Professional Documents
Culture Documents
FM59 Old Guide
FM59 Old Guide
L. Fung
AC3059
2012
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This subject guide is for a 300 course offered as part of the University of London
International Programmes in Economics, Management, Finance and the Social Sciences.
This is equivalent to Level 6 within the Framework for Higher Education Qualifications in
England, Wales and Northern Ireland (FHEQ).
For more information about the University of London International Programmes
undergraduate study in Economics, Management, Finance and the Social Sciences, see:
www.londoninternational.ac.uk
The 2012 edition of this guide was prepared for the University of London International
Programmes by:
Dr L. Fung, Lecturer in Accounting and Finance, Birkbeck, School of Business, Economics and
Informatics
It is a revised edition of previous editions of the guide prepared by J. Dahya and R.E.V. Groves,
and draws on the work of those authors.
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the author is unable to enter into any correspondence relating to, or arising
from, the guide. If you have any comments on this subject guide, favourable or unfavourable,
please use the form at the back of this guide.
Contents
Introduction ............................................................................................................ 1
Aims and objectives ....................................................................................................... 1
Syllabus......................................................................................................................... 2
Reading ........................................................................................................................ 4
How to use the subject guide......................................................................................... 4
Online study resources ................................................................................................... 5
Examination advice........................................................................................................ 6
Summary ....................................................................................................................... 7
Abbreviations ................................................................................................................ 7
Chapter 1: Financial management function and environment ............................... 9
Essential reading ........................................................................................................... 9
Further reading.............................................................................................................. 9
Works cited ................................................................................................................... 9
Aims ............................................................................................................................. 9
Learning outcomes ........................................................................................................ 9
Two key concepts in financial management .................................................................... 9
The nature and purpose of financial management ........................................................ 11
Corporate objectives .................................................................................................... 14
The agency problem .................................................................................................... 15
A reminder of your learning outcomes.......................................................................... 15
Practice questions........................................................................................................ 16
Sample examination questions ..................................................................................... 16
Chapter 2: Investment appraisals......................................................................... 17
Essential reading ......................................................................................................... 17
Further reading............................................................................................................ 17
Works cited ................................................................................................................. 17
Aims ........................................................................................................................... 17
Learning outcomes ...................................................................................................... 17
Overview ..................................................................................................................... 17
Basic investment appraisal techniques ......................................................................... 18
Pros and cons of investment appraisal techniques ........................................................ 21
Non-conventional cash flows ....................................................................................... 22
Advanced investment appraisals .................................................................................. 23
Practical consideration ................................................................................................. 33
A reminder of your learning outcomes.......................................................................... 34
Practice questions........................................................................................................ 34
Sample examination questions ..................................................................................... 34
Chapter 3: Risk and return ................................................................................... 37
Essential reading ......................................................................................................... 37
Further reading............................................................................................................ 37
Works cited ................................................................................................................. 37
Aims ........................................................................................................................... 37
Learning outcomes ...................................................................................................... 38
Overview ..................................................................................................................... 38
Introduction of risk measurement................................................................................. 38
i
59 Financial management
ii
Contents
Signalling effect........................................................................................................... 78
Agency costs on debt and equity ................................................................................. 79
Pecking order theory .................................................................................................... 81
Conclusion .................................................................................................................. 81
A reminder of your learning outcomes.......................................................................... 82
Practice questions........................................................................................................ 82
Sample examination questions ..................................................................................... 82
Chapter 7: Dividend policy ................................................................................... 83
Essential reading ......................................................................................................... 83
Further reading............................................................................................................ 83
Works cited ................................................................................................................. 83
Aims ........................................................................................................................... 83
Learning outcomes ...................................................................................................... 83
Introduction ................................................................................................................ 84
Types of dividend ........................................................................................................ 84
Dividend controversy ................................................................................................... 85
Modigliani and Miller’s argument................................................................................. 85
Clientele effect ............................................................................................................ 86
Information content of dividend and signalling effect ................................................... 87
Agency costs and dividend........................................................................................... 88
Empirical evidence ....................................................................................................... 89
Conclusion .................................................................................................................. 90
A reminder of your learning outcomes.......................................................................... 90
Practice questions........................................................................................................ 91
Sample examination questions ..................................................................................... 91
Chapter 8: Cost of capital and capital investments ............................................. 93
Essential reading ......................................................................................................... 93
Further reading............................................................................................................ 93
Aims ........................................................................................................................... 93
Learning outcomes ...................................................................................................... 93
Introduction ................................................................................................................ 93
Cost of capital and equity finance ................................................................................ 93
Cost of capital and capital structure ............................................................................. 94
A reminder of your learning outcomes.......................................................................... 97
Practice questions........................................................................................................ 98
Sample examination question ...................................................................................... 98
Chapter 9: Valuation of business .......................................................................... 99
Essential reading ......................................................................................................... 99
Further reading............................................................................................................ 99
Works cited ................................................................................................................. 99
Aims ........................................................................................................................... 99
Learning outcomes ...................................................................................................... 99
Introduction ................................................................................................................ 99
Approaches to business valuation ................................................................................ 99
Valuation of debt/bonds ............................................................................................ 102
Valuation of equity .................................................................................................... 103
Conclusion ................................................................................................................ 106
A reminder of your learning outcomes........................................................................ 106
Practice questions...................................................................................................... 106
Sample examination question .................................................................................... 106
iii
59 Financial management
iv
Introduction
Introduction
1
59 Financial management
By the end of this course and having completed the Essential reading and
activities, you should be able to:
Subject-specific objectives
• describe how different financial markets function
• estimate the value of different financial instruments (including stocks
and bonds)
• make capital budgeting decisions under both certainty and uncertainty
• apply the capital assets pricing model in practical scenarios
• discuss the capital structure theory and dividend policy of a firm
• estimate the value of derivatives and advise management how to use
derivatives in risk management and capital budgeting
• describe and assess how companies manage working capital and short-
term financing
• discuss the main motives and implications of mergers and acquisitions.
Intellectual objectives
• integrate subject matter studied on related modules and to demonstrate
the multi-disciplinary aspect of practical financial management
problems
• use academic theory and research to question established financial
theories.
Practical objectives
• be more proficient in researching materials on the internet and Online
Library
• be able to use Excel for statistical analysis.
Syllabus
The subject guide examines the key theoretical and practical issues
relating to financial management. The topics to be covered in this subject
guide are organised into the following 12 chapters:
Chapter 1: Financial management function and environment
This chapter outlines the fundamental concepts in financial management
and deals with the problems of shareholders’ wealth maximisation and
agency conflicts.
Chapter 2: Investment appraisals
In this chapter we begin with a revision of investment appraisal
techniques. The main focus of this chapter is to examine the advantages of
using the discounted cash flow technique and its application in complex
investment scenarios: capital rationing, replacement decision, project
deferment and sensitivity analysis.
Chapter 3: Risk and return
We formally examine the concept and measurement of risk and return
in this chapter. We also look at the necessary conditions for risk
diversification, portfolio theory and the two fund separation theorem.
Asset pricing models are discussed and practical considerations in
estimating beta will be covered. Empirical evidence for and against the
asset pricing models will also be illustrated.
2
Introduction
3
59 Financial management
Reading
Essential reading
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York:
McGraw-Hill, 2010) tenth edition [ISBN 9780071314268]. Hereafter called
BMA, this textbook deals with most of the topics covered in this subject
guide.
Detailed reading references in this subject guide refer to the edition of the
set textbook listed above. New editions of this textbook may have been
published by the time you study this course. You can use a more recent
edition of this book or of any of the books listed below; use the detailed
chapter and section headings and the index to identify relevant readings.
Also check the VLE regularly for updated guidance on readings.
Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and
by thinking about how these principles apply in the real world. To help
you read extensively, you have free access to the VLE and the University of
London Online Library (see below).
Other useful texts for this course include:
Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice
Hall, 2008) fourth edition [ISBN 9780273719069]. Hereafter called ARD,
this textbook also covers most of the topics in this subject guide. It is less
technical than BMA.
Copeland, T.E., J.F. Weston and K.S. Shastri Financial theory and corporate
policy. (Harlow: Pearson-Addison Wesley, 2004) fourth edition [ISBN
9780321127211].This is a classic finance textbook pitched at an advanced
level. You may use this textbook for reference as it contains some useful
updates of empirical studies in the field of corporate finance.
Watson, D. and A. Head Corporate finance passnotes. (Harlow: Pearson
Education, 2010) first edition [ISBN 9780273725268].This concise version
of a passnote neatly summarises the key concepts in financial management.
You might find it useful as a revision tool.
Apart from the above textbooks, this subject guide also refers to some of
the original articles from which the financial management theories are
developing. You should refer to the works cited in each chapter for the full
reference of these articles.
4
Introduction
3. Carefully read the suggested chapters in BMA, with the aim of gaining
an initial understanding of the topics.
4. Read the remainder of the chapter in the subject guide. You may then
approach the Further reading suggested in the subject guide and BMA.
5. The subject guide is designed to set the scope of your studies of this
topic as well as attempting to reinforce the basic messages set out
in BMA. Therefore you should pay careful attention to the examples
in both the texts and the subject guide to ensure you achieve that
basic understanding. By taking notes from BMA, and then from other
books you should have obtained the necessary material for your
understanding, application and later revision.
6. Pay particular attention to the practice questions and the examples
given in the subject guide. The material covered in the examples and
in the activity exercises complements the textbook and is important in
your preparation for the examination.
7. Ensure you have achieved the listed learning outcomes.
8. Attempt the Sample examination questions at the end of each chapter
and the quizzes on the virtual learning environment (VLE).
9. Check you have mastered each topic before moving on to the next.
10. At the end of your preparations, attempt the questions in the Sample
examination paper at the end of the subject guide. Then compare
your answers with the suggested solutions, but do remember that they
may well include more information than the Examiner would expect
in an examination paper, since the guide is trying to cover all possible
angles in the answer, a luxury you do not usually have time for in an
examination.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
• Self-testing activities: Doing these allows you to test your own
understanding of subject material.
5
59 Financial management
• Electronic study materials: The printed materials that you receive from
the University of London are available to download, including updated
reading lists and references.
• Past examination papers and Examiners’ commentaries: These provide
advice on how each examination question might best be answered.
• A student discussion forum: This is an open space for you to discuss
interests and experiences, seek support from your peers, work
collaboratively to solve problems and discuss subject material.
• Videos: There are recorded academic introductions to the subject,
interviews and debates and, for some courses, audio-visual tutorials
and conclusions.
• Recorded lectures: For some courses, where appropriate, the sessions
from previous years’ Study Weekends have been recorded and made
available.
• Study skills: Expert advice on preparing for examinations and
developing your digital literacy skills.
• Feedback forms.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.
Examination advice
Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Regulations
for relevant information about the examination, and the VLE where you
should be advised of any forthcoming changes. You should also carefully
check the rubric/instructions on the paper you actually sit and follow
those instructions.
The examination paper consists of eight questions of which you must
answer four questions. Each question carries equal marks and is divided
into several parts. The style of question varies but each question aims to
test the mixture of concepts, numerical techniques and application of each
topic. Since topics in financial management are often interlinked, it is
inevitable that some questions might examine overlapping topics.
6
Introduction
Summary
Remember this introduction is only a complementary study tool to help
you use this subject guide. Its aim is to give you a clear understanding of
what is in the subject guide and how to study successfully. Systematically
study the next 12 chapters along with the listed texts for your desired
success.
Good luck and enjoy the subject!
Abbreviations
AEV Annual equivalent value
AIM Alternative investment market
APM Arbitrage pricing model
ARD Arnold, 2008
ARR Accounting rate of return
BMA Brealey, Myers and Allen
CAPM Capital asset pricing model
CFs Cash flows
CME Capital market efficiency
CML Capital market line
CPI Consumer price index
DFs Discount factors
DPP Discounted payback period
DPS Dividend per share
EMH Efficient market hypothesis
EPS Earnings per share
7
59 Financial management
8
Chapter 1: Financial management function and environment
Essential reading
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York:
McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters 1 and 2.
Further reading
Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice
Hall; 2008) fourth edition [ISBN 9780273719069]. Chapter 1.
Works cited
Fisher, I. The theory of interest. (New York: MacMillan, 1930).
Aims
This chapter paves the foundation for you to understand what financial
management is about. In particular, we will examine the roles of financial
management, the environment in which businesses are operated, and
agency theory. More importantly we explain the two key concepts which
underpin much of the theory and practice of financial management.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• outline the nature and purpose of financial management
• describe the general environment in which businesses operate
1
• explain the relationship between financial objectives and corporate Risk is often measured
as a dispersion of the
strategies
possible return outcomes
• assess the impact of stakeholders on corporate strategies from the expected mean.
In Chapter 3 of this
• discuss the time value for money concept and the risk and return subject guide, we will
relationship. more formally define
the concept of risk in
financial management
Two key concepts in financial management and discuss the different
methods to quantify risk.
Before we look at what financial management is about, it is essential for us
to understand two key concepts which lay the foundation of this subject.
2
Return refers to the
financial reward gained
The two key concepts are:
as a result of making
i. Risk and return. an investment. It is
often defined as the
ii. Time value of money.
percentage of value gain
plus period cash flow
Risk and return received to the initial
Financial markets seem to reward investors of riskier investments1 with a investment value.
higher return.2 The following graph indicates this relationship.3 3
The graph has been
rescaled in log to fit the
page. You should note
the vast differences of
the cash returns from
each investment type.
9
59 Financial management
Index
(Approximate values)
S&P (1800)
1000
10 T Bill (14)
0.1 Year
1925 1997 end
Figure 1.1: The cash return from five different investments.
Source: BMA.
Activity 1.1
What are the main reasons for smaller companies having higher perceived risk? What are
the specific risks we are referring to?
See VLE for discussion.
10
Chapter 1: Financial management function and environment
the money invested now is based on the duration of time, the risk of the
investment and inflation.
For example, $100 invested today will earn 10% per annum of return (i.e.
$110 in one year’s time and $121 in two years’ time). An investor who
assumes a 10% return will be indifferent between receiving $100 today
and $110 in one year’s time as the two cash flows have identical value to
the investor. In the time value of money terminology, the present value
of $110 received in one year’s time is exactly $100. Similarly, the present
value of $121 received in two years’ time is exactly $100, too.
This concept can be applied to convert future cash flows into their present
values. Denote the present value of a cash flow as PV and future (t-period)
value of a cash flow as FVt. The general relationship between the present
and future value is:
FVt = PV(1+r)t where r is the time value of money measured as a
percentage
Re-arranging the above equation, we have:
FVt 1
PV = t = FVt × t
(1+ r) (1+ r)
C1
a
C1, a
Individual 1
Y1
C*1 X
Individual 2
CF1
C1, b b
I1
C0
C*0, a C*0 Y0 C0, b W0
Investing decision
What should the firm do in terms of its investments? A firm will logically
rank and invest in investment projects in descending order of their
profitability (Ri for each i). A production opportunity frontier can be
obtained (such as the curve Y0Y1). A firm will invest up to the point where
the marginal investment i* yields a return that equals the return from
the capital market (i.e. interest rate r). The total investment outlays - the
amount represented by C0Y0 - is the sum Ii for all i (i = 1 to i*). Once the
investment plan is fixed, the firm will have C*0 in period 0 remaining and
a cash return of C*1 in period 1.
