UNIVERSITY OF JUBA

College: School of Management of Sciences

Course Title: Corporate Finance
Course Code: SBA 612

Course Outline:

1. Pattern of Finance
 Sources of finance in Business
2. Capital Budgeting and Rationing
 Meaning Capital budgeting
 Examples of Capital Budgeting Decisions
 Nature of Investment Decision Making
 Procedures of Making Investment Decisions
 Assumptions of Capital Budgeting Process
 capital rationing
 Importance of Capital budgeting decisions to an organization
3. Risk and Return
 Sources of risk
 Return of an investment
 Risk of an investment
 Measuring return and risk of an investment

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4. Introduction to options
 Introduction to Black Scholes Model
i. Call Option
ii. Put Option

5. Market Efficient Hypothesis(EMH)

 Understanding EMH
 Forms of EMH
i. Strong Form
ii. Semi-Strong Form
iii. Weak Form
6. Cost of Capital
 Cost of Capital
 Specific Sources of Capital
 Importance of Cost of Capital
 The Weighted Average Cost of Capital (WACC)
 Modigliani and Miller Propositions (MM)
7. Capital Structure Decision
 Meaning of capital structure
 Factors that affect capital structure decision
8. Dividend Policy
 When should the firm pay the dividends?
 Why should the firm pay the dividends?
 How much dividends should the company pay?
 How should the firm pay the dividends?

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 REFERENCES
Bodie, Kane, Marcus (2007) Essentials Investments, Sixth edition, McGraw-Hill
International , New York, pp 2-159.
Damodaran, A., (2002). Investments Valuation, Tools and Techniques for
Determining the Value of any Asset, John Wiley and Sons, NJ.
Fabozzi, F.J, and Peterson, P.P,(2003), Financial Management and Analysis, John
Wiley and Sons Inc.New Jersey.
Maheswari.S.N.,(1996), Financial Management, Principles and Practices, Sultan
Chand and Sons, New Delhi
Reilly, F. and K. Brown, (
2006), Investment Analysis and Portfolio Management, Eight edition, South-
Western Publishing.

Prepared By: CPA Abraham Dut Atem Malek

MFINACC, BBMACC, CPA (K) & Member of ICPAK

GOOD LUCK!!

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CHAPTER ONE: PATTERN OF FINANCE
Sources of Finance in Business

There are two major sources of finance for meeting the financial requirements of any
business enterprises, which are as under:-

 Owners Fund
 Borrow Fund

1. Owners Fund

Owners fund is also called as Owners Capital or owned capital. It consists of the funds
contributed by the owners of business as well as profits reinvested in business. A company
cans raise owner’s funds in the following ways:-

 Issue of equity shares

 Ploughed back profits

1. Borrow Fund

The second source of funding to a business is the borrowed fund. Borrowed fund consists of
the amount raised by way of loans or credit. It is also known as borrowed capital. The
borrowed fund is procured from the following sources;-

 Debentures
 Bank Loans
 Loans from specialized financial institutions
 Other long term financial institutions

Types of Business Finance

All businesses require an adequate finance. They need money for investment in fixed asset
such as land, building, machinery etc. Once business is in operation, money is needed for
Working Capital, such as purchase of raw material, payment of wages, utility bills etc. A
going concern also requires extra capital to cover a temporary cash flow crisis, or purchase
new improved machinery or simply to expand the business. The financial requirements of a

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business, on the basis of time duration, are usually classified under three heads which are
as follow:-

 Short Term Finance

 Medium Term Finance
 Long Term Finance

1. Short Term Finance

Short term Sources of finance is defined as money raises for investment in business for a
period of less than one year, it is also named as working capital or circulating capital or
revolving capital.

The purpose and amount of obtaining short term capital varies with the nature and size of
the business. Generally the short term capital is required for meeting the day to day
expenses of business such as payment of utility bills, wages to the workers, unforeseen
expenses, seasonal upswings in business, increasing inventories raw material, work in
progress and finished goods etc.

The various sources of short term finance are as under:-

 Trade creditor open book account

 Advance from customers
 Installment credit
 Bank Overdraft
 Cash credit
 Discounting bills
 Against bill of lading

1. Medium Term Finance

Medium term sources of finance are required for investment in business for a medium
period which normally ranges from one to five years. The medium term funds are required
generally for the repair and modernization of machinery, renovation of the building,
adoption of new methods of production, carrying advertisement campaign on large scale in
newspapers, television etc. The various sources of medium term finance are as under:-

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  Commercial Banks
 Debentures
 Loans from Specialized Credit Institutions

1. Long Term Finance

Long term sources of finance refer to the funds, which are required for investment in
business for a period exceeding up to five years. It is also named as long term capital or
fixed capital. Long term sources of finance are mostly required for the purchased of fixed
assets, such as land, building, machinery etc. modernization and expansion of business. The
amount of long term finance varies with the nature of business, size of business, nature of
the product manufactured, the number of goods produced, and the method of production
etc. The various sources of long term finance are as under:-

 Equity shares
 Issue of right shares
 Debentures
 Loans from industrial and financial institutions
 Leasing
 Ploughing back of profits

Source: businessstudynotes.com

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CHAPTER TWO: CAPITAL BUDGETING AND RATIONING

CAPITAL BUDGETING
Capital budgeting is the process of making investment decisions in capital expenditures.
This is a firm’s decision to invest its current assets most efficiently in long term assets in
anticipation of an expected flow of benefits over several years in the future.
Capital budgeting is a dynamic process since it is possible to identify investment proposals
almost continuously and firm’s operating environment may also change and alter reliability
of a given investment actual or potential .Long term assets are those which affect the firm’s
operations beyond 1 year.

Examples of Capital Budgeting Decisions

 Cost of acquisition of assets eg, plant and machinery, land and building etc
 Cost of addition, expansion, improvement of the fixed assets.
 Cost of replacement of old assets.

Nature of Investment Decision Making

This is an investment in capital expenditure and it is characterized by the following;
 There is an exchange of current assets for future benefits
 Current assets are converted to long term assets
 Future benefits will occur over several years (long term investment)
 They have a long term and significant effect on the profitability of the concern;
 They involve, generally, huge funds.

 They are irreversible decisions

Importance of Capital budgeting decisions to an organization

 It determines whether or not to invest in short or long term projects such as setting
of an industry, purchase of plant and machinery etc.
 Helps in analyzing the proposal for expansion or creating additional capacities.
 Helps in replacement decision of assets such as old building, plant and machinery
 For financial analysis of various investment proposals in order to choose the best out
of many alternative proposals. ‘’The higher the return, the higher the risk’’ and so
projects have to be analyzed well.

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  Irreversible Nature. Once the decision for acquiring a certain asset is taken, it
becomes very difficult to dispose of these assets without incurring heavy losses.

Procedures of Making Investment Decisions

Steps
 Identify potential investment portfolios
 Evaluate the reliability for individual investment
 Choose from among the investment alternatives that compete to do the same task
( mutually exclusive , or dependent projects , independent projects )
 Construct a final capital budget and in case of inadequate or insufficient funds, reject
some of the projects based on their NPV rankings.
 Analyze the reserves of previous capital budgeting decisions to determine whether
the alternatives that had been previously accepted should be continued, modified
or terminated or abandoned

A project is abandoned if it no longer contributes to shareholders wealth regardless of the

data that made it acceptable.

Assumptions of Capital Budgeting Process

 The shareholders wealth maximization is the only investment goal / motive ie no
other operating role that can influence the investment selection decision.
 The costs and revenues are known with certainty or there exist a forecasting
technique that can generate values with very small errors.
 The costs and benefits of investment are based on cash flows i.e., they are
quantifiable as oppose to accounting profits.
 Cash flows depict a conventional pattern of time series cash flows
 The required rate of return (r)/ cost of capital is known and constant throughout
the life of the project.
 Capital rationing doesn’t exist ie., the firm is to finance the entire set of acceptable
investments.

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CAPITAL RATIONING
Capital rationing arises when insufficient funds are available to finance to finance all projects
which are apparently profitable or acceptable.
Types of capital rationing
1. Soft capital rationing
2. Hard Capital rationing
3. Single period rationing
4. Multi-period rationing

Soft capital rationing – occurs when limitation of funds is from internal management
Hard capital rationing - occurs when limitation of funds is from external providers of
funds
Single Period capital rationing -occurs when rationing doesn’t extend beyond 1 year-
short term investments- NPV OR IRR
Multi-Period capital rationing - occurs when rationing extends beyond 1 year- long term
investments- in this case NPV OR IRR doesn’t work but more advanced methods like linear
Programming.

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 CHAPTER THREE: RISK AND RETURN

SOURCES OF RISK
Return on investment and business risk always move together and at any stage of your
business life cycle, your return may turn into loss. So it is important to know about all the
sources of risk that may impact your business. There are certain sources of risks that make
financial asset risky. These sources aren’t limited to ones singled out below;

1. Interest rate Risk

2. Market Risk
3. Inflation Risk
4. Business Risk
5. Financial Risk
6. Liquidity Risk
7. Exchange rate Risk
8. Country Risk

Interest rate Risk

Interest rate risk is referred to variability in returns of a security which result from changes
in the level of interest rates. Generally securities are inversely affected by such changes.
This means that the price of security moves oppositely to the interest rate provided other
things being equal. Bonds are more affected by interest rate risk than common stocks but
normally both are affected by interest rate risk and it is very significant factor of sources of
risk for many investors.

