
• While these assumptions are clearly at odds
with the real world, we should refrain from
dismissing the CAPM as unrealistic and
impractical.

• As Sharpe (1964) observed: ‘the proper

test of a theory is not the realism of its
assumptions but the acceptability of its
implications’.
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 SYSTEMATIC RISK
• Also known as market risk, general risk,
residual risk, non-diversifiable risk, non-
specific, unavoidable risk.

• It is the type of risk in a portfolio of

investments that cannot be eliminated by
diversification since it is common to all
securities of the same general class.

www.knust.edu.gh
Cont’d

• It represents how share returns are

affected by systematic factors such as
business cycles, government policy and
changes in interest rates.

• Solnik (1974) estimated that internationally

diversified portfolios reduced unsystematic
risk to 11% in UK.

www.knust.edu.gh
Cont’d

• According to Solnik (1974) systematic risk

accounts for roughly 34% of an individual
shares total risk in the UK.

• Systematic risk is measured by the beta

coefficient.

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 UNSYSTEMATIC RISK
• Also known as diversifiable, specific,
avoidable or non-market risk.

• This is the risk specific to a particular share

.ie. The risk of individual company
performing badly or going into liquidation.

• While this type of risk accounts for about

66% of individual shares total risk in the
UK, unsystematic risk can be diversified
away.
www.knust.edu.gh
 CAPITAL ASSET PRICING MODEL
(CAPM)
• Central to the CAPM is the existence of a
linear relationship between risk and return.

• The linear relationship is defined by what

is known as the SML, where the systematic
risk of a security is compared with the risk
and return of the market and the risk free
rate in order to calculate a required
return for the security and hence a fair
price. www.knust.edu.gh
Cont’d
• The equation of the SML can be defined as:
𝑹𝒊 = 𝑹𝒇 + 𝜷 𝑹𝒎 − 𝑹𝒇
• Where;
Ri = the rate of return for security i /the
required returns for investors
Rf = the risk free rate of government
securities
𝛽 = the beta coefficient of security
Rm = the return of the market.
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• In order for the CAPM to be used in the
valuation of shares, we need an understanding
of the components that make up the SML and
how they can be calculated or approximated.

Required rate of return SML

m
Rm

Rj

Rf

Systematic risk (β)

𝜷𝒊 𝜷𝒎 = 𝟏
www.knust.edu.gh
Cont’d

• The security market line indicating the

relationship between systematic risk
(measured by beta) and the required rate
of return on capital assets.

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THE MEANING AND CALCULATION OF
BETA
• The beta (β) of a security can be defined as
an index of responsiveness of the changes
in returns of the security relative to a
change in the stock exchange or market.

• By definition, the beta of a market is

always 1 and acts as a benchmark against
which the systematic risk of securities can
be measured.
www.knust.edu.gh
Cont’d

• The beta of a security measure the

sensitivity of the returns on the security to
changes in systematic factors.

• The calculation of a share’s beta coefficient

involves collecting data on the periodic
returns of the market and the security under
consideration.

www.knust.edu.gh
Cont’d
• For example, if a security has a beta of 0.8
(.ie. Less systematic risk than the market)
and the market return increases by 10%, the
security’s return will increase by 8%.

• If the return decreases by 10%, the return of

the security decreases by 8%. This security is
commonly called a defensive security and is
most attractive to investors when the stock
market is falling.
www.knust.edu.gh
Cont’d
• Alternatively, for a security with a beta of
1.5 (.i.e. more systematic risk than the
market), if the return of the market
increases by 10%, the security’s return will
increase by 15%. If the market return
decreases by 10%, the return of the
security decreases by 15%.

• This is what is termed an aggressive

security and is most attractive to investors
when the market is rising. www.knust.edu.gh
Cont’d
• How is the beta of a security calculated?

• The risk management service of the London

Business School publishes quarterly beta
books of companies’ equity beta
coefficients. Which organisations in Ghana
do this?

• Distinguish between liability or equity,

beta’s & asset beta’s.
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 DETERMINING THE RISK FREE
RATE OF RETURN
Two (2) conditions must be met before an
asset can be described as risk free;

1. First there must be no risk of default

associated with asset.

2. Secondly, the actual return must be equal

to its expected return.
www.knust.edu.gh
 Cont’d
• In reality while no investments are totally
risk free, bonds issued by governments of
politically and economically stable countries
are generally considered to be free from risk
of default.

• Therefore, the risk free rate can be

approximated by taking the current rate of
return on short dated government bonds. In
the U.K and Ghana, this equates to the yield
on short dated treasury bills. www.knust.edu.gh
 ESTIMATING RETURNS TO THE
MARKET
• This is more difficult to calculate, it is usually
approximated by using stock exchange involves
such as FTSE 100, FTSE All share index or GSE
composite index, as a representation of the
market.

• To find the return of the market, the capital

gains of the chosen index over a one-year
period should be added to the dividend yield of
the shares in the index over the same period.
www.knust.edu.gh
Cont’d

• This is given by the following formula, which

allow us to approximate the return of the
market over the year:

• The following formula may be used:

𝑷𝟏 − 𝑷𝟎
𝑹𝒎 = + 𝐃𝐢𝐯
𝑷𝟎

www.knust.edu.gh
Cont’d
Where:
Po = the stock exchange index of the
beginning of the period.

P1 = stock exchange index at the end of the

period.

Div= the average dividend yield of the stock

exchange index over the period.
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 IMPLICATIONS OF CAPM
1. Investors calculating the required rate of
return of a security will only consider
systematic risk to be relevant.

2. Shares with high levels of systematic risk

are expected, on average to yield higher
rates of return

3. There should be a linear relationship

between systematic risk and return and
securities that are correctly priced should
plot on the SML.
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 END OF CHAPTER SIX

Lecture notes compiled by: K. Poku

www.knust.edu.gh