12
Chapter 1: Financial management function and environment
Dividend policy
In this setting, how much should the firm give out as dividend to its
shareholders in each period? The answer is simple. It should give out
C*0 and C*1 in period 0 and 1 respectively. However, would shareholders
be satisfied with these amounts in each period? Suppose we have two
individual shareholders 1 and 2. Each of them has their unique utility
function of consumption in each period. This can be represented by the
indifference curves in Figure 1.2 above. Individual 1 prefers to consume
less in period 0 and more in period 1 (the combination at ‘a’). Given the
current firm’s dividend policy, how would he be satisfied? There are two
ways to achieve it:
i. The firm will pay C0,a and invest any excess cash flow (i.e. C*0 – C0,a )
at r in period 0 and give out C*1 + (C*0 – C0,a)(1 + r). Mathematically,
it can be proved that it is equal to C1,a. Therefore the firm will pay the
exact dividend in each period to individual 1 as he prefers.
ii. Alternatively, the firm pays C*0 to individual 1 and he can invest any
excess cash flow after his consumption in period 0 in the financial
investment earning a return of r and receive the same combined cash
flow of C1,a in period 1.
This reasoning applies to any individual shareholders with any unique
utility functions. Take Individual 2 as an example. Her consumption
pattern does not match the firm’s dividend payout. Similarly there are two
ways we can satisfy her consumption pattern:
i. The firm will borrow C0,b – C*0 at r in period 0 and pay out C0,b to
Individual 2. In period 1, the firm will pay out C*1 – (C0,b – C*0)
(1 + r). Mathematically, it can be proved that it is equal to C1,b.
Therefore the firm will pay the exact dividend in each period to
Individual 2.
ii. Alternatively, the firm pays C*0 to Individual 2 and she borrows any
shortfall to make up to her consumption C0,b in period 0. In period 1,
she will receive C*1 less the loan and interest she takes out in period
0. This will leave her with a net amount exactly equal to C1,a.
The above argument indicates that financial managers do not need to
consider shareholders’ consumption patterns when fixing the investment
plan or the dividend policy. The easiest way is to maximise the firm’s
cash flows and distribute the spare cash flows as dividends. Shareholders
will use the capital markets to facilitate their consumption patterns
accordingly.
Financing decision
In the beginning, we assume that the firm has an initial cash flow of
Y0 and requires a total investment outlay of C0Y0. If any part of Y0 is
not contributed by shareholders, the firm’s dividend in period 1 will
be reduced by the funds raised from borrowing (at a cost of r) and the
interest. However, shareholders can offset this shortfall of dividend in
period 1 by investing the fund not contributed in the firm to the capital
market and earn a return exactly equal to r.
The above argument illustrates the Fisher separation in which investing,
financing and dividend decisions are all unrelated. However, if the capital
market is imperfect in such a way that external funding is restricted, the
Fisher separation might not apply. The following scenarios highlight the
practical considerations that financial managers would need to take.
13
59 Financial management
Activity 1.2
i. Why would a firm invest up to the point where the return of the marginal
investment equals the return from the capital market?
ii. What would happen to the Fisher’s separation theorem if the borrowing rate differs
from the lending rate?
See VLE for solutions.
Corporate objectives
BMA, Chapter 1, pp.37–40 discuss the goals of corporation. The general
assumption in financial management is that corporate managers will
try their best to maximise the value of the shareholders’ investment
in the corporation (i.e. shareholders’ wealth maximisation (SHWM)).
Maximisation of a company’s ordinary share price is often used as a
surrogate objective to that of maximisation of shareholder wealth. In
order to achieve this objective, it is argued that corporate managers will
maximise the value of all investments undertaken by the firm. This can be
illustrated in the following diagram:
NPV 1
NPV 2
NPV A
3 Corporate net present value SHWM
Share price
(sum of individual Projects’ NPVs)
(3) (4)
NPV 4 (2)
(1)
Figure 1.3: Shareholders’ wealth maximisation
Source: BMA.
14
Chapter 1: Financial management function and environment
• customer loyalty
• profit
• growth
• market leadership
• leadership capability
• employee commitment
• global citizenship.
While profit maximisation, social responsibility and growth represent
important supporting objectives, the overriding objective of a company
must be that of shareholders’ wealth maximisation. The financial wealth of
a shareholder can be affected by a company’s financial manager’s action.
Arguably, when good investment, financing and dividend decisions are
made, a company’s market value will increase. The rest of this subject
guide will explore how financial managers’ decisions can increase a firm’s
value.
Activity 1.3
Although shareholders’ wealth maximisation seems to be the overriding objective,
corporate managers still face a number of constraints to implement multiple objectives
simultaneously.
Identify the types of constraint that corporate managers face when assessing long-term
financial plans.
See VLE for discussion.
15
59 Financial management
• discuss the time value for money concept and the risk and return
relationship.
Practice questions
1. Compute the future value of $1,000 compounded annually for:
a. 10 years at 5%
b. 20 years at 5%
How would your answer to the above question be different if interest is
paid semi-annually?
2. Compare each of the following examples to a receipt of $100,000
today:
a. Receive $125,000 in two year’s time.
b. Receive $55,000 in one year’s time and $65,000 in two year’s time
c. Receive $31,555.7 for the next 4 years, receivable at the end of each
year.
d. Receive $10,000 for each year for an infinite period.
Assume the interest rate is 10% per year for the foreseeable future.
16
Chapter 2: Investment appraisals
Essential reading
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York:
McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters 5
and 6.
Further reading
Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice
Hall, 2008) fourth edition [ISBN 9780273719069] Chapters 2–6.
Works cited
Graham, J.R. and C.R. Harvey ‘The theory and practice of corporate finance:
evidence from the field’, Journal of Financial Economics, 60, 2001, pp.187–
243.
Aims
This chapter focuses on the techniques commonly used for investment
appraisals in practice. In particular, we concentrate on the pros and cons of
the following techniques:
• Accounting rate of return (ARR)
• Payback period (PP)
• Discounted payback period (DPB)
• Internal rate of return (IRR)
• Net present value (NPV).
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• describe the commonly used investment appraisal techniques
• apply the discounted cash flow technique in complex scenarios
• evaluate the investment decision process.
Overview
As mentioned in Chapter 1, financial managers make decisions about
which investment they should invest in to maximise their shareholders’
value. In order to do so, they need to understand how to measure the
value of investments they undertake and how these investments help to
improve the value of the firm. First, we will examine the basic techniques
and evaluate their pros and cons in investment appraisals. We will then
compare the relative merits of using NPV over IRR. Thirdly, we consider
some of the scenarios when NPV can be applied to deal with the selection
of investments. Finally, we discuss the problems relating to the application
of these investment appraisal techniques.
17
59 Financial management
18
Chapter 2: Investment appraisals
Example 2.1
Suppose we have two mutually exclusive projects, A and B. Each project
requires an initial investment in a machine, payable at the beginning of year 0.
There is no scrap value for these machines at the end of the project. Suppose
the cost of capital (discount rate) is 20% per annum. The following before-tax
operating cash flows are also known:
Before-tax operating
Year
cash flows ($)
Project 0 1 2 3 4
A (25,000) 5,000 10,000 15,000 20,000
B (2,500) 2,000 1,500 250
Payback period
We can look at the cumulative cash flow at the end of each year to determine
the PP.
Year
Project A 0 1 2 3 4
Cash flows ($) (25,000) 5,000 10,000 15,000 20,000
Discount factor (DF) (20%) 1 0.833 0.694 0.578 0.482
Present value (25,000) 4,165 6,940 8,670 9,640
Cumulative cash flows (25,000) (20,835) (13,895) (5,225) 4,415
Year
Project B 0 1 2 3 4
Cash flows ($) (2,500) 2,000 1,500 250
Discount factor (DF) (20%) 1 0.833 0.694 0.578 0.482
Present value (2,500) 1,666 1,041 144.5
Cumulative cash flows (2,500) (834) 207
For Project A, the payback period occurs in Year 4. If we assume that cash flows
arrive evenly throughout the year, we can determine the approximated payback
period at 5,225/9,640 = 0.54 year (i.e. PP at 3.54 years). Similarly, for Project
B, the PP occurs in 1.8 years.
19
59 Financial management
Year
Project A 0 1 2 3 4
Cash flows ($) (25,000) 5,000 10,000 15,000 20,000
Discount factor (DF) (20%) 1 0.833 0.694 0.578 0.482
Present value (25,000) 4,165 6,940 8,670 9,640
NPV 4,415
Year
Project B 0 1 2 3 4
Cash flows ($) (2,500) 2,000 1,500 250
Discount factor (DF) (20%) 1 0.833 0.694 0.578 0.482
Present value (2,500) 1,666 1,041 144.5
NPV 351.5
Year
Project A 0 1 2 3 4
Cash flows ($) (25,000) 5,000 10,000 15,000 20,000
Discount factor (DF) (30%) 1 0.769 0.592 0.455 0.35
Present value (25,000) 3,845 5,920 6,825 7,000
NPV (1,410)
Year
Project B 0 1 2 3
Cash flows ($) (2,500) 2,000 1,500 250
Discount factor (DF) (35%) 1 0.741 0.549 0.407
Present value (2,500) 1,482 824 102
NPV (93)
Activity 2.1
Attempt Question 1, BMA Chapter 5.
See VLE for solution.
20
Chapter 2: Investment appraisals
21
59 Financial management
• The difference between the IRR and the cost of capital can be seen as a
margin of safety.
Disadvantages:
The main limitations of using IRR in investment appraisals are that it may
not give the correct decision in the following scenarios:
• when comparing mutually excusive projects
• when projects have non-conventional cash flows
• when the cost of capital varies over time
• It discounts all flows at the IRR rate not the cost of capital rate.
Example 2.2
Suppose a project requires $100 as an initial investment. Its Year 1 and Year 2
cash flows are $260 and –$165 respectively. Based on this project’s cashflows, it
produces two possible IRRs (10% or 50%):
DF PV DF PV
Year Cash flows 50% 10%
0 –100 1 –100 1 –100
1 260 0.667 173 0.909 236
2 –165 0.445 –73 0.826 –136
Net Present Value 0 0
Suppose the cost of capital for this project is 20%. According to the IRR rule,
the project should be accepted (as the cost of capital is less than the higher IRR
of 50%). However, it should also be rejected as the cost of capital is higher than
the lower IRR of 10%. So for a project with non-conventional cash flows, the
IRR decision is sensitive to the cost of capital. Therefore it is argued that IRR
does not give an unambiguous decision when dealing with non-conventional
projects.
To further illustrate this problem, let’s look at the NPV profile of the project.
This depicts the relationship of the NPV of the project and its discount rate. In
the above example, we know that the NPV of the project is zero at both 10%
and 50%.
Suppose the cost of capital is 5%, 25% or 70%. The NPV of the project will
become –$2, $2 and –$4 respectively. The following diagram shows the NPV
profile of the project. We can see that, due to the non-conventional cash flow
pattern, the project’s NPV varies at different discount rates. It only provides a
positive NPV if the discount rate for the project’s cash flows is between 10%
and 50%.
22
Chapter 2: Investment appraisals
0
NPVs 0% 10% 20% 30% 40% 50% 60% 70% 80%
-1
-2
-3
-4
-5
Discount rates
Activity 2.2
Attempt Question 5, BMA Chapter 5.
See VLE for solution.
• sensitivity analysis.
BMA, Chapter 5, pp.143–47 deals with capital rationing and Chapter 6
deals with the remaining advanced topics. Before you proceed with the
following section, it would be advisable to skim through those sections in
the textbook.
Capital rationing
A company may have insufficient funds to undertake all positive NPV
projects. Due to the shortage of funds, this restriction is more commonly
known as capital rationing. There are two types of capital rationing.
Example 2.3
Lion plc has the following projects:
24
Chapter 2: Investment appraisals
What would be the best way to allocate the $2,500,000 funding among these
four projects?
To answer this question, we first convert the NPV into PV (Initial investment +
NPV) for each project. We then calculate the PI using the above formula.
WAPI = ∑ω i PIi + ω j
i=1
Weight Plan
Project A+B A+C A+C+D B+C B+D C+D
A 0.4 0.4 0.4 0 0 0
B 0.6 0 0 0.6 0.6 0
C 0 0.3 0.3 0.3 0 0.3
D 0 0 0.2 0 0.2 0.2
Unused cash 0 0.3 0.1 0.1 0.2 0.5
25
59 Financial management
Activity 2.3
Attempt Question 7, BMA Chapter 5.
See VLE for solution.
Example 2.4
Suppose Leopard plc has a project that produces 10,000 units of a digital diary
per year for the next four years. Each unit sells for $200. The unit production
cost is $110. The production requires a brand new machine at year 0. It costs
$2,000,000 with a scrap value of $20,000 at the end of year 4. The NPV of this
project (assuming no inflation) is determined as follows:
Year
0 1 2 3 4
Machine (2,000,000) 20,000
Revenue 2,000,000 2,000,000 2,000,000 2,000,000
Production costs (1,100,000) (1,100,000) (1,100,000) (1,100,000)
NCF before tax (2,000,000) 900,000 900,000 900,000 920,000
DF 1 0.909 0.826 0.751 0.683
PV (2,000,000) 818,100 743,400 675,900 628,360
NPV 865,760
Example 2.5
Suppose the production cost for each unit will rise by 10% per year from year 2
onward. The revised NPV of this project can be determined by incorporating the
price changes to the production costs in Example 2.4.
26
Chapter 2: Investment appraisals
Year
0 1 2 3 4
Machine (2,000,000) 20,000
Revenue 2,000,000 2,000,000 2,000,000 2,000,000
Production costs (1,100,000) (1,210,000) (1,331,000) (1,464,100)
NCF before tax (2,000,000) 900,000 790,000 669,000 555,900
DF (10%) 1 0.909 0.826 0.751 0.683
Present value (PV) (2,000,000) 818,100 652,540 502,419 379,680
Net present value (NPV) 352,739
The effect of this price change to the manufacturing costs reduces the NPV from
$865,760 to $352,739. If financial managers fail to recognise and take this price
change into consideration, it is very likely that the project’s NPV will be grossly
misstated and an incorrect decision might be reached.
Taxation
When a firm is making a profitable investment, it is likely that it will be
liable for corporate tax. When evaluating a project, the tax effect must be
considered. There are two issues relating to the after-tax NPV of a project:
Example 2.6
Suppose Leopard plc in Example 2.4 pays corporate tax at 45% on taxable
profits after capital allowances. We are told that the annual capital allowance
is determined at 25% of the written down value at the beginning of each year.
Any unrelieved written down value in the final year of the project is given out as
capital allowance in full in that year. The following table shows the calculations
of the annual capital allowance and tax payable.
Year
0 1 2 3 4
Taxable profit before capital 900,000 790,000 669,000 555,900
allowances
Written down values (WDVs) 2,000,000 1,500,000 1,125,000 843,750
Capital allowances (CAs) (500,000) (375,000) (281,250) (843,750)
Taxable profit after capital 400,000 415,000 387,750 (287,850)
allowances
Tax (45%) (180,000) (186,750) (174,488) 129,533
27
59 Financial management
The first year’s capital allowance is calculated as 25% of the written down
value of the initial investment (i.e. 25% $2,000,000 = $500,000). This is
then deducted from the taxable profit before capital allowances (i.e. the net
cash flow of year 1) to arrive at the taxable profit after capital allowances
(i.e. $900,000 – $500,000 = $400,000). The tax charge for the first year is
calculated as 45% of $400,000 (i.e. $180,000).