Financial Risk

The utilization of debt financing by companies includes the financial risk. When more
assets of the company are financed through debt then the variability in the return is
enhanced. Financial leverage/gearing is associated with the financial risk.

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Liquidity Risk

The risk connected with certain secondary market in which there is trading of security is
considered as liquidity risk. An investment that can be sold or bought immediately and
without any important concession in price is regarded as liquid. When there is high
uncertainty about the time aspect arid the concession in price, the liquidity risk is high.
There is little or no liquidity risk for the Treasury bill while the over-the-counter (OTC) stock
contains sufficient liquidity risk.

Market Risk

Market risk is considered as the variability in the returns as a consequence of fluctuations in

the entire market or aggregate stock market. Mostly common stock is more affected by
market risk but all other securities are also exposed to that risk. There is wide range of
exogenous factors associated with the securities that are included in the market risk like
wars, recessions, changes in the consumer preferences, structural changes in the economy
etc.

Inflation Risk

The purchasing power risk is the factor that affects all the securities. It also refers as the
likelihood that the purchasing power of the invested security will fall. Even if the nominal
return is safe, the real return involves risk with uncertain inflation. The risk is associated
with the interest rate risk because the increase in inflation results in the increase in the
interest rates. The reason behind this fact is that additional inflation premiums are
demanded by the lenders in order to compensate for the loss of purchasing power.

Business Risk

Business risk is the risk of conducting business in certain industry or environment. labor
problems may arise that impact a company's production. The need to retain certain key
personnel may result in increased wage costs. Loss of key personnel can affect the
company's performance and profitability – for example, if one of the company's top
salespeople takes a job with another firm, or if the company loses a key product designer.
Included in this risk category is management risk – the risk of bad management decisions
for a company.

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Exchange Rate Risk

Exchange rate risk is associated with international investments in which the returns gained
in other countries are converted back into the local currency which creates uncertainty. The
variability in returns on security as a result of fluctuations in currency is referred to as
exchange rate risk. Exchanger rate risk in also regarded as currency risk.

If the exchange rate is not in favor of the investor than the losses from the movements of
exchange rate can partially or completely counterbalance the originally gained returns.

Country Risk

In current years, country risk is regarded as one of important risk for investors. While
investing internationally, the investors should consider the political and economic stability &
viability of the country. Countries should be judged on relative basis by considering the
United States as a benchmark because of its lowest country risk.

Source: Zkjadoon (2016): Sources of Risk Business Risk-Business Study Notes.

RISK
Risk refers to the variability of the expected return of a given investment. It is a situation
where probability distribution of cash flow of an investment proposal is known, while
expected NPV is uncertain. Risk can be measured for a single investment (undiversified
risk), a group of investments (portfolio risk/ diversified risk).

RETURN
The return of investment is the profit that is derived from the acquired asset. It’s calculated
in several ways;
 Sales less cost
 NPV approach
 Expected monetary method

Since risk can be measured for a single investment or a group of investments, return
similarly can be derived from a single or a group of assets.

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Computations of Expected Returns
Return from single asset;

ER= Return of asset* probability of

return
Return from a group of assets (Portfolio);

ER= Proportion of asset in portfolio* Return of asset* probability of return

RISK MEASUREMENT
A risk of an investment can be measured using the following methods
 Variance of returns
 Standard deviation of the returns
 Co-efficient of variations

Illustration 1
Consider the following investments and their respective returns
Project A Project B

Economy Probability Return Probability Return

condition

Strong Growth 0.25 16 0.25 20

Moderate Growth 0.50 12 0.35 15

Slow Growth 0.25 8 0.40 5

Required:
a). Expected return of Project A & B
b). which project to undertake
Solution
ER/A= (0.25*16) + (0.5*12) + (0.25*8)=12
ER/B= 0.25*20 +0.35*15+0.4*5=12.5
Advice to an investor
An investor should consider investing in project B because it has higher expected return
than project A.

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 Illustration 2
Deng has an investment capital of 1,000,000 SSP. He wishes to invest in two securities, A
and B in the following proportions; A, 200,000 SSP and B, 800, 000 SSP. The return on
these securities depends on the state of the economy shown below;

Returns

State of Probability Security A Security B

economy

Boom 0.4 18% 24%

Normal 0.5 14% 22%

Recession 0.1 12% 21%

Required:
a) Compute the expected return
b) Advise Deng where necessary

Solution
Undiversified risk/individual asset
Security A = Expected Return (ER/A) = Boom =0.4 (18%) =0.072
Normal= 0.5 (14%) =0.07
Recession =0.1(12%) =0.012
Total ER/A= 0.154 (100) =15.4%
Security B = Expected Return (ER/B) = Boom = 0.4 (24%) =0.096
Normal= 0.5 (22%) =0.11
Recession =0.1(21%) =0.021
Total ER/A= 0.227(100) =22.7%
Portfolio risk / diversified =group of assets
0.2(15.4%) + .8(22.7%) = 21.24%

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Computation of Risk on Investment

Illustration 3
Consider the returns of two securities A and B which depend on the states of nature with
the following probabilities;
Security A Security B

probabilities Returns Returns %

%
0.3 12 6

0.4 15 7.5

0.3 10 5

Required:

a) Compute the standard deviation of individual securities

b) Compute the correlation co-efficient between the two securities returns and
comment

Solution
ER/A= R/A*Probability of R/A= (12*0.3) + (15*0.4) + (10*0.3) =12.6
ER/A= R/B*Probability of R/B= (6*0.3) + (7.5*0.4) + (5*0.3) = 6.3

Standard deviation (∂)

Security A Ř=12.6 Security B Ř=6.3

Prob R (R- Ř ¿ ¿2*prob R (R- Ř ¿ ¿2*prob

0.3 12 (12-12.6¿2 *0.3=0.108 6 (6-6.3¿2 *0.3=0.027

0.4 15 (15-12.6¿2 *0.4=2.306 7.5 (7.5-6.3¿2 *0.4=0.576
0.3 10 (10-12.6¿2 *0.3=2.028 5 (5-6.3¿2 *0.3=0.507
2 2
∂ = 4.442 ∂ = 1.11
∂ A=√ ∂2=2.076 ∂ B=√ ∂2=1.0536

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Correlation Coefficient
First, determine the covariance
n
COV (A, B) = ∑ (RA−ŘA)(RB−ŘB) prob
i=1

Prob RA RB n

∑ ( RA−ŘA)( RB−ŘB) prob

i=1

0.3 12 6 (12-12.6) (6-6.3)*0.3=0.054

0.4 15 7.5 (15-12.6) (7.5-6.3)*0.4=1.152

0.3 10 5 (10-12.6)(5-6.3)*0.3=1.014
COV (A,B)= 2.22

COV ( A , B) 2.22
Correlation Coefficient = = = =+1
∂ A∂B 2.1076∗1.0536

It means therefore, risk must be;

 Certain or uncertain i.e. Specific or general

 Measurable i.e. certain or uncertain

 Quantifiable i.e. expressed in monetary terms

 Probable i.e. % of occurrences known

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 CHAPTER FOUR: INTRODUCTION TO OPTIONS
INTRODUCTION
An option contract confers to the holder the right but not obligation to conduct a transaction on
or by a future date at a pre-determined price. Hence, option contract grants a right but not
obligation to either buy or sell the underlying asset at a specified price known as exercise or
strike price which can be exercised within a specified period known as exercise period.
CLASSIFICATIONS OF OPTIONS
An option can be classified into two (2) types:
1. Call option
2. Put option

Call option- This is the contract that grants the holder the right but not obligation to buy the
underlying asset at specified price known as exercise / strike price and the option can be
exercised within the period known as exercise period. This relates to European options only
because American options can be exercised anytime.
Since it is the buyer of asset who is to exercise the option, he/she will be required to pay a non-
refundable commitment fee to the seller of the asset. This fee is known as premium. Premium is
therefore one of the costs associated with option.

Put option-This grants the holder the right but not obligation to sell the underlying assets at
specified price known as exercise price within a period known as exercise period. Since it’s the
seller of the asset who is to exercise the option to sell the asset, he/she will be required to pay a
non-refundable commitment fee to the buyer of the asset. This fee is known as premium.
Financial options can be used to hedge a risk known as currency exposure, also known as
currency risk.

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OPTIONS VALUATION
An option can be said to be ‘’ in the money’’ if it’s exercised and gains are realized by the party
exercising the option. As such, Call Option gains can be realized by the buyer of the asset and
Put Options gains can be realized by the seller of the asset.
On the other hand, an option is said to be ‘’out of the money’’ if it is exercised and losses are
incurred by either the buyer or seller of the option. However, when neither gains nor losses are
realized from exercising an option, it is said to be ‘’at the money’’.
VALUE OF CALL OPTION
Value of a Call option can be computed as follows;

Vc= Max (MPS/S –E,0)

Where
Vc=Value of Call Option
MPS=Market Price Per Share or Stock Price
E= Exercise Price / Strike Price
And so the value of a Call option will be, whichever is higher the difference between the Market
Price Per Share or Stock Price and Exercise Price / Strike Price or Zero (0).
Profit/ Loss on Call option
A gain or loss, i.e., whether a Call is ‘’ in the money, out of the money or ’at the money’’ can be
computed as follows;

Vc –Premium

Where
Vc= Value of Call option computed above

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VALUE OF PUT OPTION
Value of a Put option can be computed as follows;

Vp= Max (E –MPS/S, 0)

Where
Vp=Value of Put Option
E= Exercise Price / Strike Price
MPS=Market Price Per Share or Stock Price
And so the value of a Put option will be, whichever is higher the difference between the Exercise
Price / Strike Price and Market Price Per Share or Stock Price or Zero (0).
Profit/ Loss on Put option
A gain or loss, i.e., whether a Put is ‘’ in the money, out of the money or ’at the money’’ can be
computed as follows;

Vp –Premium

Where
Vp= Value of Call option computed above

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Illustration 1
Consider a Call option with the following characteristics;
Exercise Price =100 SSP
Premium per call option=10 SSP
Time remaining to Maturity =3months
Assume the following Market Price of the underlying security ;0,30,50,80,100,110,130,150,and
160 SSP
Required;
Calculate the value of Call option and gain /loss in exercising the option
MPS E Vc=Max(MPS-E,0) Premium Profit /Loss= Comment
Vc- Premium
0 100 (0-100,0) =0 10 0-10 =-10 Call ‘’out of the money’’
for the buyer but ‘’in the
money’’ for the seller
30 100 (30-100,0) = 0 10 0-10 =-10
50 100 (50-100,0) = 0 10 0-10 =-10
80 100 (80-100,0) = 0 10 0-10 =-10
100 100 (100-100,0) = 0 10 0-10 = -10
110 100 (110-100,0) = 10 10 10-10 = 0 Call ‘’at the money’’
130 100 (130-100,0) =30 10 30-10 = 20
150 100 (150-100,0) = 50 10 50-10 = 40 Call ‘’in the money’’ for
the buyer but ‘’out of the
money’’ for the seller
160 100 (160-100,0) = 60 10 60-10 =50

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FACTORS THAT AFFECT VALUE OF THE OPTION
A Value of an option is affected by the following factors;
 Market Price (MPS/S)
 Exercise Price (E)
 Time to expiration (T)
 Volatility of returns (∂)
 The risk-free rate (Rf)

Call Option
i. Market Price (MPS/S)----- The higher the price the greater the value of a call option
value (+)
ii. Exercise Price (K/E)----- The lower the exercise price the greater the value of a call
option (-)
iii. Time to expiration (T) --------The longer the time the higher the value of a call option
(+)
iv. Volatility of returns (∂) ------The higher the volatility the greater the call option value
(+)
v. The risk-free rate (Rf) – ----The higher the interest rate the greater the value of option
(+)

This can be denoted as:

Put Option
i. Market Price (MPS/S) - ----The lower the price the greater the value of a call option
value (+)
ii. Exercise Price (K/E) ------ The lower the exercise price the greater the value of a call
option (-)

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 iii. Time to expiration (T)--------The longer the time the higher the value of a call option
(+)
iv. Volatility of returns (∂)------ The higher the volatility the greater the call option value
(+)
v. The risk-free rate (Rf)---- – The lower the interest rate the greater the value of option
(+)

This can be denoted as

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 BLACK SCHOLES MODEL
The Black Scholes model is an option pricing model used to calculate the fair/theoretical

price of European calls and puts options that was developed in 1973 by the Economics

Nobel laureates; Fisher Black and Myron Scholes based on a series of assumptions.

An option is a derivative instrument which gives one a right but not an obligation to buy or

sell

An underlying asset in the future at a pre-determined price called exercise or strike price.

There are three types of options:

(a) European options, which can be exercised only at maturity

(b) American options - can be exercised at any time, and

(c) Bermuda options- a hybrid options; a combination of European and American options,

exercisable at the date of expiration, and on certain specified dates that occur between the

purchase date and the date of expiration.

A call option gives the holder the right but not an obligation to buy the underlying asset by

a certain date for a specified price.

While a put option gives the holder aright but not an obligation to sell underlying price by a

certain date for a specified price.

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1. Intrinsic Value and Time Value of Options
- Intrinsic value of a call is the difference between the strike price and the spot price of
the
Underlying (i.e. the greater of 0 or St-K, thence = Max [0, St-K]), and vice versa for put
option Intrinsic value (Max [0, K-ST])
- An option's time value is equal to its premium (the cost of the option) minus its
intrinsic value). (i.e. Time value of a call = Ct-max [0-St-K]). For the put option
time value = Pt-Max (0-K=St) such that in both cases, the option value must exceed
intrinsic value.

Assumptions of Black and Scholes Model

 The options are European and can only be exercised at expiration date.
 No dividends are paid out during the life of the option. - In the real world,
most companies pay dividends to their shareholders. The basic Black-Scholes model
was later adjusted for dividends by Robert Merton (1973)
 Efficient markets (i.e., market movements cannot be predicted) which in real world
is unrealistic
 It assumes that there are no fees for buying and selling options and stocks
and no barriers to trading which is not true of any market.
 The risk-free rate and volatility of the underlying are known and constant.
While volatility can be relatively constant in very short term, it is never constant in
longer term. In the real world, there is no such thing as a risk-free rate, but it is
possible to use the U.S. Government Treasury Bills 30-day rate since the U. S.
government is deemed to be credible enough.
 Follows a lognormal distribution; i.e. returns on the underlying are normally
distributed. This assumption is reasonable in the real world.
 The underlying asset price follows a geometric Brownian motion; This may
not be realistic since given that real markets move in response to discrete news
events such as earnings announcements (Existence of jumps in the market)
 Markets are perfectly liquid and it is possible to purchase or sell any amount of
stock or options or their fractions at any given time.

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Factors That Affect the Option Value:
 Spot Market Price (S) - the higher the price the greater the value of a call option value
(+)
 Exercise Price (K) - The lower the exercise price the greater the value of a call option (-)
 Time to expiration (T) -The longer the time the higher the value of a call option (+)
 Volatility of returns (∂)- The higher the volatility the greater the call option value (+)
 The risk-free rate (rf) – The higher the interest rate the greater the value of option (+)

Mathematical Representation

Illustrations
1. Consider: (Call price: 58.82, Put Price :1.43)
 Spot Price (SP) =300 SSP
 Strike Price (ST) =250 SSP
 Time to Expiry (T)-Years =1
 Volatility (∂) %= 15
 Risk-Free Interest Rate (r) %= 3

2. Consider :

 Time to maturity (T) = 1 year

 Current Price (S) = $120
 Strike Price (K) = $100

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  Risk-Free Rate (r) = 1%
 Price Volatility (∂)= 50%

CHAPTER FIVE: MARKET EFFICIENT HYPOTHESIS (EMH)

EFFICIENT MARKETS HYPOTHESES (EMH)

The efficient markets hypothesis, popularly known as the Random Walk Theory is the
propositions that current stock prices fully reflect available information about the value of
the firm, and there is no way to excess profits ( more than the market overall), by using
this information. It deals with one the most fundamental and exciting issues in finance-why
prices change in security markets and how those changes take place.
Many investors try to identify securities that are undervalued and that are expected to
increase in value in future, and particularly those that will increase more than others. Many
investors including investment managers believe that they can select securities that will
outperform the market. They use a variety of forecasting and valuation techniques to aid
them in their investment decisions. Obviously, any edge that an investor possesses can be
translated into substantial profits. If a manager of a mutual fund with 10$ billion in assets
can increase the fund’s return, after transaction costs, by 1/10th of 1 percent, this would
result in 10$ million gain. The EMH asserts that none of these techniques are effectives
(i.e., the advantage gained doesn’t exceed the transaction and research costs incurred, and
therefore no one can predictably outperform the market.
Arguably, no other theory in Economics or Finance generates more passionate discussion
between its challengers and opponents. For example, noted Havard Financial Economist,
Michael Jensen writes, ‘’ there is no other proposition in Economics which has more solid
empirical evidence supporting it than the Efficient Market Hyopthesis’’, while investment
Maven Peter Lynch claims,’’ Efficient markets? That is a bunch of junk, crazy stuff’’.
The EMH suggests that profiting from predicting price movements is very difficult and
unlikely. The main engine behind price changes is the arrival of ‘’new information’’. A
market is said to be ‘’efficient’’ if prices adjust quickly and on average, without bias, to
new information. As a result, the current prices of securities reflect all the available
information at any given point in time. Consequently, there is no reason to believe that
prices are too high or too low. Security prices adjust before an investor has time to trade on
and profit from a new a piece of information.
The key reason for existence of an efficient market is intense competition among investors
to profit from any new information. The ability to identify over and under-priced stocks is

26
very valuable (it would allow investors to buy some stocks for less than their ‘’true’’ value
and sell others for more than they were worth). Consequently, many people spend a
significant amount of time and resources in an effort to detect ‘’mis-priced’’ stocks.
Naturally, as more and more analysts compete against each other in their effort to take
advantage of over-and –under-valued securities, the likelihood of being able to find and
exploit such mis-priced securities become smaller and smaller. In equilibrium, only a
relatively small number of analysts will be able to profit from detection of mis-priced
securities, mostly by chance. For the vast majority of investors, the information analysis
payoff would likely not outweigh the transaction costs.
Most crucial implication of the EMH can be put in the form of slogan: Trust market prices!
At any point in time, prices of securities in efficient markets reflect all known information
available to investors. There is no room for fooling investors and as a result, all investments
in efficient markets are fairly priced i.e., on average investors get exactly what they pay for.
Fair pricing of all securities doesn’t mean that they will all perform similarly, or that even
the likelihood of rising or falling in price is the same for all the securities.
According to capital markets theory, the expected return from a security is primarily a
function of its risk. The price of the security reflects the present value of its expected future
cash flows, which incorporates many factors such as volatility, liquidity and risk of
bankruptcy.
However, while prices are rationally based, changes in prices are expected to be random
and unpredictable, because new information, by its very nature, is unpredictable. Therefore
stock prices are said to follow a random walk.
In summary an efficient capital market has the following characteristics;
1. Information whether good or bad is quickly reflected in security prices.
2. Transaction costs e.g. commission paid to broker should be minimal so that they
don’t discourage the buying and selling of securities.
3. Investors’ should not obtain high returns for having received information earlier than
others hence all investors should receive information at the same time.
4. There are no investors who will buy securities in large quantities with an aim of
influencing security price by causing an artificial shortage.
5. No investor will make abnormal gains simply because they are experienced or
knowledgeable because the stock exchanges rules will not allow this.