For years 2 and 3, the same approach for the calculation of capital allowances
and tax charges applies. However, at the beginning of year 4, the unrelieved
written down value of the initial investment ($843,750) will be treated as
the capital allowance for that year. This gives rise to a negative figure for the
taxable profit after capital allowances. If Leopard plc has sufficient profits
from its other operations, it can use this ‘tax relief’ to reduce the tax charge
for the other parts of its operations, saving the company from paying taxes of
$129,533 (45% of $287,850). Given that this tax saving is generated as a result
of this project, it should therefore be considered as a relevant cash flow for this
project’s NPV.
Year
0 1 2 3 4
Machine (2,000,000) 20,000
Revenue 2,000,000 2,000,000 2,000,000 2,000,000
Production costs (1,100,000) (1,210,000) (1,331,000) (1,464,100)
NCF before tax (2,000,000) 900,000 790,000 669,000 555,900
Tax (180,000) (186,750) (174,488) 129,533
NCF after tax (2,000,000) 720,000 603,250 494,513 685,433
DF 1 0.909 0.826 0.751 0.683
PV (2,000,000) 654,480 498,285 371,379 468,150
NPV (7,706)
In this case, taxes are paid in the same year as the profits to which they are
related. The amount of taxes paid reduces the net cash flow of the project. Note
that the tax saving in year 4 is included as a positive cash flow. The after-tax
NPV of this project (after discounting) is now –$7,706, suggesting that it should
not be accepted. We can clearly see in this case that the tax effect on a project’s
acceptability cannot be ignored as it turns the positive NPV into negative.
28
Chapter 2: Investment appraisals
Year
0 1 2 3 4 5
Machine (2,000,000) 20,000
Revenue 2,000,000 2,000,000 2,000,000 2,000,000
Production costs (1,100,000) (1,210,000) (1,331,000) (1,464,100)
NCF before tax (2,000,000) 900,000 790,000 669,000 555,900
Tax (180,000) (186,750) (174,488) 129,533
NCF after tax (2,000,000) 900,000 610,000 482,250 381,413 129,533
DF 1 0.909 0.826 0.751 0.683 0.621
PV (2,000,000) 818,100 503,860 362,170 260,505 80,440
NPV 25,074
In this case, tax is payable one year after the profit to which it is related. The
first year’s tax is payable at the end of year 2 and the second year’s tax is
payable at the end of year 3 and so on. Despite this being a four-year project
it now has cash flow (tax savings) arising in year 5. As we can see from
Case 2, paying tax in arrears helps improve the after-tax NPV of the project.
Consequently, the project should be accepted.
The timing of when tax is paid is therefore crucial for the evaluation of a
project’s acceptability.
Activity 2.4
Attempt Question 16, BMA Chapter 6.
See VLE for solution.
Replacement decision
When considering a scenario where we have to select mutually exclusive
projects with different life spans and where each project can be replicated
in exact cash flow patterns, the simple NPV rule might not necessarily give
the correct advice. To see why this might be the case, let us consider the
following example.
Example 2.7
Lion plc is considering two different machines in an operation. The following
net operating cash outflows for these two machines are given:
$ Year
Machines 0 1 2 3 4
A (100,000) (10,000) (10,000) (10,000) (10,000)
B (75,000) (15,000) (15,000) (15,000)
In this example, both machines have different life spans and cash flow patterns.
How do we compare the value of using these two machines in the operations?
Suppose Lion plc has a cost of capital of 10% per annum. The NPV of running
these two machines can be calculated as follows:
29
59 Financial management
$ Year
Machine A 0 1 2 3 4
NCF (100,000) (10,000) (10,000) (10,000) (10,000)
DF 1 0.909 0.826 0.751 0.683
PV (100,000) (9,090) (8,260) (7,510) (6,830)
NPV (131,690)
$ Year
Machine B 0 1 2 3
NCF (75,000) (15,000) (15,000) (15,000)
DF 1 0.909 0.826 0.751
PV (75,000) (13,635) (12,390) (11,265)
NPV (112,290)
On the basis of the NPV calculations, it seems to cost the company less to run
Machine B ($112,290 compared to $131,690). However, if the operation is a
going concern and we have to replace the machine once it has expired, how do
we know if Machine B still gives the best value to the company?
To answer this question, we need to find a way to compare the two machines’
cash flows in a consistent manner. This can be done by converting a project’s
NPV into its annual equivalent value (AEV).
Suppose we can hire a machine, C, for $x each year for the next four years.
It has the same functionalities as Machine A and the hiring company is
responsible for all the running cost of Machine C. What would be the equivalent
hiring cost we would be willing to pay if both machines (A and C) have the
same value to the company?
For these two machines to have the same value to the company, their total
running costs (measured at today’s value, i.e. present value) must be identical.
Consequently this means:
x x x x
+ 2 + 3 + 4 = 131,690
1.1 1.1 1.1 1.1
⎛ 1 1 1 1 ⎞
x⎜ + 2 + 3 + 4 ⎟ = 131,690
⎝ 1.1 1.1 1.1 1.1 ⎠
x(A10%, 4 years ) = 131,690
131,690 131,690
x= = = 41,556
A10%, 4 years 3.169
We can now convert Machine B’s NPV into its AEV in the same way as the
calculation above:
112 , 290
Machine B´s AEV = = 45 ,169
2 .486
30
Chapter 2: Investment appraisals
Delaying projects
In some cases it might be more advantageous for a company to delay the
commencement of a project. This might be a result of one of the following:
• There might be uncertainty about the outcomes of the project. Delaying
its commencement might allow the company to obtain vital information
to revise future cash flows which might give a higher NPV.
• There might be capital rationing in the current period and the company
needs to postpone the project due to shortage of funding.
In deciding whether a project should be postponed, we can treat the delay
of each project as separate and mutually exclusive. We can then evaluate
each option’s NPV accordingly.
Example 2.8
Rooster Ltd. is considering a new product, a roast chicken stand. It allows
a chicken to be roasted on all sides while maintaining its juiciness. The
production requires a new machine which has a purchase price of $100,000
with four years of economic life and no residual value by the end of the
fourth year. Each unit of the roast chicken stand is expected to generate a net
contribution of $5 (selling price minus variable costs). Market research, which
costs $25,000, indicates that future demand will be subject to the state of the
economy. If the economy is strong, the demand will be 10,000 units per year
for the next five years. However, if the economy is weak, the demand will fall
to only 5,000 units per annum. There is an equal chance for each state of the
economy to materialise. It is also expected that once the state of the economy is
set, it will stay that way for the next four years.
Rooster has a choice to delay the production until the end of the year. If it
does so, the whole production cycle will be shortened to three years. The same
machine will still be required by the end of the year at the same expected
purchase price. However, it can be sold for $25,000 at the end of the production
process (i.e. three years after the commencement of production). But more
importantly, delaying the commencement of production will allow the company
to know exactly which way the economy is going to unfold for the next few
years.
Advise the management on what action should be taken regarding this project.
Approach:
Introducing probability theory we can calculate the expected net present value,
E(NPV), for the project.
If Rooster Ltd. commences the production now:
Expected demand in the next 4 years = 50% 5,000 units + 50% 10,000
units = 7,500 units
31
59 Financial management
Year
No delay 0 1 2 3 4
Machine (100,000)
Contribution 37,500 37,500 37,500 37,500
E(NCF) (100,000) 37,500 37,500 37,500 37,500
DF 1 0.909 0.826 0.751 0.683
E(PV) (100,000) 34,088 30,975 28,163 25,613
E(NPV) 18,838
This is the expected NPV that the production could generate. However, the
economy is weak, Rooster can only sell 5,000 units per year. What, then, would
be the outcome of this state?
If Rooster is to face a weak economy for the next four years, the revised NPV
will be as follows:
Year
Weak state 0 1 2 3 4
Machine (100,000)
Contribution 25,000 25,000 25,000 25,000
NCF (100,000) 25,000 25,000 25,000 25,000
DF 1 0.909 0.826 0.751 0.683
PV (100,000) 22,725 20,650 18,775 17,075
NPV (20,775)
In other words, there is a 50% chance that Rooster will suffer a negative NPV of
$20,775. (If the good state had occurred at the outset then the NPV would have
been $58,450. (NB. 0.5 $58,450 + 0.5 ($20,775) = $18,838.) Should the
company delay the project and wait for the economic situation to materialise
before committing to production? If the company delays the production by a
year, there are two possible actions that the company will take by the end of the
year. It could abandon production if a weak economy materialises. It would not
be advantageous to produce if the company could only sell 5,000 units per year
in a weak economy. You can check the NPV under this option. However, if a
strong economy materialises in year 1, the company will commence production
in that year with the following NPV:
Year
Delay 0 1 2 3 4
Machine (100,000) 25,000
Contribution 50,000 50,000 50,000
NCF 0 (100,000) 50,000 50,000 75,000
DF 1 0.909 0.826 0.751 0.683
PV 0 (90,900) 41,300 37,550 51,225
NPV 39,175
The expected NPV of delaying production would then be $19,587.5 (50% 0
+ 50% $39,175). On the basis of the NPV consideration, it seems to be more
advantageous for the company to delay production by one year.
In this example, deferring the project allows the company to eliminate the
possibility of facing a loss in a weak economy. Even though the financial return
32
Chapter 2: Investment appraisals
to delay the project seems low ($19,587.5 vs. $18,838), the risk elimination
might be treated as more valuable by a more risk-averse company.
Sensitivity analysis
This method evaluates the impact of changes in a project’s variables on its
NPV. In a single variable situation, we can assess by how much a variable
needs to change before a project returns a loss. For example, referring to
the data in Example 2.4, we can ask:
1. By how much does the selling price need to drop before the project’s
NPV disappears?
2. By how much does the production cost per unit need to rise before the
project’s NPV disappears?
3. By how much does the discount rate need to rise before the project’s
NPV disappears?
To answer any of the above questions, we can use a trial-and-error
method. With the aid of a spreadsheet and changing the parameters
accordingly, we can see how the NPV will change. See the spreadsheet on
the VLE of the demonstration.
Alternatively, we can observe the relationship of the variable with the
overall NPV. Recall from Example 2.4 that each unit of the product sells
at $200 and the NPV of the project stands at $865,760. Let’s assume that
the selling price of each unit drops by $x. To make the NPV disappear, the
present value of the loss in revenue (or contribution) must be identical to
the NPV. We, therefore, can equate the PV of the loss in contribution to the
project’s original NPV as follows:
10,000x 10,000x 10,000x 10,000x
+ + + = 865,760
1.1 1.12 1.13 1.14
10,000x × A10%,4 = 865,760
10,000x × 3.169 = 865,760
x = 27.32
If the selling price drops by $27.32, the NPV will disappear. This gives
a safety net for the company as to how much it can afford to reduce the
selling price before incurring a loss. You can test each variable using the
approach outlined above and determine how sensitive the NPV is to each
of the variables considered. This is of benefit to management in both the
decision-making phase and the project management phase.
Practical consideration
Graham and Harvey (2001) surveyed 392 chief financial officers (CFOs)
in the USA. They asked each CFO to rank the importance of each appraisal
method in practice. Figure 2.2 below shows the findings of their survey.
Watson and Head (2010) summarise the findings as follow:
• Discounted cash flow methods appear to be more popular than non-
DCF methods.
• Payback is used in large organisations in conjunction with other
investment appraisal methods.
• IRR is more popular than NPV in small companies but NPV is the most
popular investment appraisal method in large companies.
• ARR, the least popular investment appraisal method, continues to be
used with other methods.
33
59 Financial management
Practice questions
1. BMA Chapter 5, Questions 10–15.
BMA Chapter 6, Questions 22, 26, 28 and 29.
36
Chapter 3: Risk and return
Essential reading
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance.
(New York: McGraw-Hill, 2010) tenth edition [ISBN 9780071314268]
Chapters 7 and 8.
Further reading
Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice
Hall, 2008) fourth edition [ISBN 9780273719069] Chapters 6–8.
Works cited
Banz, Rolf W. ‘The relationship between return and market value of common
stocks’, Journal of Financial Economics 9, 1981, pp.3–18.
Basu, Sanjoy ‘The relationship between earnings’ yield, market value and
return for NYSE Common Stocks: Further Evidence’, Journal of Financial
Economics 12, 1983, pp.129–56.
Chen, Nai-Fu, Richard Roll and Stephen A. Ross ‘Economic forces and the stock
market’, Journal of Business 59(3) 1986, pp.383–403
Daves, Phillip R., Michael C. Ehrhardt and Robert A. Kunkel ‘Estimating
systematic risk: the choice of return interval and estimation period’, Journal
of Financial and Strategic Decisions, 13(1) 2000, pp.7–13.
Fama, Eugene F. and Kenneth R. French ‘The cross-section of expected stock
returns’, Journal of Finance 47(2), 1992, pp.427–65.
Fama, Eugene F. and Kenneth R. French ‘Multifactor explanations of asset
pricing anomalies’, Journal of Finance 51(1), 1996, pp.55–84.
Ferson, Wayne E. ‘Theory and empirical testing of asset pricing models’, Centre
of security prices (University of Chicago) 352, 1992.
Graham, John R. and Campbell R. Harvey ‘The theory and practice of corporate
finance: evidence from the field’, Journal of Financial Economics 60, 2001,
pp.187–243.
Kim, Dongcheol ‘The errors in the variables problem in the cross-section of
expected stock returns’, Journal of Finance 50(5), 1995, pp.1605–34.
Kothari, S.P., Jay Shanken and Richard G. Sloan ‘Another look at the cross-
section of expected returns’, Journal of Finance 50(1), 1995, pp.185–224.
Markowitz, Harry M. ‘Portfolio selection’, Journal of Finance 7(1), 1952, pp.77–91.
Reinganum, Marc R. ‘Misspecification of capital asset pricing: empirical
anomalies based on earnings’ yields and market values’, Journal of Financial
Economics 9(1), 1981, pp.19–46.
Roll, Richard ‘A critique of the asset pricing theory’s tests, Part I: on past and
potential testability of the theory’, Journal of Financial Economics 4(2),
1977, pp.129–76.
Shanken, Jay ‘On the estimation of beta pricing models’, Review of Financial
Studies 5(1), 1992, pp.1–33.
Aims
In this chapter we formally examine the concept and measurement of
risk and return. In particular, we look at the necessary conditions for risk
diversification, the portfolio theory and the two fund separation theorem.
Asset pricing models are also discussed and practical considerations in
estimating beta will be covered. Empirical evidence for and against the
asset pricing models will be illustrated.
37
59 Financial management
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• describe the meaning of risk and return
• calculate the risk and return of a single security
• discuss the concept of risk reduction/diversification and how it relates
to portfolio management
• calculate the risk and return of a portfolio of securities
• discuss the implications of the capital market line (CML)
• discuss the theoretical foundation and empirical evidence of the capital
asset pricing model (CAPM) and its application in practice.