Need for Market Efficiency

An efficient market facilitates transactions therefore promoting liquidity and fair prices. All
deals are made to all in the capital market therefore a large number of buyers and sellers

27
interact in the capital market and the demand and supply forces help in determining the
prices.
Since the information is publicly available and since no single investor is large enough to
influence the security prices, the capital market provides a measure of fair price of
securities. Financial manager borrows and lends (invests) funds in the capital facilities the
allocation of funds between the savers and borrowers. The allocation will be optimum if the
capital has an efficient pricing mechanism.
Capital market deals in securities and a security price has been observed to move randomly
and unpredictably. The randomness of the security price may be interpreted to mean that
investors in capital market take a quick cognizance to all information relating to the security
prices and that security prices quickly adjust to such information therefore efficiency of
security prices depends on the speed of price adjustment to any available information. The
more the speed of adjustment, the more the efficiency of the process will be.
The capital market efficiency may therefore be defined as the ability of securities to
reflect And Incorporate All Relevant Information in Their Prices.
Types of Market Efficiency
Operational Efficiency
Transaction costs do not affect the prices but they can cause on transaction to be more
profitable than another.
Transaction cost of two similar financial transactions may be different. Therefore investors
would prefer one transaction over another. Similarly, transaction costs of how a person took
a transaction may exhibit difficult gain. Therefore efficiency may not be that perfect but to
develop a framework for analysing financial decision, a good starting point to assume that
markets are perfect.

Information Efficiency
The degree of efficiency in the market depends on their level of disclosure and the speed
with which the information is processed by the market and incorporated in the share prices.
Most financial information is published and publicly available but sometimes cetrain persons
may have superior information than others.
Allocation Efficiency
This is how fast and how evenly commodities are allocated to various players in the market.
This leads appropriate investment in the market i.e., when forces of demand and supply

28
regulate the price and the information about the changes are available, then allocation of
transactions is appropriately done.

Forms of Efficient Markets Hypothesis (EMH)

The EMH predicts that market prices should incorporate all available information at any
point in time. There are, however, different kinds of information that influence security
values. Consequently, financial researchers distinguish among the three forms depending on
what is meant by the term ‘’all available information’’.
1. Weak Form EMH
2. Semi- Strong EMH
3. Strong EMH

The weak form of EMH asserts that the current price fully incorporates information
contained in the past historical of prices only. That is, nobody can detect mis-priced
securities and ‘’beat’’ the market by analysing the past prices. The weak form of the
hypothesis got its name from a reason-security prices are arguably the most public as well
as the most easily available pieces of information. Therefore, one should not be able to
profit from something that ‘’everybody else knows’’. On the other hand, many financial
analysts attempt to generate profits by studying what this hypothesis asserts is of no value-
past stock price series and trading volume data. This technique is called technical
analysis.
The empirical evidence for this forms of market efficiency and therefore against the value of
technical analysis, is pretty strong and quite consistent. After taking into account
transaction costs of analyzing and of trading securities, it is very difficult to make money on
publicly available information such as the past sequence of stock prices.
How does one know the capital is efficient in its weak form?
To answer this question, one needs to find out the correlation between security prices over
time:
1. In an efficient capital market, there should not exist a significant correlation between
the security prices over time.
2. An alternative method of testing a weakly efficiency market hypothesis is to
formulate trading strategies using security prices and compare their performance
with stock market performance.
3. The capital market will be inefficient if investors trading strategies could ‘’beat’’ the
market.

29
Weak form efficiency implies that excess returns can be carried by using investment
strategies based on historical share price. It also implies that technical analysis techniques
will be able to consistently produce excess returns though some forms of fundamental
analysis may not still provide excess returns.
Semi-Strong Form EMH
The semi-strong of EMH suggests that the current price fully incorporates all publicly
available information. Public information includes not only past prices, but also data
reported in company financial statements ( annual reports, income statements, filling for
security and Exchange commission etc.), earnings and dividends announcements,
announced mergers plan, the financial situation of company’s competitors, expectations
regarding macro-economic factors( inflation, unemployment) etc. In fact public information
doesn’t even have to be a strictly financial in nature. For example, for the analysis of
pharmaceutical companies, the relevant public information may include the current
(published) state of research in pain-relieving drugs.
The assertion behind semi-strong market efficiency is still that one should not be able to
profit using that ‘’ everybody else knows’’ (information is public).Nevertheless, this
assumption far stronger than that the weak form efficiency. Semi-strong efficiency of the
markets requires the existence of market analysts who not only financial economist able to
comprehend implications of vast information but also macro-economists , experts adept at
understanding processes in products and input markets.
Arguably, acquisition of such skills must take a lot of time and efforts. In addition, the
‘’public’’ information may be relatively difficult to gather and costly to process. It may not
be sufficient to gain information, say for the major newspapers and company’s -produced
publications. One may have to follow wire reports, professional publications and databases,
local papers, research journals etc. in order to gather all information necessary to effectively
analyse securities.

How can we test that the capital market is semi-strong?

1. One can study the effect of securities such as dividends, bonus issues, rights issues,
changes in account policies, the speed with which price share is adjusted to this
information.
2. The semi-strong form market implies that the share price reflect an event or inform
very quickly and therefore it is not possible for an investor to ‘’beat’’ the market
using such information.

30
Strong Form of EMH
The strong form of EMH states that the current price fully incorporates all existing
information, both publicly/published and private/unpublished (sometimes called inside
information). The main difference between the semi-strong and strong is that, in the latter,
nobody should be able to systematically generate profits if even the trading information isn’t
publicly known at the time. In other words, in strong form of EMHs states that a company’s
management (insiders) are not able to gain systematically gain from inside information by
buying shares ten minutes after they decided ( but didn’t publicly announce) to pursue what
they perceive to be a very profitable acquisition. Similarly, the members of company’s
research department aren’t able to profit from new revolutionary discovery the completed
half an hour ago.
The rational for strong form of EMH is that market anticipates, in unbiased, future
developments and therefore the stock price may have incorporated the information and
evaluated in a much more objective and informative way than insiders. Not surprisingly,
though, empirical research in finance has found evidence that is inconsistent with strong of
the EMH.
In conclusion, we can say that strong form efficiency can be realized when
following characteristics surface;
1. Share prices reflect no information, public and private and everyone can earn
returns.
2. If there are legal buyers to private information becoming public as with insider
trading laws, strong efficiency form is possible except in the case where laws are
universally agreed upon.
3. To test for strong efficiency, a market needs not exist where investors can
consistently earn deficit returns over a short period of time.
4. Even if some managers are not constantly observed to be beaten by the market, no
reputations even that strong form efficiency. Some observers dispute the notion that
market behaves consistently with EMH especially in its stronger form. Some can’t
believe that man-made markets are strong form efficient for reason of insufficiency
including slow diffusion of information, the greater power of some market
participants (financial institutions) and the existence of apparently sophisticated
professional investors. Only a privileged few may have price knowledge of loss about

31
 to be enacted and this is why it is difficult to test for strong efficiency in the capital
market.

Assumptions Made For EMH

1. All investors are rational
2. Rational investors have adequate funds
3. Information is instantly available to rational investors
4. Rational investors don’t believe that markets are semi-strong efficient
5. Transaction costs, market impacts effect and required compensation for risk aren’t
large enough to deter prices close to fundamental-value.

If the EMH is valid, are investment analysts and fund managers worthwhile?
The EMH suggests that all relevant information is quickly incorporated into security prices.
This implies that there is no space for making profits from forecasting stock prices.
Investment analysis is concerned with stock selection and market timing. Stock selection
entails trying to ascertain mis-priced investments with the view of buying under-priced
securities and selling over-priced securities.
Active fund management seeks to use the results of investment analysis to manage
portfolios outperform benchmarks, such as stock indices. If investment analysis is
ineffective, active fund management is pointless. Investors would do better to invest in
funds that aim to track stock indices and thereby avoid the expense of investment analysis
and active fund management.
Market timing attempts to forecast the points in time at which markets turn upwards or
downwards. The EMH suggests that investment analysis is pointless on the ground that
available information is already reflected in assets prices and therefore can’t be used to
make forecast of price changes.
However, there is a paradox for new information to become incorporated into security
prices, there may be need to buying or selling based on that information. Investors who
undertake those trades could make profits. Those who are first to receive, or react to new
information will make profits. Investment analysis and active fund management on part of
those who act quickest would be profitable. The absence of any profitable opportunities
would require all investor, both buyers and sellers, to instantly adjust their prices
expectations in light of new information.

What is relevance of the EMH to incorporate financial managers?