Overview
In Chapter 1, we mentioned that one of the key concepts in financial
management is the relationship between risk and return. So how does
this concept link to the value creation and project appraisal? In Chapter
2, we discussed the selection of suitable investment projects that would
create value for a firm and its shareholders. We assume that those projects’
cash flows are given with certainty. However, in reality, cash flows from
an investment project seldom materialise as expected. So how might the
variation of the realised cash flows affect an investment’s value?
To be able to answer these questions, we will first need to understand
what we mean by risk and how corporate managers can measure such risk.
(3.1)
Example 3.1
Suppose we have an investment that has the following historic returns:
38
Chapter 3: Risk and return
Answer:
This investment has an average return of 4% for the last five years. We can
assume that the historic mean return of this investment is 4% (our best estimate
in the absence of any further information about this investment). We can
calculate the standard deviation of the returns by taking the square root of
the average of the squared deviation of each annual return to its mean. The
following table lists the results.
Based on the calculation above, we can say that this investment on average
provides a return of 4% per annum. However, none of the past five years’
returns meet the expected return. In years 1, 4 and 5, the realised returns
are higher than expected (upside risk). Whereas in years 2 and 3, returns are
lower than expected (downside risk). This kind of deviation from the mean
(expectation) constitutes the concept of risk in financial management. As long
as (i) the returns of an investment follow the normal distribution and (ii)
investors have no preference toward the upside and downside risks, standard
deviation will be a neat measurement of risk for this type of investment.
Activity 3.1
Attempt Question 3 of BMA, Chapter 7.
See VLE for solution.
Example 3.2
a. In Example 3.1, what is the probability that an investor will receive
a return of 10% from the investment?
b. What is the probability that an investor will not suffer a loss in the
investment?
Answers
a. The probability of a outcome from a normal distribution can be
expressed as:
(3.2)
39
59 Financial management
2πσ 2
(10−4 ) 2
1 −
= e 2×24.5
2 × 3.1416 × 24.5
= 0.038
b. The probability for an investor not suffering from a loss is equal to
the probability that the return is equal to or larger than 0%. Given
that a normal distribution curve is symmetrical at the mean value,
we can easily see that the probability of returns equal to and larger
than 4% would be 50%. So what is the probability that a return is
between 0% and 4%?
To answer this, we first define the z-value as:
Activity 3.2
What would be the probability for an investor to earn a return of 8% in Example 3.1?
See VLE for solution.
(3.3a)
and
(3.3b)
Two-asset portfolio
Let’s first examine how the risk of a portfolio with two securities can be
calculated.
Example 3.3
Suppose that you are considering an investment portfolio with two stocks, Rose
Plc and Thorn Plc. The returns of these two stocks for the last five years are in
columns 1 and 2 of the table below.
1 2 3 4 5 6 7
2 2
Year Rose, Rx Thorn, Ry Rx–E(Rx) [Rx – E(Rx)] Ry–E(Ry) [Ry–E(Ry)] [Rx–E(Rx)][Ry– E (Ry)]
1 4 2 0 0 –1 1 0
2 11 –2 7 49 –5 25 –35
3 13 6 9 81 3 9 27
4 –8 –1 –12 144 –4 16 48
5 0 10 –4 16 7 49 –28
Sum 20 15 290 100 12
Mean 4 3 Variance 72.5 Variance 25 Covariance = 3
Standard deviation 8.5 5
Coefficient of
0.07
correlation
Note that the variance and covariance are calculated using the following
formulas:
2
T
(3.4a)
t =1
2
T
y
(3.4b)
t =1
T
x
t =1
(3.4c)
To see the diversification effect, we first calculate the standard deviation of the
two companies and their covariance. Covariance measures the co-movement
of the two stocks. At first glance, Rose and Thorn are not moving in the same
direction all the time, suggesting that they are not perfectly correlated. To see
the extent of their co-movement, we compute the covariance and coefficient of
correlation.
Next, we combine the two stocks with different weights in a portfolio. Using
equations 3.3a and 3.3b we can compute the portfolio’s risk and expected
return based on different weights as follows:
41
59 Financial management
2.5
2
1.5
1
0.5
0
0 1 2 3 4 5 6 7 8 9
Risk (standard deviation)
Activity 3.3
Suppose we have two stocks, A and B with the following characteristics:
Return Risk
A 10 10
B 5 5
Sketch the efficient frontier of a portfolio which consists of stock A and B, assuming that
the coefficient of correlation equals:
a. 1
b. 0
c. –1
See VLE for solution.
42
Chapter 3: Risk and return
Multi-asset portfolio
The above analysis can be extended to a multi-asset scenario. Suppose it
is free to buy and sell assets to form a portfolio. An investor may want to
combine more assets in her portfolio if more risk can be diversified. To see
how this may work, let’s take a look of the analysis below.
Recall equations 3.3a and 3.3b
(3.5a)
⎯ ⎯
Define σ2 as the average variance and σij as the average covariance,
1 2 § 1 · (3.5b)
V p2 V ¨1 ¸V ij
N © N ¹
If N is sufficiently large (i.e. N → ∞), then
1 2 § 1 ·
V o0 and ¨1 ¸V ij oV ij
N © N ¹
That implies
V p2 V ij (3.5c)
Implications
There are a few key implications from the above analysis worth noting.
i. As an investor combines more assets in a portfolio, the limiting
portfolio’s risk will gradually be reduced as both the first and second
term in equation 3.5a will slowly disappear. Consequently, the shape of
the efficient frontier will change and move more to the north-western
quadrant of the mean-variance space.
In Figure 3.2, each half-egg shell represents the possible weighted
combinations for two assets. The composite of all assets constitutes the
efficient frontier. The area underneath the efficient frontier consists of
feasible but not efficient portfolios.
43
59 Financial management
Standard Deviation
2
market = ij
iv. If one can lend or borrow at some risk-free rate of interest, an investor,
who previously holds a risky portfolio on the efficient frontier, may
now combine the risk-free asset with the market portfolio. This can be
represented graphically:
Expected
M ng
Return (%) wi
o rro
B
ing
end
L
rf
Standard Deviation
E Rm R f
E Rp Rf
Vm
Vp
(3.6)
Activity 3.4
Equation 3.6 required that there is a single risk-free rate in the capital markets. In
practice, investors could seldom borrow and lend at the same risk-free rate. How would
this affect the capital market line?
See VLE for discussion.
Example 3.4
It is expected that the market has an average return of 10% and the risk-free
asset has a return of 5%. The standard deviation of returns on the market has
been 7% in the past. What is the expected return of a portfolio with a standard
deviation of 10%?
Using equation 3.6, we have
E Rm R f
E Rp Rf
Vm
Vp
10 5
5 u 10
7
12.14
Activity 3.5
Attempt Question 5 of BMA, Chapter 8.
See VLE for solution.
In the above analysis, we address the issue of risk and return relating to a
portfolio. We now turn our attention to individual assets. At the beginning
of the chapter, we defined risk and return for a single investment. When
an investor holds a single investment (or asset), he or she faces the entire
variation of returns of that asset. Consequently, the standard deviation
will be a good proxy for risk to such an investor. However as we have seen
in the discussion of portfolio theory and diversification of risk, a sensible
investor should form portfolios with many assets in order to eliminate
‘risk’. The relationship between the number of assets and portfolio risk is
depicted in Figure 3.4.
45
59 Financial management
Porolio’s
standard
deviaon
0 Number of securies 15
Activity 3.6
Given Figure 3.4, what is the implication for small investors who have only a small
amount of capital to invest?
See VLE for discussion.
and
(3.8)
where 2i is the variance of the return on the risky asset i; m2 is the variance
of the return on the market portfolio; and im is the covariance of returns
between asset i and the market portfolio. The marginal rate of substitution
(MRS) between the expected return and risk of the market portfolio is
46
Chapter 3: Risk and return
defined as the ratio of the partial differentiation of its expected return over
the partial differentiation of its expected risk of the portfolio with respect to a.
In equilibrium, all marketable assets are included in the market portfolio and
there is no excess demand or supply for any individual asset. This implies that:
(3.9)
Also note that the MRS at the point of the market portfolio on the efficient
frontier is the same as the slope of the capital market line (CML) at the
point of tangency to the efficient frontier. It can be shown that:
(3.10)
f
[
[
(3.11)
where i = im / m. Equation 3.11, also known as the equation of CAPM
or security market line, shows that there is an exact linear relationship
between an asset’s return and its beta. This beta measures the risk of an
asset relative to the market. We can from now on call it the market risk of
an asset.
Return
BETA
1.0
Activity 3.7
Attempt Question 7 of BMA, Chapter 8.
See VLE for solution.
Estimation of beta
Equation 3.11 depicts that there is a linear relationship between risk
and return on individual assets. The risk is measured in terms of its risk
relative to the market (beta) and return is what investors and the market
would expect to receive given this level of market risk. Consequently
knowing beta would allow us to estimate the expected return on an asset
or security.
How do we estimate the beta for a company? The following example
demonstrates a simple approach which can be used in practice.
47
59 Financial management
Example 3.5
SpringTime plc is an all-equity financed company on the London Stock
Exchange. For the last five years, its stock returns and the returns on FTSE100
are as follows:
Returns on Returns on
Year
SpringTime (%) FTSE100 (%)
1 10 8
2 6 1
3 -4 10
4 24 12
5 19 14
The risk-free rate is 5% per annum.
Using the above information, we can estimate beta and the expected return on
SpringTime. The approach is as follows:
1. Compute the mean return of SpringTime and FTSE100 (Column I and II).
2. Determine the deviation of each observation from its mean (Column III and
IV).
3. Calculate the covariance of returns between SpringTime and FTSE100 by
averaging the sum of the products of each pair of deviations (Column V).
4. Calculate the variance of returns on FTSE100 (being the average of the sum
of the squared deviations of Column VI).
5. Estimate the beta.
6. Substitute beta into the CAPM equation.
I II III IV V VI
SpringTime’s
Year FTSE100’s return DEV, S DEV, M III IV IV IV
return
% % % % % %
1 10 8 -1 -1 1 1
2 6 1 -5 -8 40 64
3 -4 10 -15 1 -15 1
4 24 12 13 3 39 9
5 19 14 8 5 40 25
Sum 55 45 105 100
Mean 11 9 Covariance 21
Variance 20
Covariance
= 5 + 1.05 (9 – 5)
= 9.2
48
Chapter 3: Risk and return
Activity 3.8
Attempt Question 15 of BMA, Chapter 8.
See VLE for solution.
I II III IV V VI
SpringTime’s
Year FTSE100’s return DEV, S DEV, M III IV IV IV
return
% % % % % %
1 10 8 -1 -1 1 1
2 6 1 -5 -8 40 64
3 -4 10 -15 1 -15 1
4 24 12 13 3 39 9
5 19 14 8 5 40 25
Sum 55 45 105 100
Mean 11 9 Covariance 26.25
Variance 25
You can see that the differences lie on the calculation of the covariance
and variance. We re-calculate the covariance and variance using
equations 3.4a – 3.4c. However, the beta remains unchanged (26.25/25
= 1.05).
iii. The estimation of beta is sensitive to both the return intervals and the
sample periods. Daves, Ehrhardt and Kunkel (2000) have the following
conclusion:
‘Financial managers can estimate the cost of equity via the
CAPM approach. If the financial manager estimates the firm’s
beta... then the financial manager must select both the return
interval and the estimation period. Regarding return interval...
the financial manager should always select daily returns because
daily returns result in the smallest standard error of beta or
greatest precision of the beta estimate. However, regarding
estimation period, the financial manager faces a dilemma. While
a longer estimation period results in a tighter standard error for
the estimate of beta, a longer estimation period also results in
a higher likelihood that there will be a significant change in the
beta. Thus, the beta estimated over longer estimation periods
is more likely to be biased and of little use to the financial
manager.’
49
59 Financial management
50
Chapter 3: Risk and return
Activity 3.9
Attempt Question 21 of BMA, Chapter 8.
See VLE for solution.
51
59 Financial management
Practice questions
1. Suppose we have the following inflation rates, stock markets and US
Treasury Bill returns between 2006 and 2010:
Year Inflation (%) S&P 500 Return (%) T-bill Return (%)
2006 3.3 23.1 5.2
2007 1.7 33.4 5.3
2008 1.6 28.6 4.9
2009 2.7 21.0 4.7
2010 3.4 -9.1 5.9
a. What was the real return on the S&P 500 in each year?
b. What was the average real return?
c. What was the risk premium in each year?
d. What was the average risk premium?
e. What was the standard deviation of the risk premium?
2. Is standard deviation an appropriate measure of risk for financial
investments or projects? Discuss.
3. A game of chance offers the following odds and payoffs. Each play of
the game costs £100, so the net profit per play is the payoff less £100:
52
Chapter 3: Risk and return
Peppers Corn
Expected return 10 10
Standard deviation 5 5
If the returns on Peppers are independent of those on Corn, what will
be the composition of his optimal portfolio? Would the composition of
the portfolio be different if a risk-free investment is available to James?
3. What are the necessary conditions for an efficient diversification of
risk?
a. What is the relationship between the number of available securities
and the gains from diversification?
b. Does this relationship have any implication for the small investor?
c. ‘In theory, an investor in risky securities is presumed to select
an investment portfolio which is on the efficient frontier and
touches one of his indifference curves at a tangent. But in
practice, neither the efficient frontier nor the indifference can be
estimated with high degree accuracy. Therefore, the portfolio
theory is redundant.’
Explain the terms in bold in the above statement. Critically assess their
validity.
4. Suppose that you have estimated the expected returns and betas of the
following five stocks using annual data available for the last 10 years:
53
59 Financial management
54
Chapter 4: Capital market efficiency
Essential reading
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York:
McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapter 13.
Further reading
Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice
Hall, 2008) fourth edition [ISBN 9780273719069] Chapter 14.
Aims
The first part of this chapter introduces you to the theory and practice
of capital markets. It considers the concept of an efficient capital market
with its implications for the raising of capital and the assurances for a fair
game situation for the transfer of funds between investors. The types and
the degrees of efficiency have been tested in many various ways with more
recent research findings highlighting certain anomalies which give support
to those who have questioned the concept. Discrepancies in types and
degrees of efficiency between different international markets have also
been identified. The efficient market hypothesis has important implications
for all market operators and their agents.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• describe the nature and types of capital markets
• explain the efficient market hypothesis, its different levels, the
anomalies and deviations between theory and practice as well as
summarise the evidence that has been produced both in support for
and against the hypothesis
• explain the implications of market efficiency for the various operators
who use the markets or provide information regarding them (e.g.
investors, companies raising funds and financial analysts)
• discuss how the financial markets operate particularly with respect to
the provision of funds for companies
• list/outline the range of securities used to generate funds for
companies including a more in-depth insight of the main forms of debt
and equity.
Capital markets
The primary function of the capital markets is to enable investors
and companies to raise funds. The secondary function is to provide
opportunities for providers of funds to liquidate their investments. Note
that this latter function is vitally important because, without the facility to
exit from an investment, few people or institutions would be prepared to
make investment funds available. Thus the marketplace is providing the
needed interface for investors to interact with companies, through their
management, that wish to raise funds as well as other investors who may
wish to buy or sell existing financial assets.
55
59 Financial management
Types of efficiency
An efficient market needs operational, allocational and informational
efficiency. A perfect market requires that trading is costless, that
information is costless and freely available, and that no single investor is
dominant.