32
The relevance of the EMH for financial management is that, if the hypothesis holds true. If
the company makes a ‘’good’’ financial decision, this will be reflected in an increase in the
share price. Similarly, a ‘’bad’’ financial decision will cause the share price to fall. In order
to maximise the shareholder’s wealth , then the financial manager need only to concentrate
on maximizing the net present value of investment projects, and need to give no
consideration to such matters such as the way in which the future position of the company
will be reflected in the company’s financial statements. The financial managers may utilize
rational decision rules and have confidence that the market will rapidly cause the effects of
those decisions to be reflected in the company’s share prices.
What are the implications of the EMH to an investor and to company and
managers?
1. There is no need to pay for investment research.
2. Studying published accounts and stock market tips will not generate abnormal
returns.
3. There are no bargains to be found on efficient stock exchanges to company and
managers.
4. Timing of new issues and rights issues isn’t important since capital market securities
are never under -priced.
5. Altering the financial statements will not mislead the market
6. An efficient market correctly the value of company and expectations about its future
performance and returns. The financial manager should therefore focus on making
good financial decisions which increase the shareholders wealth as they will be
correctly interpreted by the market and share price will adjust accordingly.

Behavioral Finance
EMH remains one of the cornerstones of the modern finance theory. It implies that, on
average, assets trade at prices equal to their intrinsic values. As we noted in the text, the
logic the EMH I straightforward. If stock’s prices is ‘’ too low’’, rational traders will quickly
take advantage if this opportunity and will buy the stock. Their actions will quickly push
prices back to their equilibrium level. Likewise, if prices are ‘too high’’, rational traders will
sell the stock, pushing price down to its equilibrium level. Proponents of EMH argue that
prices can’t systematically wrong unless you believe that market participants are unable or
willing to take advantage of profitable trading opportunities.
While the logic behind the EMH is compelling, many events in the real world seem to be
inconsistent with the EMH. This has spurred a growing field that is called behavioural
finance theory. Rather than assuming that investors are rational, behavioural finance

33
theorists borrow insights from psychology to better understand how irrational behaviour can
be sustained over time.
Pioneers in this field include Psychologists Daniel Kahneman and Amos Tversky and Richard
Thaler, who is a professor of finance at the University of Chicago. Their work has
encouraged a growing number of scholars to work in these promising areas of research.
Professor Thaler and his colleague, Nicolas Barberis, have summarized much of this
research in a recent article, which is cited below. They argue that behavioural finance
theory’s criticism of the EMH rests on two important books. First, it is often difficult or risky
for traders to take advantage of mispriced assets. For example, even if you know that a
stock’s price is too low because investors have over reacted to recent news bad news, a
trader with limited capital may be reluctant to buy the stock for fear that the market forces
that pushed the price down may work to it artificially low for a period of time. On the other
hand, during the recent stock market bubble, many traders who believed (correctly) that
stock prices were too high lost a lot of money selling in the early stages of the bubble
because stock prices went even higher before they eventually collapsed.
While the first building block explains why mispricing may persist, the second tries to
understand how mispricing can occur in the first place. This component is where the insights
from psychology come into play. For example, Kahneman and Tversky suggested that
individuals view potential losses and potential gains very differently. I f you ask an average
person whether he or she would rather Have 500$ with certainty or flip a fair coin and
receive 1,000$ if a head comes up and nothing if it comes out tail, most would prefer the
certain amount of 500$, which suggests an aversion to risk. However, if you ask the same
person whether he or she would rather pay 500$ with certainty or flip a coin and pay
1,000$ if it is head and if it is tail. Most would say they prefer to flip a coin. Other studies
suggest that people’s willingness to take a gamble depends on recent performance.
Gamblers who are ahead tend to take on more risks, whereas those who are behind tend to
become more conservative.
This experience suggests that investors and managers behave differently in down markets
than they do in up markets, which may explain why those who made money in the early
stock market bubbles continue to keep investing in these stocks, even as their prices went
higher. Other evidence suggests that individuals tend to overestimate their true abilities.
For example, a large majority (90% in some studies) of us believe that we have above
average driving ability or above average ability to get along well with others. Barberis and
Thaler point out this.

34
Overconfidence may in part stem from other biases, self-attribution bias and hindsight
bias.
Self-attribution bias refers people’s tendency to ascribe any success they have in some
activity to their own talents, while blaming failure on bad luck, rather than on their own
ineptitude. If this done repeatedly, it will some make pleasing but erroneous conclusion that
they are very talented. For example, investor may become overconfident after several
quarters of investing.
Hindsight bias is the tendency of people to believe, that after an event had occurred that
they predicted it before it happened. If people think they predicted the past better than they
actually did, they may also believe that they can predict the future better than they actually
can.
Behavioral finance is the study of influence of psychology on the behavior of financial
practitioners and subsequent effects on the markets. Behavioral finance is of interest
because it helps to explain why and how markets may be inefficient. Biasness gives rise to
excessive trading and retention of losing the position well after the evidence indicates that
the bias for original investment has changed. This shows that managers under-perform their
benchmark and most investors are aware of the facts, although the urge to deny over
powers of the rational conclusion.
Most of the standardized assumptions that underlie investment forecast and portfolio
management are wrong. The fail to take into account emotional and psychological bias of
those practising the investment acts. Fear, greed, risk seeking, evasion and peer
pressures all play role in the underperformance of many investment managers relative to
their objectives. Behavioral finance with its roots in psychology of human decision making
explains to us why most investment managers are:
1. More confident than they should be in their forecasting ability
2. Do not process information instantly
3. Experience illusion of control
4. Do not act as if the choices they make come from a probability distribution
5. Give undue credence to management and research.

Which Systematic biasness can occur in financial market?

1. Tendency to give too much emphasis to more cent information
2. Tendency to weigh prospective losses about twice heavily than prospective profits.
Prospect theory suggests that they should be weighted equally.

35
 3. Overconfidence- tendency on the part of investors to regard success as arising from
their expertise while failures are due to back luck or actions of the others.
4. Representativeness- many investors extrapolate price movement. They believe if
prices have been rising in the past then they will continue to rise, and conversely
with falling prices.
5. Conservatism- investors are slow to change to change their views following the
receipt of new information.
6. Narrow framing- tendency of investors to focus too narrowly.
7. Ambiguity aversion suggests investors prefer to invest in companies that they feel
they understand.
8. Confirmation bias- investors pay more attention to evidence that supports their
opinions than to evidence that contradicts them.
9. Cognitive bias-it is the illusion of control.

Efficient and Fundamental Analysis

In finance the EMH asserts that financial markets are informational efficient or the prices on
traded assets e.g. stocks, bonds or properties, already reflect all known information and
therefore are unbiased in the sense that they reflect collective beliefs of all investors about
future prospects.
EMH states that it isn’t possible consistently outperform the market by using any
information that market already knows except through ‘’luck’’.

Anomalies in Efficient Market

Efficiency in the market doesn’t rule out price anomalies because as much as the
participants are aware of the information likelihood that through cartels, they can
manipulate commodity i.e., securities and assets is likely.
Some can force a variety of pricing hence face pricing problems such as unnecessary
discounting and quoting prices below break-even point.

36
Causes of inefficiency or anomalies
1. Insider trading

This occurs when investors seek to obtain additional information from relatives or friends
who could be working in the company in which they intend to purchase securities from.
These investors end-up receiving information earlier than other investors in the market.
2. Taxation effect

In instances whereby some companies are required to pay taxes while others not required
then those which pay taxes are likely to report lower profits when compare to those which
do not pay taxes. Hence, market investors will end-up over valuing security of these
companies which don’t pay taxes and under- valuing security of these companies which pay
taxes.
3. Small Business gap effect

Because of sizes of the company, the market may end-up over-valuing or under-valuing its
securities e.g. security prices of small companies may under-valued and vice versa.

37
CHAPTER SIX: COST OF CAPITAL

COST OF CAPITAL

Cost of Capital – This is a minimum rate of return that a firm must earn on its projects in
order to retain its market value and also attract funds. It is also a compensation for both
time and risk for the market providers of the funds. It is a financial yardstick or standard of
allocating funds supplied by owners and creditors to various investment projects.
Importance of Cost of Capital

Evaluation of investments
Cost of Capital is a minimum rate of return that a firm must earn in order to be acceptable.

Evaluation of management performance

This regards generation and utilization of funds. This is done by comparing the actual cost of
capital to the forecast cost of capital or comparing the actual returns earned on a project
against actual cost of funds.
Firm’s Value Maximization
The major objective of the finance manager is to maximize the shareholders’ wealth (firm’s
value). In order to achieve this goal, the firm must attempt to minimize all input costs
including cost of capital.
To decide debt policy
In determining the optimal debt policy, the firm must consider the specific sources of capital
and choose that mix that reduces the overall cost.

38
Specific Sources of Capital
This represents the cost of a specific component of capital in the firm’s capital structure.
These are;
 Cost of ordinary shares
 Cost of preference shares
 Cost of debt
 Cost of retained earning

The Cost of Ordinary Shares (Ke)

1. Zero dividend growth rate of ordinary shares

D
If value (price) (Ke), Po =
r
But since cost of capital is equal to required rate of return(r), then
D
Po==
ke
Where
Po =Market Price per share
D=Dividend per share
Ke= Cost of Equity
Making (Ke) the subject of the formula,
D
Ke==
Po
2. Constant dividend growth rate ordinary share

Do(1+ g)
If value (price) (Ke) for constant growth rate, Po =
r−g
Substituting r for Ke,
Do(1+ g)
, Po =
Ke−g
Making Ke subject of the formula;
Do( 1+ g) D1
Ke = +g = +g
Po Po
The Cost of Preference Shares (Kp)
For perpetual securities;

39
 D
If value (price) (Kp), Po =
r
But since cost of capital is equal to required rate of return(r), then
D
If value (price) (Kp), Po =
Kp

Making Kp the subject of the formula,

D
Kp =
Po
Where
Kp = Cost of preference shares
Po = Market Price Shares
D= Dividend per Shares
The Cost of Debentures or Bonds
The cost of irredeemable debentures (Kd)
The cost of perpetual security is called the current or flat yield. Irredeemable debentures
are perpetual securities.
I
If Vd =
r
But since cost of capital is equal to required rate of return(r), then
I
Vd =
Kd
Making Kd the subject of the formula,
I
Kd== ( 1−t )
Vd
Since debenture interest is tax allowable.
Where
Kd= Cost cost of debt
I = Interest
Vd= Value of debt
T = Ttax rate
The Cost of Redeemable Debentures
The cost of redeemable debentures is called redemption yield or yield to maturity. It
considers capital gain and losses associated with the security. Yield to Maturity is calculated
as follow;

40
 Pb
I +(Mn− )
n (1-T)
( Mn+ Pb)/2

Where
I = Interest
Mn=Nominal Value of security
Pb= Market Value of security
n = Number of years to maturity
T= Tax rate
Example
A company has a 4 year 12% 1000 SSP debenture which is redeemable at par. The current
market value of the debenture is 900 SSP. Assuming a Corporate Tax of 30% . Determine
the yield to maturity of this debenture.
Solution
n=4 years
Mn=1000 SSP
Pb=900 SSP
T= 30%
I = 12*10000= 120

120+(1000−900)/4
(1-0.3) =10.68%
(1000+ 900)/2

The Weighted Average Cost of Capital (WACC)

This also known as the composite or overall cost of capital. It is the average cost of all the
sources of finance already employed by the company. Weight average cost of capital is
more relevant in decision making as opposed to the component cost of capital. This is
because it can be used;
As discounting rate or required rate of return for evaluating the company’s existing projects.
To indicate the overall risk level of the company by comparing the weighted average cost of
capital of the company with that of its competitors. The higher the WACC, the more risky
the company and vice versa.

Steps of Calculating WACC

41
 1. Calculate the component cost of each source of finance used in the company’s capital
stricture
2. Divide the capital component of each specific source of fiancé by the total of the firm
3. Multiply the specific component cost with its proportion/weight in capital structure
4. Add all the individual costs so as to obtain WACC

Example
Consider a company with the following capital structure.
Source Amount (SSP) After Tax component %

Ordinary share 80,000 18

Preference share 20,000 15
Debentures 50,000 12

Required
Calculate the WACC of this company

Solution
1.Source 2.Amount 3.After Tax 4.Proportio 5.Cost of 6.WACC
(SSP) component n Capital %
% (2/total) (4*5)

Ordinary 80,000 18 0.54 18 9.72

share
Preference 20,000 15 0.14 15 2.10
share
Debentures 50,000 12 0.34 12 4.08
Total 150,000 15.90

42
Modigliani and Miller Propositions (MM)
Modigliani and Miller Proposition (MM) include the following;
I. MM I without corporation taxes
II. MM II with corporation taxes
III. MM III with corporation taxes and personal taxes
IV. MM IV with corporation taxes and financial distress

MM I without Corporation Taxes

This approach is identical to the net operating income approach. MM argues that in the
absence of taxes, a firm’s market value and cost of capital remains invariant to the capital
structure changes. They argue that two firms only differ in the way they are financed and
their total market values.
Investors sell their shares of the overvalued firm and buy shares of the undervalued firm
and continue this process until the two firms command the same value. This process is
called Arbitrage process.
Illustration 1
Consider two firms; Kush Bank and Liberty Commercial Bank are identical in all respects
except in capital structure. Both firms have EBIT of 900,000 SSP while Liberty Commercial
Bank is all Equity Financed, the cost of Equity for both firms is 10% and Liberty has 400,000
SSP of 7.5% debt. Assume that there are no taxes.
Required:
I. Compute the values of the two firms using the Net Income Approach

43
 II. Show the nature of Arbitrage Process that will occur to equate values of the two
firms

Solution
Value of firm =Equity (Ks) + Debt (Kd)
Where
Ks=Cost of Equity
Kd=Cost of Debt/Debenture
But
EBIT −I
Ks¿
Ks
And

Ks¿
∫¿¿
Kd

Description Kush Bank Liberty Bank

Debt 400,000 -
EBIT 900,000 900,0000
Interest (300,000) -
(7.5%) (W-
1)
EBIT −I 6,000,000 9,000,000
Ks¿
Ks

Kd¿
∫¿¿ 4,000,000 -

Kd

Value of 10,000,000 90,000,00

firm=Ks+Kd

Workings
W1-7.5% (400,000) =300,000
Arbitrage process without taxes

44
MM argues that the above valuation represents disequilibrium that might not persist for
long. Therefore, investors will quickly know that Kush Bank is overvalued while Liberty is
undervalued.
Consider an investor, who owns 10% of Kush Bank’s stock, his/her arbitrage will be as
follows;
S/he will dispose 10% of his stock, that is 10% of 6m and borrow debt of 10% of 4m.
Arbitrage Process
Total income =600,000+400,000=1,000,000
Therefore 1m is to be invested in firm U.
Old income
10%*600,000=60,000 SSP
New income
1, 000,00 /900,000
Less Interest
7.5% (400,000)=30,000
70,0000
Arbitrage gain =70, 000-60,000=10,000
MM argues that investors will sell the shares of Kush Ban and buy shares of Liberty
Commercial Bank and continue with this process until the two firms command the same
value. Therefore, at this point MM argues that without taxes, the value of undervalued firm
is equal o the value of leveraged firm.
Special Assumptions
I. There are no transaction costs
II. Corporations and individuals can borrow at same rate of interest.

MM II with Corporation Taxes

Under this proportion, MM argues that capital structure is relevant. With taxes MM
proportion changed and they argue that leveraged firm commands a higher value because
interest on debt is tax deductible to the issuing firm.
Whereas dividends aren’t tax deductible to the dividend paying corporations. Consequently,
the total amount of funds available to pay debt and shareholders is greater bif debt is
employed.
The Equilibrium value of the firm is expressed by the following relationship:
VL=Vu+BT
Whereas
B=Amount of debt paid

45
T=Tax rate
BT=Present value of interest tax shield
VL=Equilibrium value of the leveraged firm
EBIT−I (1−t)
Vu=
Ks
Since there is debt
EBIT (1−t)
Vu=
Ks
Where Vu= value of unleveraged firm
MM model leads to a conclusion that in the world of taxes, the value of the firm will be
maximized and its overall cost minimized if it uses debt in the capital structure ie 100%
leveraged.

Illustration 2
Consider two (2) firms that are identical in all respects except on their capital structure.
Firm L has 4m SSP of 7.5% debt while firm U is all Equity financed. Both firms have EBIT of
900,000 SSP. The Equity capitalization rate is 10% and the corporation tax is 40%.
Required:
I. Calculate the values of the two (2) firms using the net income approach
II. Using the MM models, calculate the equilibrium values
III. Show how the investor of the overvalued firm can increase his/ her returns without
increasing the risk (arbitrage process).

Solution
Description Firm L Firm U
(SSP) (SSP)
EBIT 900,000 900,000
Interest(7.5% (300,000) -
EBIT) (W-1)
EBT 600,000 900,000
Corporation Tax (240,000) (360,000)
40% EBT(W-2-3)

PAT 360,000 540,000

Vu= 3,600,000 5,400,000

46
 EBIT−I (1−t)
Ks

Interest 4,000,000
Vu=
Kd

Value of 7,600,00 5,400,000

firm=Ks+Kd 0

Workings
W-1 7.5% (900,000)
W-2 -40% (600,000) = 240,000
W-3-40% (900,000) = 360,000
W-4 7.5% (300,000)=4,000,000
W-5 =VL=VU+BT=5,400,000 + (0.4*4,000,000) =7,000,000
According to MM valuation, the 7,600,000 of the firm represents disequilibrium.
Investors will therefore buy those of the undervalued firm and in the process bringing
down the value of the overvalued firm.
Consider an investor who owns 5% of the firm L’s stocks, then he will dispose his value,
that is 5% of 3,600,000 SSP and borrow 5% of 4,000,000 and his interest in firm U will
be;
Total amount invested=5% (3600000) +5% (400000) =380,000 SSP
Arbitrage Process
Old income
5% (3600000) =18,000 SSP
New income
380,00
∗5,40,000=38,000
5,400,000
Less Interest
7.5% (200,000)(1-0.4)= (9000)
29,000

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Arbitrage gain= 29,000-18,000= 11,000 SSP

MM therefore argues that arbitrage process will cease when the value of the leveraged firm
is 7,000,000 SSP.