• Operational efficiency – means that transaction costs should be as low as
possible and that sales are quickly effected.
• Allocational efficiency – means that capital markets allocate funds to
their most productive use.
• Informational efficiency – means that security prices fully and fairly
reflect all relevant information so that they are fair prices.
When discussing efficiency, the majority of the research findings in the
literature relate to pricing efficiency. It is to this that the efficient market
hypothesis (EMH) relates.
56
Chapter 4: Capital market efficiency
Activity 4.1
Look at a local paper which quotes daily share prices. Select a company and plot the
closing share prices for the five days in one week with time on the x axis. Draw a line of
best fit through those five points. Then plot the next Monday’s closing price. By reading
the paper about Monday’s market activities try to explain why the plot for Monday’s
price is where it is, on, above or below the trend line you have drawn. Is your explanation
drawn from the weak, semi-strong or strong form?
See VLE for discussion.
Rationality
Investors are rational. They seek returns to compensate for their
investment risk and would avoid unnecessary risk wherever possible.
The stock market is rational in the sense that stock prices reflect their
fundamental values. If such rationality is in place, it is argued that
investors and the market will value securities based on their fundamentals.
Arbitrage
Arbitrage is possible to ensure securities that are out of price would be
aligned to their fundamental values. Even if most investors are irrational
in the same way, as long as some rational investors can arbitrage and
eliminate the influence of the irrational traders’ actions, then prices can be
restored to their efficient level. However, if arbitrage is not possible, any
mispricing in securities would not be adjusted.
57
59 Financial management
Activity 4.2
Identify and explain which forms of efficiency are adhered to and/or violated in each of
the following situations:
i. Stock returns tend to be lower in December than in January.
ii. Small capitalised stocks perform substantially better than the market while large
capitalised stocks perform significantly worse than the market in 2006.
iii. The London Stock Exchange has recently published a report on insider trading. It has
been found that there is no evidence for any insider trading.
iv. BAC plc has just announced a record profit but its share price falls by 10%.
v. Mrs Smith announced on national TV that she can predict stock returns better than
the capital asset pricing model.
See VLE for discussion.
58
Chapter 4: Capital market efficiency
Implications of EMH
Investors
If markets are adhering to the strong form efficiency, then no one can
obtain abnormal returns by using any private or public information.
Equity research is pointless and no bargains exist on the capital markets.
Investors are best advised to buy a portfolio of shares and to hold those
shares rather than look for opportunities to buy ‘cheap’ shares. This is
because securities reliably reflect all known information about a business,
so if shares look cheap it is illusory – all that will happen is that the
investor will waste time and money seeking out the ‘cheap’ shares, then
spend money on agents’ fees etc. to sell part of the existing portfolio and
replace it with the ‘cheap’ shares.
However, if the market is not adhering to the strong form efficiency, then
for the vast majority of people, public information cannot be used to earn
abnormal returns. Arguably only those investors who have superior private
information would gain. The perception of a fair game market could be
improved by more constraints and deterrents placed on insider dealers.
Similarly, if the markets are adhering to the semi-strong form efficiency,
fundamental analysis (which looks for the fundamental value of a share)
would not add value. Instead, investors need to press for a greater
volume of timely information to ensure that stock prices reflect full public
information about companies.
If the markets are adhering to the weak form efficiency, then technical
analysis (which seeks to predict share prices from studying their historic
movements) would be redundant as past stock price patterns would have
already been incorporated in the current stock prices.
Companies
Accounting misinformation will not fool investors generally. There is a
body of evidence which suggests that attempts by corporate managers to
make alterations to the accounting bases, to figures published in annual
accounts which have the effect of giving a changed view of the profit for
a period or the assets on the balance sheet, will not affect the market
price of the business’s shares; this is provided that the facts concerning
the alterations to the accounting bases are made public. However not
everything may be made public and in any case some manipulation
may be possible within the guidelines and thus not published. There
are numerous reasons why management wants financial information
presented in a particular way (e.g. income smoothing because of the link
with a management remuneration scheme).
The timing of issues of new shares by businesses is not an important
question. It seems that corporate managers are frequently concerned not
to issue shares at a point where share prices are historically low, since in
59
59 Financial management
order for the issue to be successful the new issue would have to be at a
low price; this is irrational if current share prices reflect all that is known
about the business. Only where the businesses’ managers have economic
information about the business that they have yet to release into the public
domain would delay be justified. Again, anecdotal evidence can show in
specific instances where businesses did lose out by having to issue at the
wrong time.
Possibly the shift in research findings reflects a genuine lessening of CME
over recent times, perhaps caused by an effective decline in the number of
individual investors active in the market.
Possibly it reflects the use of more sophisticated research techniques in
recent studies, which are leading to a truer view of things.
Activity 4.3
Summarise the six lessons of market efficiency on pp.358–61 of BMA, Chapter 13. In your
opinion, how far do you agree that the capital markets are informationally efficient?
See VLE for discussion.
Practice questions
Critically comment on each of the following statements:
1. ‘The stock market is depressed at the moment. This is a very bad time
for our business to make an issue of new shares to the public.’
2. ‘If stock market prices are efficient, it means that all investors have
complete information about all of the shares quoted in that market.’
3. ‘The stock market cannot be semi-strong efficient, otherwise you
wouldn’t have all those well paid analysts spending most of their
working day poring over business reports and other published
information.’
60
Chapter 4: Capital market efficiency
61
59 Financial management
Notes
62
Chapter 5: Sources of finance
Essential reading
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New
York: McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters
14 and 15.
Further reading
Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice
Hall, 2008) fourth edition [ISBN 9780273719069] Chapters 9–12.
Aims
In this chapter we focus on the main reasons why firms raise funds from
capital markets and discuss the main methods of raising equity and debt.
We will also discuss the pros and cons of each method of fund-raising.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• discuss how the financial markets operate, particularly with respect to
the provision of funds for companies
• outline the range of securities used to generate funds for companies,
including a more in-depth insight of the main forms of debt and equity.
Introduction
In Chapter 2 we discussed why firms engage in financial investments.
In order to maximise the value of a firm, managers must come up with
sufficient cash flows to undertake all positive NPV projects. A firm may
rely on two sources of funds: internal and external.1 1
We will discuss more
thoroughly the theory
of capital structure in
Internal funds Chapter 6. In particular
the pecking order theory
The main source of internal funds comes from retained earnings. Firms will be covered.
set aside resources by retaining part of their yearly earnings for future
investment purposes. It is often argued that internal funds are much more
preferred to external funds because:
• retained earnings are seen as a ready source of cash or cash equivalent
• there is no issue or transaction cost involved with retained earnings
(as opposed to equity or debt issues – see below)
• there is no dilution of control with retained earnings
• no public scrutiny of why the funds are needed and how they are to be
used.
63
59 Financial management
External funds
External funds can be roughly divided into equity finance and debt finance.
1. Equity finance
Equity finance can be raised by selling ordinary shares to existing
shareholders or new investors. These shares can be sold or bought
in stock exchanges around the world. Ordinary shareholders are
the ultimate bearers of risk in a company, as they are at the base of
the creditor hierarchy and stand to lose everything in the event of
liquidation. They therefore demand a higher return to compensate for
the risk they bear.
Ordinary shares have a nominal (or par) value which gives every
shareholder an equal voting right. An ordinary share is normally issued
at a price higher than the par value. The difference is called the share
premium. However, the issued price is not normally the same as the
market price of a share and the share price fluctuates on the basis of
how stock markets value the company.
2. Debt finance
Debt finance refers to the borrowings of a company to finance its
operations. We will cover this on page 68.
Activity 5.1
On 4 May 2010, Essar Energy, an Indian oil and gas producer, issued ordinary shares at
£4.20 for a total of £5,470m on the main London Stock Exchange. Its share price as on
1 November was £2.97.
(Sources: www.essarenergy.com/ and www.newissuecentre.co.uk/2010issues.htm)
Why would a company such as Essar Energy issue ordinary shares on a stock exchange?
Why did the share price of Essar fall after the issue on 4 May 2010?
See VLE for discussion.
Flotation
Many companies, such as Essar, would like to issue shares on stock
exchanges. The main reasons for companies to do so are to:
• raise funds for current and future investments, ease out liquidity
shortages and reduce debts
• gain easier access to equity and other sources of finance in the future
• use quoted shares in various ways, such as in a take-over bid.
However, flotation of shares in stock exchanges is not without
consequences. Some of the concerns are listed below:
• Meeting investors’ expectations – it is evident that once a company is
floated on a stock exchange, it will be more heavily scrutinised by the
public and especially existing investors. As share prices are supposed
to reflect the investors’ expectations about the company’s future
dividends, managers must try hard to ensure that this expectation is
met.
• Costs of flotation – the process of flotation is a very expensive exercise
for a company. It is often thought that most companies would at
some point in their life cycle have to consider flotation in the stock
markets. The attraction or benefits from a flotation must outweigh the
limitations.
64
Chapter 5: Sources of finance
Activity 5.3
Read the following article:
www.fundinguniverse.com/company-histories/DaimlerChrysler-AG-Company-History.html
In your opinion, why did Daimler-Benz (the luxurious car maker) seek listing on the New
York Stock Exchange?
See VLE for discussion.
Share issues
We have discussed at great length the pros and cons of issuing shares in
stock markets. In the following section, we will look at the mechanism of
issuing shares to the public.
65
59 Financial management
Issuing process
Given the complexity of raising funds in the stock markets, it is often
considered to be essential that advisers should be appointed. These
advisers fall into the following categories:
• Sponsor
This is normally an investment banker, stockbroker or another
professional who possesses all the necessary expertise and is approved
by the local listing agents to act as an adviser to issuing firms. The
sponsor (commonly known as the issuing house) will first examine and
assess if going public is the appropriate corporate objective by taking
into consideration the composition of the board. The sponsor will also
advise on the issue price and the number of shares to be issued given
the market conditions and the method and timing of the equity issue.
• Underwriters
Since it is difficult to estimate the precise demand of the new shares, an
issuing company will normally appoint an underwriter (or a syndicate
of underwriters) to underwrite any unsubscribed shares. If the price
set by the sponsor is too high, the demand will be less than supply and
the issuing firm will be left with unwanted shares. This implies that the
firm will not be able to raise sufficient funds for its use. To ensure that
this is not going to happen, a firm will pay the underwriters a sum of
money (acting like an insurance premium). In return, the underwriters
will guarantee to buy back any unwanted shares. The price of the
unwanted shares that the underwriters will buy back from the issuing
firm will be lower than the original issue price to the public.
• Other professionals
Accountants and lawyers provide reports about the issuing firm’s
financial position and advise on legal matters relating to the equity
issue.
In considering issuing shares to the public, a company might need to take
the following factors into account:
Price stability – a newly floated firm should ensure that its share
price is stable to give investors additional confidence. Therefore it
is important that after listing, the issuing firm has the continuing
obligation to release any price-sensitive information to the market as
soon as possible.
Timing – market timing for new share issues is crucial to determine if
the issue is going to be fully subscribed. The Industrial and Commercial
Bank of China (ICBC) simultaneously floated its shares on both the
Hong Kong Stock Exchange and the Shanghai Stock Exchange. It was
the world’s largest IPO at that time. Due to the favourable market
timing, the shares were heavily over-subscribed and the share price
ended up some 15% over the initial offer price by the end of the first
trading day.
Initial returns – investors are drawn to the prospect of receiving ‘good’
returns from their IPO shares. Companies which seek to float their
shares for the first time might need to consider underpricing their
3
See BMA pp.400–401
and Figure 15.3.
shares to attract investors.3
Long-term performance – even though there are investors who
often look for ‘bargain’ or short-term profit from their investment,
the majority of them are looking for sustainable long-term returns
66
Chapter 5: Sources of finance
Rights issues
Apart from issuing shares to the public, a company can also raise funds
directly from its existing investors. This is known as a rights issue. In a
rights issue, new shares are issued pro-rata to existing shareholders which
preserves the existing patterns of ownership and control. It is cheaper
than an offer for sale, but is limited by funds at the disposal of existing
shareholders. Shares in a rights issue are usually offered at a discount
(around 15% to 20%) on the current market price, making them more
attractive to shareholders and allowing for any adverse share price
movements.
After a rights issue, shares would be traded at the theoretical ex-rights
price. The theoretical ex-rights price is given by:
P N + PN N N
Pe = 0 0
N
Where:
P0 is the share price before the rights issue
N0 is the number of old shares
N is the total number of shares after the rights issue
PN is the issued price of the rights issue
NN is the number of new shares created from the rights issue
Example 5.1
TLC plc’s current share price is £10 each. There are 1m ordinary shares in issue.
The company considers a one for four rights issue at an issuing price of £8 per
new share. What is the theoretical share price after the rights issue?
P0 N 0 + PN N N
Pe =
N
1,000,000 250,000
= £10 × + £8 ×
1,250,000 1,250,000
= £9.60.
Rights can be sold to investors: the value of rights is the difference between
the theoretical ex-rights price and the rights issue price. If shareholders either
buy the offered shares or sell their rights, there is no effect on their wealth.
In the case when a shareholder accepts the rights and buys the share, her net
worth is £9.60 5 – £8 = £40 which is the same value before she subscribes
to the new share (i.e. £10 for each of the 4 shares she owns). If she sells the
rights, she should have (under the no arbitrage assumption) the same wealth.
Consequently, the value of the rights must be calculated as £10 4 – £9.60 4
= £1.60.
However, the actual ex-rights price will be different from the theoretical ex-
rights price due to market expectations about the economy, the company and
dividends.
67
59 Financial management
Private issues
Sometimes it is more advantageous for a company to issue shares privately
to potential shareholders. Some of the possible ways of offering shares to
private investors are listed below:
• Placement or placing – this involves issuing blocks of new shares at
a fixed price to institutional investors. It is a low-cost issuing method
involving little risk. There is no limit on the amount to be placed. It is a
popular choice for small to medium-sized share issues.
• Offer for sale – this is when the issuing firm’s sponsor offers the shares
by inviting institutional and individual investors. Normally the offer
is at a fixed price usually for large issues of new equity and involves
offering shares to the public through an issuing house or a sponsoring
investment bank. A variation to this is the offer for sale by tender. Here
investors are invited to state at what price they are willing to buy the
shares. The sponsor will gather all information and determine a price
(the strike price) that will guarantee all shares are sold. This strike
price will be the selling price for all the shares. Those investors who
submit a bid price higher than the strike price will be allocated shares,
while those who submit a price lower than the strike price will not be
allocated any shares. This method is popular when the actual issued
price is difficult to determine.
Debt finance
Advantages of debt financing
The issue of loan capital (debt) can bring certain advantages to a business
and its shareholders. These advantages include:
• By employing loan capital to help finance the business, the returns to
equity shareholders will increase, providing the returns from the funds
invested exceed the cost of servicing the loan.
68
Chapter 5: Sources of finance
69
59 Financial management
Practice questions
BMA, Chapter 15, Questions 10, 14, 15 and 16.
70
Chapter 6: Capital structure
Essential reading
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York:
McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters 17
and 18.
Further reading
Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice
Hall, 2008) fourth edition [ISBN 9780273719069] Chapter 21.
Works cited
Altman, Edward I. ‘A further empirical investigation of the bankruptcy cost
question’, Journal of Finance 39, 1984, pp.1067–89.
DeAngelo, H. and R.W. Masulis ‘Optimal capital structure under corporate and
personal taxation’, Journal of Financial Economics 8, 1980, pp.3–29.
Graham, J.R. and C.R. Harvey ‘The theory and practice of corporate finance:
evidence from the field’, Journal of Financial Economics 60, 2001, pp.187–
243.
Jensen, M.C. and W.H. Meckling ‘Theory of the firm: managerial behavior,
agency costs and ownership structure theory of the firm’, Journal of
Financial Economics 3, 1976, pp.305–60.
Miller, M. ‘Debt and taxes’, Journal of Finance 32, 1977, pp.261–75.
Modigliani, F. and M.H. Miller ‘The cost of capital, corporate finance and the
theory of investment’, American Economic Review 48, 1958, pp.261–96.
Modigliani, F. and M.H. Miller ‘Taxes and the cost of capital: a correction’,
American Economic Review 53, 1963, pp.433–43.
Warner, J.B. ‘Bankruptcy costs: some evidence’, Journal of Finance 32, 1977,
pp.337–47.
Aims
We have discussed the reasons for companies to raise funds from external
sources in Chapter 5. In this chapter we will look more formally at how
different sources of funds raised by companies may affect their values.
In particular we will examine the various contrasting theories on capital
structure.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• describe and assess how Modigliani and Miller’s arguments on capital
structure with and without taxes might affect the way we look at
optimal capital structure
• examine thoroughly concepts of risky debt, signalling effect and agency
costs of both equity and debt in the capital structure theory
• discuss the implications of the pecking order theory.
71
59 Financial management
Introduction
We discussed in Chapter 5 how firms raise funds from equity and debt.
In this chapter we examine the capital structure theory and attempt to
provide an answer to the following question: Can a firm create additional
value through the use of a financing policy which does not change the
nature of the assets held by the firm?
If the answer to the above question is ‘no’, then corporate managers should
only be focusing on maximising the firm’s value by undertaking all positive
Net Present Value (NPV) projects. This is the conclusion we arrived at in
Chapters 1 and 2. However, if the answer is ‘yes’, then the financing policy
becomes important and an optimal way of funding projects must be found.
Example 6.1
A B
$’000 $’000
Earnings 1,000 1,000
Interest (100)
Earnings available for dividends 1,000 900
Suppose Company A and B are identical in every respect except in their
capital structure. Company A is an all-equity financed firm whereas Company
B is partly financed with debt. Given that they are identical, both companies
generate the same cash flows. Suppose they pay out all earnings, after
interest and tax, to shareholders as dividend. Shareholders in Company A will
receive $1,000,000 as dividends at the end of the period while stakeholders
of Company B who have claims on both the debt and equity would have a
72
Chapter 6: Capital structure
combined cash return of $1,000,000 as well. Since the cash returns to both
stakeholders are the same, the value of their investments must be identical (to
avoid arbitrage in an efficient market); and hence we have MM’s proposition I
(without tax):
The value of an unlevered firm is equal to the value of a levered firm:
Vu = VL (6.1)
Proposition I tells us that regardless of how a firm is financed, its value will
always be independent of the level of debt. The average return on assets will be
identical across all firms in the same risk class.
However, as the percentage of debt (relative to equity) increases, a larger share
of earnings would be distributed to debt-holders as interest. Shareholders’
potential return will thus be affected. This increases the shareholders’ financial
risk. The required rate of return by shareholders will need to increase to
compensate for the higher financial risk. However, the weighted average cost
of capital (WACC) remains constant as the value of the company remains
unchanged.
R Re
Ro
Rd
D/E
Figure 6.1: Cost of capital and debt-equity ratio
Since assets are financed by a mixture of debt and equity, the average return on
assets must be the same as the WACC.
D E
Ra = Rd + Re
D+ E D+ E (6.2)
where
R a is the average return on assets
R d and R e are the return on debt and equity respectively
D and E are the market value of debt and equity respectively
73
59 Financial management
Example 6.2
A firm has £2 million of debt and 100,000 of outstanding shares at £30 each. If
investors can borrow at 8% and the shareholders require 15% return, what is
the firm’s WACC?
Answer:
The value of debt, D = £2 million.
The value of Equity, E = 100,000 shares £30 per share = £3 million.
D E
Ra = R + R
D+ E d D+ E e
2 3
= × 8% + × 15%
2+3 2+3
= 12.2%
Activity 6.1
Attempt Question 3 of BMA, Chapter 17, p.463.
See VLE for solution.
Example 6.3
A B
$’000 $’000
Earnings 1,000 1,000
Interest (100)
Earnings before tax 1,000 900
Tax (200) (180)
Dividend 800 720
The after-tax cash return to a 100% shareholder in Company A is $800,000.
The after-tax cash return to an investor who owns all the debt and equity of
Company B would be $820,000 ($100,000 of interest + $720,000 of dividend).
Given that the cash returns are not identical, the value of these two companies
must be different (in order to avoid arbitrage in an efficient market).
By how much would the value of B be different from A?
In most countries, interest on debt is deducted before corporate tax is
calculated. This tax deductibility of debt interest provides an additional after-
tax cash flow to the stakeholders in B. The difference of the after-tax cash
return between B and A is exactly the same as the tax saving arising from the
interest (i.e. interest tax rate = $100,000 20% = $20,000). So over the
lifetime of the debt, the amount of tax savings interest would be:
∞
Interest × Tc
∑ = Tc D
(1+ rd )
i
i=1
This tax saving represents the value of a levered firm over an unlevered firm.
Consequently, the MM proposition 1 in the world with tax will become:
VL = Vu + Tc D (6.4)
74
Chapter 6: Capital structure
Where Tc is the corporate tax rate and D is the market value of debt.
Similar to the previous explanation, shareholders will demand a higher return
to compensate for the increased risk due to higher level of debt. However,
the tax deductibility of interest allows the company to save up taxes for
shareholders. The perceived risk, which increases as a result of higher levels of
debt, would to some extent be offset by the tax shield. Consequently the MM
Proposition 2 will become:
D (6.5)
Re = Ra + (Ra − Rd )(1 − Tc )
E
What is the implication of the above argument?
According to the tax argument, a firm can maximise its value by using all debt
financing.
Activity 6.2
Discuss what the following companies should do with their debt policy:
1. Company A has a substantially high corporate tax rate.
2. Company B is a large, established company with a high taxable profit level.
3. Company C is a newly established company.
See VLE for discussion.
Personal taxes
We have discussed the effect of corporate tax on debt policy. We now
turn our attention to personal taxes. Suppose investors pay taxes on their
investment income. The total after-tax cash return to stakeholders in a
levered firm can be represented as follows:
C = (EBIT – Rd D)(1–Tc) (1–Te) + Rd D(1–Td)
= EBIT(1–Tc)(1–Te) + Rd D [(1–Td) – (1–Tc) (1–Te)] (6.6)
Where:
EBIT = earnings before interest and tax
D = market value of debt
Rd = return on debt
Tc, Te and Td are the tax rates on the corporation’s profit, equity and debt
respectively.
Miller (1977) argues that the first term represents the payments to equity-
holders in an all-equity financed firm and the second term represents the
tax shield effect from debts. If these cash flows are perpetual, the total
value of the levered firm can then be calculated by discounting the two
terms by the appropriate rates. Consequently, it can be represented by the
following mathematical expression:
VL = +
[ ]
EBIT (1 − Tc)(1 − Te ) Rd D (1 − Td ) − (1 − Tc)(1 − Te ) (6.7)
RUe Rd (1 − Td )
⎡ (1 − T )(1 − T )⎤
= VU + ⎢1 − ⎥D
c e
⎢⎣ (1 − Td ) ⎥⎦
It should be noted that the discount rate for the after-tax dividend income
to equity-holders is the required rate of return by the equity-holders
whereas the discount rate for the after-tax debt interest income should be
discounted by the effective required rate of return by debt-holders. We can
75
59 Financial management
see from equation (6.7) that an incentive to issue debt is provided if:
⎡ (1 − T )(1 − T )⎤
⎢1 − c e
⎥ > 0 more advantageous to issue debt
⎢⎣ (1 − Td ) ⎥⎦
⎡ (1 − T )(1 − T )⎤
⎢1 − c e
⎥ < 0 less advantageous to issue debt
⎢⎣ (1 − Td ) ⎥⎦
Activity 6.3
In many countries, the tax rate for both income from dividends and capital gain is the
same. How would that affect equation 6.7 and what advice would you give to companies
about their debt policy?
See VLE for discussion.
Activity 6.4
What level of debt would you expect to find in the following companies (based on
DeAngelo and Masulis, 1980)?
1. A national utility company (such as a water company) which has a long-term plan for
substantial capital investment.
2. An oil exploration company which hires most of the equipment.
3. A pharmaceutical company which has committed itself to a high level of research and
development activities.
See VLE for discussion.
Financial distress
So far we have assumed that corporate debt is relatively risk free. In
reality, only a small percentage of corporations receive the AAA rating
from credit agencies. If corporate debt is not risk free, then how significant
is the potential cost of bankruptcy?
Warner (1977) looks at data from 11 railroad bankruptcies between 1933
and 1955 in the USA. He measures only direct costs of bankruptcy (i.e.
legal and professional fees and managerial time spent in administering the
bankruptcy). He finds out that the bankruptcy cost represents 1% of the
market value of the firm seven years prior to bankruptcy, and it rises to
5.3% immediately before the bankruptcy.
Altman (1984) examines the indirect costs of bankruptcy of 19 companies
which experienced financial distress between 1970 and 1978. He
measures mainly the loss of profit opportunities. He finds out that these
costs of financial distress represent about 8.1% of the average firm’s value
three years prior to bankruptcy and they rise to 10.5% in the year of
76
Chapter 6: Capital structure
Activity 6.5
Attempt Question 17 of BMA, Chapter 18.
See VLE for solution.
Trade-off theory
In the previous sections, we discuss the benefits of debt issues and how
the interest on debt can provide a tax shield effect. However, debt also
increases the probability of financial distress and the cost of administering
bankruptcy. An optimal capital structure may exist when the marginal tax
shield benefit equals the marginal cost of financial distress.
Market Value
Value of
unlevered
firm
D/E rao
Opmal
debt rao
Figure 6.2: Trade-off theory
Figure 6.2 shows the trade-off theory. As the debt increases, the value
of a firm increases as the tax shield of debt interest kicks in. However,
as the level of debt increases, the potential cost of financial distress also
increases. Part of the tax shield benefit is cancelled out by the cost of
financial distress. The net increase in the firm’s value will be smaller
than the tax shield effect alone. The optimal capital structure is reached
when the marginal cost of financial distress equals the marginal tax shield
benefit, the firm should stop issuing more debt.
Activity 6.6
Attempt Question 7 of BMA, Chapter 18.
See VLE for solution.
77
59 Financial management
Signalling effect
The trade-off theory appears to have provided a solution for corporate
managers to form the optimal capital structure. However, in reality,
suppose there are two types of firms in the market: good quality firms
characterised by high future cash flows, and poor quality firms with
low future cash flows. The true quality is not observable by the market.
Investors would not be able to distinguish the true quality between these
two types of firms. Consequently, they will all be valued at the same price.
The question is: How do managers of good quality firms signal their firms’
true quality to the market?
It is argued that a carefully selected debt policy might be able to signal the
true quality of a good firm. Let’s consider the following scenario:
A firm with a high level of debt implies that there is a higher probability of
bankruptcy. If this is a poor quality firm, it would not have sufficient profit
to absorb the potential tax shield from debt interest and it would have
insufficient funds to pay the debt interest and would thus be insolvent.
Therefore, only managers who are in charge of good quality firms would
be willing to adhere to a high level of debt. The market sees this as a
signal sent by the financial managers about the true quality of their firm.
Its share price would rise accordingly. However, in order to ensure that the
debt can be signalled effectively, the following conditions must be met:
1. The market must adhere to the semi-strong but not strong form;
otherwise the firm’s value can be observed.
2. There is an incentive for the managers in a good quality firm to signal
the firm’s true value.
3. The penalty of using a misleading signal by managers in a poor firm is
more costly than the short-term gain.
So what incentive do we have for ‘good’ and ‘bad’ managers telling the truth?
If the signal is linked with a manager’s compensation scheme, M, such that:
M = (1 + r) 0 V0 + 1 V1 ≥ B
or
M = (1 + r) 0 V0 + 1 (V1 – C) if V1 < B
where
0, 1 = positive weights
r = the one-period interest rate
V0, V1 = the current and future value of the firm
B = the face value of debt
C = a penalty paid if bankruptcy occurs, i.e. V < B.
A manager’s compensation is based on the realised value of the firm at
time 0 and 1. Suppose that B* is the maximum amount of debt that a poor
quality firm (type B) can carry. Managers from a good quality firm (type
A) will set a debt level higher than B* at time 0. The value of the firm at
time 1 will be V1a, and the value of the firm at time 0, V0a is the discounted
value of V1a. Managers will receive the following positive compensation:
V1a
M = (1 + r ) γ 0 + γ 1V1a
1+ r
If managers of a poor quality firm try to raise the debt level above B*, the
value of the firm at time 0 will be the same as that of the good quality
78
Chapter 6: Capital structure
firm, V0a. However, the value of the firm at time 1 when the market
realises that this is a poor quality firm will be V1b. If this value is less
than B*, managers of the poor quality firm will receive the following
compensation:
In other words, the penalty exceeds the total incentive payments over the
period.
80
Chapter 6: Capital structure
Activity 6.7
Agency costs relate to both the direct and indirect monitoring costs on the agents’
behaviour and the indirect costs of sub-optimal agents’ action. How can we measure
these costs in practice?
See VLE for discussion.
Conclusion
The search for an optimal capital structure continues. This chapter outlined
several theories on capital structure. MM argued that a firm’s value is not
affected by its capital structure. However, tax and financial distress lead us
to the trade-off theory. When information is not shared equally between
managers and investors (asymmetric information), the signalling effect on
debt and equity may lead us to the pecking order theory.
81
59 Financial management
Practice questions
BMA Chapter 18, Questions 18, 19 and 27.
Essential reading
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York:
McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapter 16.
Further reading
Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice
Hall, 2008) fourth edition [ISBN 9780273719069] Chapter 22.
Works cited
Black, F. and M. Scholes ‘The effects of dividend yield and dividend policy on
common stock prices and returns’, Journal of Financial Economics, 1(1), 1974,
pp.1–22.
Brav, A., J.R. Graham, C.R. Harvey and R. Michaely ‘Payout policy in the 21st
century’, Journal of Financial Economics 77, 2005, pp.483–527.
Elton, E. and M. Gruber ‘Marginal stockholders’ tax rates and the clientele effect’,
Review of Economics and Statistics 52(2), 1970, pp.68–74.
Fama, E.F. ‘The empirical relationships between the dividend and investment
decisions of firms’, American Economic Review 64(3), 1974, pp.304–18.
Fama, E.F. and H. Babiak ‘Dividend policy: an empirical analysis’, Journal of the
American Statistical Association 63(324), 1968, p.1132.
Gordon, M.J. ‘Dividends, earnings and stock prices’, Review of Economics and
Statistics 41(2), 1959, pp.99–105.
Lintner, J. ‘Distribution of incomes of corporations among dividends, retained
earnings and taxes’, American Economic Review 46, 1956, pp.97–113.