MM III with Corporate and Personal Taxes

If investors pay the same rate of personal taxes on debt, as well as stock return, then the
advantage of corporate tax in favour of debt capital remains constant. MM argues that
personal taxes simply reduce but don’t eliminate the advantage of corporate taxes in favour
of debt capital.
Under this approach therefore,
EBIT (1−TC )(1−Tp)
Vu=
Ks
Where
TC=Corporate Tax Rate
TP=Personal Tax Rate
Therefore, the advantage on a SSP of debt will be;
BTc (1−Tp)
❑

And therefore the equilibrium value of the firm will be

VL= Vu+
BTc (1−Tp)
❑

Illustration 3
Given the following facts about Ivory Bank
 EBIT= 900,000 SSP
 Corporation tax rate =40%
 Cost of debt=7.5%
 Value of debt =4m SSP
 Cost of Equity= 10%

Personal tax rate=30%

Required:
I. Calculate the value of unleveraged firm

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 II. Calculate the value of leveraged firm

Solution
EBIT (1−TC )(1−Tp)
Vu=
Ks
900,000(1−0.4)(1−0.3)
= 3,780,000 SSP
0.1

VL= Vu+
BTc (1−Tp)
❑
VL= 3,780,000+
4,000,000∗0.4 ( 1−0.3 ) = 4,900,000 SSP
❑
Note: The advantage of corporate tax in favour of debt in the company.

In the above formula, VL= Vu+

BTc (1−Tp) is only valid if the personal tax rate applicable
❑
to stock as well as debt is the same.
In many countries, however, stock income dividends and capital gains are taxed at rates
that are effectively lower than that of the debt income (interest).
Where the personal tax rate on stock income differs from personal tax rate on debt income,
then the advantage on a SSP of debt is given as follows;

(1−Tc )(1−TPs)
Tax advantage on SSP of debt= 1-
1−TPd

EBIT (1−TC )(1−Tps)

Vu=
Ks

At equilibrium

(1−Tc)(1−TPs)
VL =Vu + B 1-
1−TPd

Notes:
1. If (1-Tc) (1-Tps) > (1-Tpd), then the tax advantage on debt is negative and hence
the debt should be avoided.

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 2. If (1-Tc) (1-Tps) < (1-Tpd), then the tax advantage on debt is positive and hence
the debt should be used heavily in the business.
3. If (1-Tc) (1-Tps) = (1-Tpd), then the tax advantage on debt is zero and hence the
capital structure is irrelevant.

MM IV with Taxes, Bankruptcy and Agency Costs

MM explains the practical behaviour of managers and their capital structure decisions.
In practice, managers don’t use debt heavily because they are risk averse.
MM argues that after reasonable limit of debt is exceeded, two costs arise, ie bankruptcy
and agency costs that effectively reduce the firm value.
Bankruptcy Costs
In perfect capital market, there are no costs associated with bankruptcy. If a firm is
bankrupt, assets can be sold at their economic lives and therefore there are no legal or
administrative costs.
In real world however, there are considerable costs associated with bankruptcy when
assets are disposed under distressed condition at a significant discount (deep discount)
below their economic values.
Legal and administrative costs associated with bankruptcy proceeds are quite high
Finally, an impending bankruptcy entails significant costs in firm of sharply impaired
operational efficiency.
Probability of bankruptcy increases at an increasing rate that leverage beyond a certain
level (reasonable limit).
Bankruptcy costs represent a loan that can be diversified and hence, the investors
expect higher rate of return from a firm that is faced with prospects of bankruptcy.

Agency Costs
When a firm obtains debt capital, creditors will put restrictions in form of protective
covenants eg
 Approval by creditors before managerial appointments are made
 Maintenance of current ratios above certain level
 Limitations on the rate of dividend
 Constrains on additional issue of capital
 Limitation on further investments

50
This restriction entails considerable legal and enforcement costs and they also impair
operational efficiency of the firm.
These costs generally reduce the firm value and they are eventually borne by common
shareholders in the form of wealth reduction.
When leverage is high, lenders will usually impose excessive agency costs that will reduce
the value of the firm.

CHAPTER SEVEN: CAPITAL STRUCTURE DECISION

CAPITAL STRUCTURE
Capital structure---is the mix of debt and equity used by the firm in financing its activities.
This decision plays an important role in the maximization of shareholders wealth (firm’s
value). Poor capital structure can result in a high cost of capital and hence low net present
values (NPV) investment projects since NPV is inversely related to the cost of capital, the
firm must make proper decisions on how its investments are going to be financed.

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Theoretically, an optimum capital structure should be planned for every firm every time an
investment decision is to be made. This is the mix of debt and equity that minimizes the
overall cost of capital and simultaneously maximizes firm’s value.

FACTORS TO CONSIDER IN CAPITAL STRUCTURE DECISION

Profitability
The capital structure of the firm should be most advantageous in term its profitability. The
maximum use of debt should be encouraged as this is a cheaper source of financing.
Solvency
This is the ability of the firm to service its obligations as and when they fall due. Excessive
use of debt threatens the firm’s solvency. It should therefore be only used to the extent that
it doesn’t add significant risk to the firm.
There is trade-off between risk (solvency) and profitability (return) in the determination of
proper capital structure.
Flexibility
The firm should be able to change a capital structure to meet changing conditions with
minimum cost and delay.
Capacity
This is the ability of the firm to absorb debt. The firm’s debt carrying capacity is influenced
mainly by its cash inflows.
Control
Capital structure should involve minimal loss of the company’s shareholders. This factor is
important especially where a firm is owned by a few numbers of ordinary shareholders.
Corporate Tax Rates
In economies where corporate taxes are high, companies should be encouraged to use more
debt capital in order to enjoy interest tax shield benefit.

Industrial Norms
A company may adapt a capital structure which is similar to that its competitors or similar
to the industry where it operates.
Size of the company
Large and well established companies would have a wide access to capital markets and vice
versa. Large companies may therefore have a higher gearing ratio and vice versa.
Nature of assets

52
A company with more tangible assets which it can pledge as a security to obtain debt many
end up having more debt in its capital structure and vice versa.
Management attitude towards risk
If the company’s management is composed of risk averse managers, then the company will
end up using less debt in its capital structure so as to reduce its financial risk and vice
versa.

CHAPTER EIGHT: DIVIDEND POLICY

Dividends are part of earnings that are distributed to ordinary shareholders for investing in
the company. Dividend decisions are important to the company for main reasons;
2. They provide a solution to the dividend problems i.e., does payment of
dividend increase or reduce value of the firm.

53
 3. It’s part of the company’s financial strategy i.e., payment of high dividend
minimizes retained earnings and hence the need for more debt capital in the
company’s structure.

A dividend policy decision involves the following four critical issues questions of -
4Qs.2WHs;
1) When should the firm pay the dividends?
2) Why should the firm pay the dividends?
3) How much dividends should the company pay?
4) How should the firm pay the dividends?

WHEN SHOULD THE FIRM PAY THE DIVIDENDS?

A company can pay dividends twice in the course of financial year i.e., interim and final or it
can pay dividend once i.e., final dividends.
The question on whether to pay dividend interim and final dividends or just final dividend
will depend on;
 The company’s liquidity position
 The expectation of the shareholders
 The need for cash for financing purpose

HOW MUCH DIVIDENDS SHOULD THE COMPANY PAY?

There are four (4) different dividend policies that influence the amount of dividend per share
that the company can pay. This includes;
a) Constant dividend pay-out ratio

Under this policy, a company could pay a fixed proportion of its earnings attributable to
ordinary shareholders as dividends.
Since earnings fluctuate over time, the Earnings Per Shares-EPS and Dividend Per Shares-
DPS will also fluctuate.
This policy has the following implications;
 It creates uncertainty as to the amount of dividend income receivable by
shareholders.
 The shareholders may require a higher rate of return to compensate them for
uncertainty.
b) Constant/ Fixed Dividend Per Share

Under this policy, a company could pay fixed amount of dividend per share irrespective of
the level of earnings.

54
Therefore in this case, the ordinary shareholders are treated as preference shareholders
because they receive constant dividends.
In this case, EPS may fluctuate over time but the dividend per share remains constant.
This policy has the following implications;
I. It creates certainty and is therefore preferred to low income earners
II. Certainty reduces the shareholders’ required rate return.
III. When the firm has high earnings, more income will be retained for future financing
needs.
c) Low Constant Dividend Per Shares plus Bonuses

Under this policy, dividend per share is set at very low level and is paid every year.
However, a bonus or extra dividend is paid in the year(s) of supernormal earnings.
This extra ordinary dividend is paid in such a way that it is not seen as commitment to a
firm to continue paying the same in future.
Therefore the EPS will be fluctuating overtime while DPS will remain constant with
occasional bonuses or surpluses.
Implications of this policy
 It gives the flexibility to increase dividends when earnings are high
 It gives shareholders a chance to participate in supernormal earnings

d). Residual Dividend Payment Policy

In this case, dividends are paid out of earnings left after all profitable investment
opportunities have been financed.
Therefore, out of earnings attributable to ordinary shareholders, the first allocation is
towards financing all projects yielding positive NPV.
This policy attempts to maximize the value of the firm and shareholders wealth.
This policy has the followings merits:

a) Savings on floatation costs

The use of internally generated funds (earnings) to finance new projects doesn’t involve
floatation cost as compared to issue of new securities.
b) Avoidance of dilution of ownership

With no issue of additional ordinary shares, there will be no dilution of ownership’s control
and future DPS of the firm.
c) Tax Position of shareholders

55
The investment of earnings in projects with positive NPV will lead to increase in MPS and
investors will realize capital gains and are not taxed in other countries.
This will reduce the tax burden of the shareholders who have high income from other
sources.
HOW SHOULD THE FIRM PAY DIVIDENDS?
A company can pay dividends in different forms such as;
1. Cash Payment

This is the most common mode of dividend payment. However, the payment of cash
dividend will depend on;
a) The company’s liquidity position
b) The financing needs of the company

2. Bonus/ Script Issue

This is also known as dividend re-investment scheme. It involves giving free shares to
existing shareholders instead of cash dividends.
The shares will be given in proportion of the shareholders’ ownership.