Litzenberger, R. and K. Ramaswamy ‘The effects of personal taxes and dividends
on capital asset prices: theory and empirical evidence’, Journal of Financial
Economics 7(2), 1979, pp.163–95.
Modigliani, F. and M.H. Miller ‘The cost of capital, corporate finance and the
theory of investment’, American Economic Review 48, 1958, pp.261–96.
Aims
Corporate dividend policy, or how companies can provide a return to
shareholders by way of a cash distribution or other means, is one of the more
important financial decisions management has to make. So this chapter will
cover how a firm’s value can or cannot be affected by the chosen dividend
policy. It starts by mentioning the different types of dividend and follows
on with the irrelevancy argument before discussing and describing other
theories such as the clientele effect, the information content of dividends
and the agency costs on dividends. Some practical aspects concerning the
determination of the policy in practice – such as what are non-cash dividends
and whether they should be paid – are covered.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• explain how companies decide on dividend payments
• describe and critique the theory and practice of corporate dividend policy
83
59 Financial management
Introduction
In Chapter 16 of BMA you will be exposed to the theory and practices
associated with corporate dividend policy. We will present opposing views
of the effects of dividend policy on the valuation of shares and discuss
the significance of the traditional view of dividends. This chapter also
addresses informational aspects of dividend payments and potential
clientele effects and how dividend payments are set in practice. The
general intention of this chapter is to provide an in-depth discussion on
the controversial question of how dividend policy affects firm value.
Dividend policy has been the source of some controversy over the years.
In this chapter we consider the nature of that controversy and the factors
that influence dividend policy in practice. We also consider alternatives to
dividend payments which a business might consider.
Types of dividend
Corporations can pay out cash to their shareholders roughly in three ways:
1. Cash dividend
Investors look for a return from their investment holding in
corporations. It is therefore natural for corporations to pay dividends
on a regular basis (yearly, half-yearly or quarterly) as a return to
their shareholders. Some corporations pay a high percentage of their
corporate earnings as dividend whereas some choose to keep the
dividend payout ratio low.1 1
See Securities Investors
Association (Singapore)
However in some cases, a corporation may choose to pay a one-off
for a list of top paying
special dividend. companies: http://
2. Stock2 repurchase www.sias.org.sg/index.
php?option=com_co
Another way for a corporation to pay out to shareholders would be ntent&view=article
through a stock repurchase. Figure 16.1 of BMA shows the history &id=248%3Adivide
of dividend and stock repurchases in the USA between 1980 and nd-payout-ratio-top-50-
2008. One emerging fact is that the absolute amount of stock being companies&catid=20%3
Apress-releases&Itemid=43
repurchased by corporations from their shareholders has increased
&lang=en
significantly over that period. What is the main reason for that?
2
The term ‘Stock’ is
There are four ways to repurchase shares from shareholders:3
often used in the United
i. open market States to refer to shares
issued by companies.
ii. tender offer
3
See BMA p.422.
iii. auction
iv. private negotiation.
3. Scrip dividend
Scrip dividend (or bonus shares) is an issue of shares (not for cash) to
existing shareholders.
Activity 7.1
Read BMA p.422. Identify the main advantages and disadvantages of the four methods of
stock repurchase described above.
See VLE for discussion.
84
Chapter 7: Dividend policy
Dividend controversy
The key question is what effect would a change in the cash dividend
paid have on the value of a firm, given its capital budgeting plan and
borrowing decision. To examine the controversy surrounding dividend
policy, we must isolate dividend policy from other issues in financial
management. If we fix the investment outlays and the level of borrowings,
the only possible source of cash to increase dividend would be the issue
of new shares. So here we consider dividend policy as a trade-off between
retained earnings vs. paying out cash dividends and issuing new shares.
Example 7.14 4
Adapted from BMA,
Chapter 16.
Bear Inc. is currently traded at $10 each with 1,000,000 shares in issue. It
has $1,000,000 of cash and $9,000,000 of other assets (measured at their
market value). Suppose the firm has an investment opportunity which requires
$1,000,000 of initial investment outlay and can produce a net present value of
$2,000,000. If Bear Inc. is to undertake this investment, its value (in an efficient
market) will go up to $12,000,000.
$’000
Original value ($10 1,000,000 shares) 10,000
Investment opportunity (NPV) 2,000
New value 12,000
New share price ($12,000,000/1,000,000) $12
Suppose Bear Inc. has now earmarked the $1,000,000 in the cash account for
investment. If existing shareholders would like to receive a dividend of $1 per
share, what should Bear Inc. do? To raise the amount necessary for the cash
dividend, Bear Inc. would need to issue $1,000,000 of shares. It should be noted
that the cash raised from the share issues is distributed out immediately as a
cash dividend to shareholders. The value of the firm would therefore remain at
$12,000,000.
85
59 Financial management
But what would happen to the share price after the share issue and cash dividend
payment?
Let x be the number of new shares issued and p be the new share price after the
new share issue and dividend payment. We have the following two conditions:
(1) xp = 1,000,000
(2) (x + 1,000,000) = 12,000,000
(1) represents the $1,000,000 raised from the share issue
(2) indicates the value of the firm after the share issue.
Solving (1) and (2) simultaneously, we can easily see that the new price, p is
equal to $11 and the number of new shares issued is 90,909 ($1,000,000/$11).
What this example illustrates is that the shareholder’s value remains unchanged.
If the firm invests and pays out no dividend, each share entitles the existing
shareholder to a value of $12 (equal to the share value). However, if the firm
invests but pays out dividend from a new share issue, the same shareholder
will have a value of $12 (equal to the new share value of $11 + $1 of dividend
received). Therefore dividend policy does not alter a shareholder’s value. If the
existing shareholder would like to receive a dividend (but the firm does not pay
out), he or she can sell their shares to generate a ‘home-made’ dividend.
But MM’s argument is based on some restrictive assumptions!
First they assume that there is no transaction cost for shareholders to sell their
shares should they wish to generate a ‘home-made’ dividend. Second, MM
assume that shareholders do not pay any tax on investment income. If these two
assumptions are not valid, the irrelevancy argument of dividend might not hold.
So let’s see how these might change our understanding of dividend policy.
Clientele effect
In reality, investors are often facing the following scenarios:
1. Buying and selling shares incur transaction costs (such as stamp duty,
brokerage fees etc).
2. Income from either the cash dividend or selling the shares is treated as
taxable income.
3. Investors have different income requirements and consumption
patterns.
Given these constraints, investors must consider their liquidity requirement
(subject to the consumption pattern) and their tax position before deciding
in which company they would like to invest.
Tax consideration
It is often argued that different investors are attracted to shares of
different businesses on the basis of their particular dividend policy.
Investors should consider their tax position before deciding which
company to invest in. We can easily hypothesise that those investors who
have a higher marginal tax rate on dividend income (than capital gain)
would prefer to invest in a firm which has a low dividend payout policy,
and those who have a lower tax rate on dividend income would prefer
to invest in a firm with a high dividend payout policy. Those who do not
have to pay any taxes or have the same marginal tax rate on both dividend
income and capital gain would naturally be indifferent to the different
dividend payout options.
86
Chapter 7: Dividend policy
So, given these three groups of investors, each type of firm (classified by
the level of dividend payout) caters to its own ‘clientele’ of investors. It can
be seen that any change in the dividend payout level by a firm may upset
its investors as they may be subject to higher tax. If they are, they will sell
their shares and re-invest in firms which cater for their tax consideration.
The firm which alters its dividend policy may therefore witness price
changes in its shares. What it means is that dividend policy might be
relevant in this tax clientele context.5 5
Also clientele effect
relates to investors’
Activity 7.2 preference for specific
payout patterns such
In most countries the tax rate on dividend income and capital gain is identical. Does it
as fixed percentage
imply that the tax clientele effect is irrelevant? payout of profits, fixed
See VLE for discussion. percentage growth in
annual dividend etc.
Liquidity requirement
Some investors – such as pensioners, institutional investors and insurance
companies – require regular dividends as a source of income to meet their
consumption and liquidity requirement. They would prefer companies to
pay dividends. If selling shares to generate cash flows incurs unnecessary
transaction cost, these tax-paying investors may prefer to hold dividend
paying shares. As a result, similar to the tax clientele effect, firms will
attract different clientele of investors. If a firm changes its dividend policy,
it might upset its investors and its share price will fall as a result when
investors rebalance their portfolios.
Activity 7.3
On 18 November 2003 Vodafone announced a £2.5bn share repurchase and an increase
of dividends by 20% to £1.5bn. Its share price went up by 6.4% on the day.
In Chapter 4 we discussed the market efficiency hypothesis. Share prices react to new
information in a semi-strong form efficient market. So what information arrived on 18
November 2003 that caused the share price of Vodafone to move up by 6.4%? What
does the share repurchase have to do with the share price? What information does the
increase in dividend convey to the market?
See VLE for discussion.
87
59 Financial management
Activity 7.4
What are the main reasons why a firm’s true quality cannot be observed? Does it imply
that a higher degree of transparency of information is needed?
See VLE for discussion.
88
Chapter 7: Dividend policy
To mitigate this problem, as one may recall in the section above, managers
in a poor quality firm would not increase dividend payouts as the penalty
of managing a bankrupt firm would be severe. Secondly, bondholders
would foresee that every firm has a chance of running into financial
difficulty. So before they lend, they would impose all kind of restrictions to
stop managers from paying out large dividends when the firm is suffering
financial distress.
Another possible conflict would be between managers and shareholders.
So far we assume that managers work for the best interest of their
shareholders. So what if they don’t? Managers might engage in sub-
optimal investment decision-making and use any spare cash (which is
not invested) to pay for private uses (new office, company cars, etc.). As
the control over such a firm is lost as shareholders don’t participate in
day-to-day operations, the only thing shareholders can do, would be to
vote against the re-appointment of the managers or sell their shares as a
protest. However, these actions might come too late to recover the loss
that shareholders might have already suffered.
To mitigate this problem, one might opt to drain the company of cash
by requesting a high dividend payout. When management need cash
for future investments, they have to approach shareholders for capital
funding. Shareholders can exercise some control over their savings
by refusing to buy the firm’s new securities if they are suspicious of
managerial behaviour, but then there are the transaction costs to be paid
for raising the cash this way.
Empirical evidence
The importance of dividend decisions
Lintner (1956), Fama and Babiak (1968) and Fama (1974) concluded that
managers prefer a stable dividend policy and are reluctant to increase
dividends to a level which cannot be sustained.
Gordon (1959) finds positive correlation between a high payout ratio
(dividend per share/earnings per share) and high price to earnings
(market price/earnings per share) ratio among firms. He argues that
investors value companies more with high payout ratios. However, the two
ratios in his analysis contain the earnings per share as the denominator, so
when earnings move, both variables move.
If a company’s earnings are volatile (high risk), it tends to have lower PE.
This company is likely to have a low payout ratio to reduce exposure to
volatile earnings shifts.
ratio can be sustained over a long time period. Similarly, there is usually
reluctance for firms to cut dividends because of the (adverse) signals
which such an action may send out.
There is also evidence to suggest that managers of a firm consider the
firm’s level of earnings to be the most important influence on the dividend
decision. However, a more recent survey conducted by Brav, Graham,
Harvey and Michaely (2005) indicated that:
...maintaining the dividend level is on par with investment
decisions, while repurchases are made out of the residual cash
flow after investment spending. Perceived stability of future
earnings still affects dividend policy as in Lintner (1956).
However, 50 years later, we find that the link between dividends
and earnings has weakened. Many managers now favour
repurchases because they are viewed as being more flexible
than dividends and can be used in an attempt to time the equity
market or to increase earnings per share. Executives believe that
institutions are indifferent between dividends and repurchases
and that payout policies have little impact on their investor
clientele. In general, management views provide little support
for agency, signalling and clientele hypotheses of payout policy.
Tax considerations play a secondary role.
Conclusion
BMA, Chapter 16 has a good summary of the theories we discussed in
this chapter of the subject guide. In short, what we know about dividend
policy is that it seems to link with the life cycle of a firm. A young and
fast growing firm is likely to pay no dividend or repurchase no shares.
It is possibly that it will prefer to rely on internal funding for future
investments. As it matures and profitable investment opportunities become
less available, it will be forced to pay out dividend or repurchase shares
to avoid the agency cost of dividends and improve the signalling effect on
dividend.
90
Chapter 7: Dividend policy
Practice questions
BMA, Chapter 16, Questions 9, 10, 12, 23, 24, 26 and 29.
91
59 Financial management
Notes
92
Chapter 8: Cost of capital and capital investments
Essential reading
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York:
McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapter 19.
Further reading
Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice
Hall, 2008) fourth edition [ISBN 9780273719069] Chapter 19.
Aims
This chapter focuses on how leveraged firms measure their cost of capital.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• calculate and explain the cost of debt, both before and after tax
• calculate the weighted average cost of capital (WACC) for a firm and
explain the meaning of the number produced
• explain the difficulty of using WACC to appraise investment projects in
practice.
Introduction
In Chapter 2 of this subject guide we discussed how managers select
projects based on projects’ NPVs. In this chapter we discuss how corporate
managers choose the discount rate for projects when they are financed
with debt and equity. BMA’s Chapter 19 begins with a good summary of
how projects should be evaluated. You should read that before proceeding
with the rest of this chapter.
βe = ∑ω j β j
j =1
( )
E (Re ) = ∑ω j E R j = E (Ra )
j =1
93
59 Financial management
Example 8.1
Suppose ABC Ltd., a 100% equity financed company, has three projects, A, B
and C. Their betas and values are as follows:
If the linear relationship depicted in the CAPM holds, the average beta of a
firm must be the weighted average of the equity and debt:
E D
βa = βe + (1 − t c ) βd
(8.4)
E +D E +D
94
Chapter 8: Cost of capital and capital investments
Example 8.2
Make-it-easy plc has 100,000 shares at the current market price of £10 each.
It also has £500,000 worth of debt. The expected return on equity is 12%. The
debt is estimated to be relatively risk free and has a return of 5%. Corporate tax
rate is 40% per annum.
Calculate the WACC.
Answer:
1,000 500
WACC = × 12 + × 5 × (1 − 0.4 )
1,000 + 500 1,000 + 500
=9
This WACC can be used as a discount rate for appraising average projects in
the company. So under what circumstances can we use WACC as an effective
discount rate?
Projects do not need to be financed at exactly the same ratio of debt and
equity each time when funds are raised. WACC can still be used as long as the
company adheres to a fixed debt and equity ratio over time (i.e. the weights on
debt and equity remain unchanged).
The risk of each project is not fundamentally different from each other. New
projects to be undertaken are not going to change much of the risk profile
of the company. If a company is undertaking a significant project with very
different risk level to the existing investment portfolio, the WACC might not be
effective.
Example 8.3
Using the information from Example 8.2, suppose Make-it-easy plc decides to
venture into a risky operation. It requires £1,500,000 as an initial investment
outlay. It is expected to generate £200,000 per annum of perpetual net cash
flows. This risky operation has an estimated beta of 2. The company intends to
raise the funds from existing equity-holders. Assume that the market return is
10% per annum.