This method has the following advantages;

 There is conservation of cash since money isn’t distributed as dividend.
 There is tax advantage whereby free shares can be sold to realize capital gains that
are taxed in some countries like Kenya.
 In case of increase in future profits, the bonus issue will be an indication of high
future dividends to the existing shareholders.

4. Stock Split/ Reverse Split

This is the process that a company undertakes to reduce the par value of its shares and to
increase the number of ordinary shares by the same proportion.
The major reason for stock split is to make the shares attractive and more affordable than
before. Stock split has no effect on the net worth of the company.
Reverse Stock Split is the opposite of the stock split. It involves the consolidation of the
shares into bigger units of stocks.

56
In this case, the number of ordinary shares is reduced while the par value is increased by
the same proportion that has been used to reduce the ordinary shares outstanding.
5. Stock/share Re-purchase

This is where a company buys back the ordinary shares from existing shareholders by
paying them a price that is slightly higher than the market price.
Stock re-purchase reduces the number of ordinary shares outstanding and this will increase
the EPS and DPS to shareholders who will in the firm.
Stock re-purchase is carried out by a form with excess funds but has no investment
opportunities.
6. Rights Issue

This is a method of issuing additional shares to existing shareholders. In right issue,

shareholders are given a priori or a right to purchase the shares from the company at a
price that is slightly lower than the existing MPS.
This price is known as offer price or the subscription price. The shareholders will buy
additional according to their current shareholding.
Rights refer to the number of shares that an investor is holding that will enable him/her to
buy one/more share(s) after the rights issue.
Existing number of shares
Number of Rights = be issued ¿
Shares ¿
Each and every to purchase one share will have its own value. Before the rights issue, the
market price of the shares will be include the value of the right and this is called cum-
right-market price per SSP.
NPV
Cum-rights MPS = MPS before rights issue +
Number of shares
After the rights issue, the Market Price Share –MPS will exclude the value of rights. This
price will be called the Theoretical Ex-Rights Price.
Theoretical Ex-Rights Price=

Market Value of Existing Shares+ Amount ¿ be raised through rights ¿

NNumber of existing shares +shares issued thr
 The rights issue doesn’t increase the wealth of existing shareholders.
 This is because it involves the transfer of wealth from one form to the other ie from
cash to the ordinary shares.
 On declaration of the rights issue, shareholders have 3 options;
1. To exercise the rights to buy shares

57
 In this case, the wealth of the shareholders and his percentage ownership remain
same.
2. Sell the rights to buy shares

In this case, shareholders’ wealth remains the same but his percentage
ownership declines.

3. Ignore the right issue

In this case, the shareholders % ownership and wealth decline.

WHY SHOULD THE FIRM PAY THE DIVIDENDS?

The question on why pay dividends can be answered by various dividend theories and
attempt to explain whether the payment of dividends affect value of the firm. They include;
1. MM. Dividend Irrelevance Theory

In this case MM argues that dividend policy has no effect on either the price of the firm’s
stock or its cost of capital.
They state that dividend policy is therefore irrelevant
They argue that firm’s value is determined by its basic earnings power or cash flows and the
risk class.
The dividend policy has therefore no effect on the manner the earnings or dividends of the
firm behave.
 They based their view on the following assumptions;
 There are no transactions associated with the floatation of shares.
 There are no taxes on Corporate and Personal income.
 The company’s investment policy is independent of the dividend policy.
 The information known to managers is also is known to the managers.
2. Agency Theory of Dividends

The agency problem between the shareholders and the management can be solved through
the payment of dividends.
This can be explained as follows;
a) If all earnings are paid out as dividend, managers will require raising additional
equity capital to finance future projects.
b) This will expose the managers to providers of capital in order to finance the future
projects.

58
  If the managers were to seek the external borrowing, they must engage in activities
that maximize the shareholders wealth or value of the firm and they must make full
disclosure of the activities to the providers of the funds.
 Managers will become self -regulated and there will be no need of incurring agency
costs.
 Therefore the higher the dividends, the higher the value of the firm and vice versa.
3. The Bird in Hand Theory of Dividend

The theory is based on certainty of dividends over the capital gains.

The theory argues that if dividends are paid, then they are used to finance projects with
positive (+ve) NPV.
This leads to an increase in MPS, leading to the realization of capital gains in future.
Theory can be summarized as follows;
 Investors who are risk averse will prefer dividend to capital gains.
 Dividend income is immediate and more certain (The Bird in Hand) compare to
capital gains that are receivable in future which are highly uncertain.
 Given that most investors prefer certain income, they will prefer dividend income to
capital gains and therefore a company that pays high dividends will have higher
value and vice and versa.
4. The Clientele Theory of Dividend

Different groups of shareholders prefer different pay-out ratio policies eg retired individuals
prefer current income and could like to invest in company with high pay-out ratio.
However, investors in their peak earnings years have no need of current investment income
and will simply re-invest any dividend received after paying taxes.
However, MM argues that one clientele is as good as any other. The existence of dividend
of clientele effect doesn’t suggest that one policy is better than other.
5. Tax Differential Theory of Dividend

This theory argues that capital gains tax is generally lower than tax on dividend income.
Investors pay taxes on dividends in the same year when the dividends are received whereas
the capital gains tax if any is only payable when gains are actually realized i.e. when shares
are sold.
From the tax point of view, investors will therefore prefer capital gains to dividends income
in order to minimise the tax burden.
7. Information Signaling Theory

59
It was developed by Stephen Ross in 1977. Ross observed from empirical studies that firms
that with increased significant dividend payments have a corresponding increase in shares
prices.
Whereas those firms that significant reduced dividend payments have a corresponding
decline of share prices. This in his opinion suggests that investor will prefer dividends to
capital gains.
In response however, he argues that investors’ reaction on changes in dividends policy
doesn’t necessarily show that investor prefer dividends to capital gains. Rather the fact that
prices follow a dividend action simply indicates that there is important information.
DIVIDEND MODELS
Over the years, various models have been developed establish the relationship between
dividends and stock prices.
The most important of them is Walter’s model. Walter devised an easy and simple formula;
Maximize the wealth position of the shareholders. He considers dividends as one of the
important factors determining, the market value.
According to Walter, in the long run, share prices reflect present value of future stream of
dividends. Retained earnings influence stock prices through the effect on further dividends.
Assumptions of Walter’s Model
a) The company is a going concern with perpetual lifespan.
b) The only source of finance is retained earnings i.e., there is no other alternatives
means of financing.
c) The cost of capital and return on investment are constant throughout the life of the
company.

1
Price= ¿
K
Where
K= Cost of capital
D= Dividend Per Share
E= Earnings Per Share
ROI= Return on Investment
P= Market Price Per Share

Note:
If the IRR (ROI) is higher than the market capitalisation rate (cost of capital) the value of
ordinary shares will be higher even if dividends are low.

60
However, if ROI within the business is low than what the market expects, the value of share
will be low. In such cases, the shareholders will expect high dividends.
Walter’s model explains why markets prices of shares of a growing companies are high even
dividends payments are low.
It also explains why markets prices of shares of certain companies can pay, high dividends
and retain low profits are high.
Illustration 1
A ltd pays dividends of 5 SSP per share in 2009-2010. The company follows a fixed dividend
pay-out Ratio of 30% and earns a return of 18% on its investment. The cost of capital is
12%. Determine the market value of company using Walter’s model.
Solution
K= 12%
DPS= 5 SSP
ROI = 18%
EPS =16.7 (W-1)
DPS
DPR =
EPS
DPS
EPS =
DPR
Where DPR= Dividend Pay-out Ratio
5
EPS= =16.7/share (W-1)
0.3
Price=¿)
Market Price of A ltd = 187.92

LINTNER’s MODEL OF DIVIDEND

This model has the following implications

61
 1. Firms establish their dividends in accordance with the level of current earnings.
2. Changes of dividends overtime don’t correspond exactly to changes in earnings in
immediate period.

According to Lintner;

D1= Change in Dividends (D1-D0) * Adjustment factor +D0

Or
D1= Pay-out Ratio * EPS –D0 + D0

Illustration 2
Liberty Commercial Bank follows a fixed dividend pay-out Ratio of 60%. In the financial year
2010/2011, it declared and paid dividend of 1.2 per share when its Earning Per Share was
300 SSP. If the adjustment factor is 0.7, determine the changes in dividends over time for
Liberty Commercial Bank.
Solution
D1= Pay-out Ratio * EPS –D0 + D0
D1= ((0-6*300)-1.2)) 0.7+1.2 =126.36

Factors Affecting Dividend Policies in Practice

1. Investment opportunities available to the firm

62
The firm with good investment opportunities attempts to conserve their cash flows. They
will therefore only pay the dividends after investment opportunities have been exploited.
2. Alternative sources of finance

If a firm is able to raise the capital easily from external sources, it can distribute more
dividends since it will not rely heavily on retained earnings.
3. Loan Covenants

A firm will be restricted by debt covenants from paying dividends unless retained earnings
exceed a certain level.
4. Profit stability

A company with a stable pattern of profits is in a better position to pay high dividends than
firms with reliable profits.
5. Control

Low dividend policy and hence high profit retention can help the firm to avoid the need of
issuing new shares, implying that control of shareholders isn’t diluted.
6. Impairment of capital rule

Common dividends can’t legally exceed retained earnings. The legal restriction is designed
to protect creditors. Without this rule, a firm in financial difficulties may distribute most of
its earnings to the shareholders as dividends.

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