If Make-it-easy uses the WACC (9% as in Example 8.2) to evaluate this risky
operation, the net present value of the risky operation will be calculated as:
200,000
NPV = −1,500,000 = 722,222
0.09
Make-it-easy will accept this venture as the NPC is higher than zero. However,
the risk of this venture is significantly higher than the company’s average
project risk. Consequently, a higher discount rate should be used to compensate
for the increased risk. Using the CAPM, the expected return on a project with a
beta equal to 2 should be
( )
E Rrisky = 5 + 2 × (10 − 5) = 15
Using this risk-adjusted rate, the risky operation’s NPV should be:
200,000
NPV = −1,500,000 = −1,666,667
0.15
95
59 Financial management
Return (%)
SML
Over investment
WACC
Rf Under investment
Risk
Activity 8.1
Consider the three projects in Example 8.1. Identify whether their NPVs are over- or
under-estimated if the WACC is used as the discount rate.
See VLE for solution.
Example 8.4
The managers of Grand plc would like to estimate their firm’s equity beta.
Grand has only had a stock market quotation for two months. Managers fear
that the lack of market data for their firm may make it difficult to estimate the
correct beta for Grand plc.
As a result they decide to use some existing firms’ data as it would be
inappropriate to attempt to estimate beta from Grand’s actual share price
behaviour over such a short period. Instead it is proposed to ascertain, and,
where necessary, adjust the observed equity betas of other companies operating
in the same industry, and with the same operating characteristics as Grand,
as these should be based on similar levels of systematic risk and be capable of
providing an accurate estimate of Grand’s beta.
96
Chapter 8: Cost of capital and capital investments
Two companies have been identified as firms having operations in the same
industry as Grand that utilise identical operating characteristics. However, only
one company, Big plc, operates exclusively in the same industry as Grand. The
other two companies have some dissimilar activities or opportunities in addition
to operating characteristics that are identical to those of Grand.
Details of the three companies are:
i. Big plc
It operates exclusively in the same industry as Grand plc. Its observed
equity beta is 1.12. It is financed with 60% equity and 40% debt.
ii. Large plc
It has an observed equity beta of 1.11. It has two divisions. Division A
represents 30% of Large plc and has an equity beta equal to 1.9. Division
B shares very similar operating characteristics with Grand plc. Large plc is
financed entirely by equity.
iii. Grand plc is financed entirely by equity. It has a tax rate of 40%.
Assume that all debts are virtually risk free; determine three possible estimates
of the likely equity beta of Grand plc, based on the information provided for Big
and Large.
Approach:
i. Using the data from Big plc and equation (8.6), we first ‘de-gear’ Big plc’s
beta:
D
βe = βa + (βa − βd )(1 − t c )
E
40
1.12 = βa + (1 − 0.4) β assume that the debt is risk free
60 a
βa = 0.8
The de-geared beta of Big plc can be a proxy for Grand’s all equity beta.
ii. Both Grand and Large are all equity financed. However, only Division B
of Large shares the same operating characteristics of Grand. So one may
argue that the beta for Division B would be a good proxy for Grand’s asset
beta. Given that Large’s equity beta would be a weighted average of the
divisional betas, we have:
βe = aβA + (1 − a)βB
1.11 = 0.3 × 1.9 + 0.7 × βB
βB = 0.77
Grand’s equity beta can be proxied as 0.77.
Activity 8.2
Suppose that the risk-free rate and the expected return on the market in Example 8.4 are
5% and 10% respectively. Estimate the expected return of Grand plc.
See VLE for solution.
97
59 Financial management
Practice questions
BMA, Chapter 19, Questions 6, 17, 18 and 28.
98
Chapter 9: Valuation of business
Essential reading
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York:
McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters 3, 4
and 21.
Further reading
Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice
Hall, 2008) fourth edition [ISBN 9780273719069] Chapters 15–18 and 20.
Works cited
Rappaport, A. Creating shareholder value. (New York: Free Press, 1998) Revised
and updated edition [ISBN 9780684844107].
Aims
In this chapter we focus on three main methods of valuing a business.
They are:
1. Asset based.
2. Earning based.
3. Cash flow based.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• apply the three methods of valuing a business
• explain how the value of equity and bond can be measured and
calculated
• discuss the key issues of measuring business in real life.
Introduction
Business valuation is an important topic in finance management. We have
seen in previous chapters that managers need to focus on value creation
when taking on positive NPV projects, valuing businesses in mergers and
acquisition activities, developing capital structure and dividend policies. In
this chapter we will more formally address the issues of valuation.
There are three broad approaches to business valuation. They are:
1. Asset based valuation.
2. Earnings based valuation.
3. Cash flow based valuation.
Activity 9.1
Examine the financial statements of Coca Cola. Determine a value for the company using
the asset based valuation method. Why might the value you determine differ from the
stock market’s valuation (i.e. share price number of shares in issue)?
See VLE for discussion.
The following table shows some UK retailers and their historic PER.
Retailers PER
Alliance Boots 23.6
Debenhams 11.6
DSG International 17.5
HMV 10.5
JJB Sports 24.0
Kingfisher 21.6
Marks and Spencer 21.0
Next 16.4
Table 9.1: UK retailers and their historic PER.
Source of information: Financial Times, 5 May 2007 (also Arnold, 2008).
100
Chapter 9: Valuation of business
Example 9.1
The following data relates to Company A plc:
$ $
Investment 1 X Equity (shares) X
Investment 2 X Debt (borrowings) X
Investment 3 X
….
Total value of investments XX Total value of capital XX
On the other hand, these investments are funded by the company’s two
types of finance – mainly equity (shares) and debt (borrowings). The value
of the business can therefore be evaluated by measuring the sum of the
value of these two types of finance.
101
59 Financial management
Valuation of debt/bonds
A company which borrows would need to set out
i. how long the borrowing is for
ii. the amount it borrows
iii. the interest it promises to pay during the life time of the borrowing.
A lender will receive a certain sum of cash flows over the life of the
debt depending on the terms and structure of the above three aspects.
The value of such debt (borrowing) to the lender will therefore be the
discounted value of the cash flows that the lender can receive from the
borrowing firm. Consequently, the expected market value of redeemable
fixed interest debt will be found by discounting interest payments and
redemption value by the cost of debt:
T
I RV
D=∑ + (9.3)
t =1 (1+ Rd ) (1+ Rd )
t T
Where:
D = market value of the debt
T = number of years to maturity
Rd = rate of return (before tax) required by debt investors
RV = redemption value
I = interest paid.
Example 9.2
What is the value of a 5 year 10% bond if the yield to maturity is 15% per
annum? Assume that the face value is $100.
Answer:
The annual interest received by a bondholder is $100 × 10% (face value ×
coupon rate) = $10. The yield to maturity is the required rate of return by
the lender for a bond of this kind. It is also the discount rate for the valuation
purpose. Putting these together we have:
10 10 10 10 10 100
D= + + + + +
1.15 1.15 2 1.15 3 1.15 4 1.15 5 1.15 5
= 10 × A 5,15% +100 × DF5,15%
= 10 × 3.352 +100 × 0.497
= 83.22
Activity 9.2
What would be the value of the same debt in Example 9.2 if the yield to maturity were
now 5% per annum?
See VLE for solution.
Where:
D = ex-interest market value
I = annual interest paid
Rd = rate of return required by debt investors.
Example 9.3
Consider the case of a 5% irredeemable bond of £100 par value where bond
investors require a yield of 10% per annum. The expected market value of the
bond will be:
I £5
D= = = £50
Rd 0.1
Valuation of equity
We now turn our attention to the value of equity (shares). A shareholder
who owns a share in a company will receive cash flow in terms of the
resale value of the share and/or dividend paid by the company. Suppose
that at the end of the period, the price for a quoted share is Pt. Assume
that shareholders receive dividends Divt at the end of each time period t.
Let the discount rate (or the required rate of return) by the shareholders
be r%. The value of a share can then be computed as:
E (Div1 ) E (P1 )
P0 = +
1+ r 1+ r
But the expected one period share price is the discounted value of the
expected dividend receivable and the resale value of the share in year 2:
...
...
∞
E (DIVt )
=∑
t =1 (1+ r)t (9.5)
This is the discounted dividend model for the valuation of shares. To use
this model to estimate share prices in reality, we will need to estimate a
company’s future dividend and its cost of equity.
In Chapter 3 we discussed how one can use the capital asset pricing
model (CAPM) to estimate the required rate of return by equity-holders.
If this estimation process provides us with the correct discount rate, the
remainder of our work is to estimate the forecasted dividend.
103
59 Financial management
P0 =
(1+ g) Div0 (9.7)
r−g
Equations (9.6) and (9.7) are known as the constant dividend model and
Gordon’s growth model.
Activity 9.3
Sunlight plc paid the following dividends for the last 5 years: £1.30, 1.40, 1.55, 1.70 and
1.90. The company’s current cost of capital is 14% per annum.
Suppose dividend is expected to grow at the historic growth rate of the last 5 years for
the foreseeable future, what would be the estimated share price of Sunlight? If dividend
is only expected to grow at the historic rate for the next 3 years and thereafter stays
constant, what will be the revised share price?
Answer:
We first calculate the historic growth rate of dividend. Given that Div (0) was £1.30 and
Div (4) was £1.90. We can depict this relationship as follows:
Div(4) = Div (0) × (1+ g) 4 ⇒ g = 10% 1 1
For examination
purposes, you can
Case 1 – when dividend is growing at 10% infinitely. Using the constant growth model, assume that the
the share price is: growth on dividend
is not compounded.
(1+ g)D0 (1+ 0.1) × 1.90 2.09
P0 = = = = 52.25 Consequently we have
r−g 0.14 − 0.1 0.04 Div(4) = Div(0) (1 + 4g)
Case 2 – when dividend only grows at 10% for 3 years and thereafter stays constant, the g = 11.5%
share price is:
Div1 Div 2 Div 3 P3
P0 = + 2 + 3 +
(1+ r ) (1+ r ) (1+ r ) (1+ r )
3
Note that P3 is the terminal price at the end of year 3. Those who obtain a share at that
time would be entitled to dividend from year 4 to infinity. Therefore the terminal price is:
Div 4 Div 5 Div 6
P3 = + 2 + + ......
(1+ r) (1+ r) (1+ r)3
Div 3
= since all future dividends are identical to dividend in year 3
r
Substituting P3 into the discounted dividend equation and taking the growth for the first
three years’ dividend, we have:
1.1 × 1.90 1.12 × 1.90 1.13 × 1.90 1.13 × 1.90 0.14
P0 = + + +
(1.14) (1.14)2 (1.14)3 (1.14)3
2.09 2.299 2.5289 2.5289 0.14
= + + +
(1.14 ) (1.14 )2 (1.14 )3 (1.14)3
= 1.833 +1.769 +1.707 +12.192
= 17.501
104
Chapter 9: Valuation of business
Practical considerations
This section is based on Arnold (2008) Chapters 15–18.
We often think that an increase in earnings over time must be a good
indicator of value creation. However, measurement of value creation based
on earnings can be misleading:
• the accounting rules which define the earnings figures can be distorting
and subject to judgments and manipulation
• the investment required to generate the earnings growth is often not
adequately represented
• the time value of money is not included in the consideration
• the risk of the company is not being considered thoroughly.
Value-based management
The recent talk about value-based management brings together three
important aspects of corporate management: finance function, strategy of
a firm and organisational capabilities. There are three steps to create value
to shareholders:
1. Mission statement with value for shareholders at its core.
2. Measuring shareholder value for the entire corporation.
3. Actively managing to create shareholder value.
105
59 Financial management
Conclusion
It is not easy to estimate correctly how much a business is worth. In this
chapter we showed three different approaches to estimate a value of a
business. Each method, based on different assumptions, provided different
valuations of a business. We should try to understand the advantages and
disadvantages of each of those three methods.
Practice questions
BMA Chapter 3, Questions 4, 9, 18 and 31.
BMA Chapter 4, Questions 16, 18, 24 and 29.
Required:
a. What is the balance sheet value of Falcon Ltd.?
b. What is the market value of the bond in Falcon, assuming that the
market risk, beta, of the bond is 0.5.
106
Chapter 9: Valuation of business
107
59 Financial management
Notes
108
Chapter 10: Mergers
Essential reading
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York:
McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapter 31.
Further reading
Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice
Hall, 2008) fourth edition [ISBN 9780273719069] Chapter 23.
Aims
Most companies are involved in either a merger or a takeover at some time
during their corporate existence, so understanding the motives and tactics
behind mergers is very important. There are waves of merger activity and
an explanation for this is given in this chapter. The motives and theories
behind mergers and takeovers are also described. To achieve success in
taking over a company requires knowledge of appropriate tactics, as well
as knowledge of defence tactics should a company not wish to be taken
over – these are explained. We then move onto a section which looks at
corporate restructuring and divesting.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• describe the motives for a merger
• explain the tactics employed in attempting to bring about a merger or
to defend against a merger
• express the advantages and disadvantages of alternative methods of
financing mergers
• describe the merger process and the main regulatory constraints
• investigate the benefits derived from a merger
• appreciate a merger as an investment decision, a financing decision
and a dividend decision.
Introduction
This chapter focuses on trying to explain the motives and tactics involved
in merger and acquisition activity. During periods of intense merger
activity, financial managers spend a great deal of time searching for firms
to acquire or they spend time worrying about firms that are likely to take
their firm over. When one firm buys another, it is exactly the same as
undertaking any ordinary investment. Therefore, from our earlier studies
of financial management we will know that the investment should only
proceed if there is going to be a net contribution to shareholder wealth.
The only problem is that mergers are very difficult to evaluate because
the benefits and costs may not be easy to measure and due to tax they are
more complicated than, say, buying a machine, as legal and accounting
regulations need to be followed.
109
59 Financial management
The terms merger and takeover are used interchangeably. This is because
in many instances it is not clear whether one or the other is occurring.
Strictly, a merger is when two companies of equal size come together and
continue to have an interest in the combined business. A merger supports
the idea of the combination while, in a takeover or acquisition, a larger
company makes a bid for a smaller company, and the directors of the
smaller company do not recommend that shareholders sell their shares to
the purchaser and neither the pre-bid shareholders nor the directors of the
company have any interest in the combined firm.
In a merger, the accounting rules emphasise the continuity of ownership,
while in a takeover, the emphasis is rather on a purchase and discontinuity
of ownership; the main differences between the accounting rules are
concerned with the treatment of goodwill, value of shares exchanged and
pre-acquisition profits.
Economies of scale
You may have come across this term in your earlier studies. In short,
economies of scale can be found in the following areas:
• In production – a larger firm may be able to reduce its per unit cost by
using excess capacity or spreading fixed costs across more units.
• In finance – a large firm may be able to reduce its per unit
administrative cost when administrating finance issues.
Internalisation of transactions
This usually occurs when firms vertically integrate (vertical integration
backwards occurs by the acquisition of firms that supply raw materials and
vertical integration forwards occurs when firms are acquired nearer the
selling of the product). It is an important form of merger as it eliminates
transaction costs when firms have to deal with each other. One drawback
is that by merging two large firms, extra costs may result. For example,
suppliers may be less inclined to compete with one another, leading to
higher prices paid by the merged entity. Another problem is that firms may
be over-integrating. In this case, the benefits of reducing transaction costs
may be outweighed by the increase in costs of mergers.
Market power
During the boom of 1979–85, it was estimated that 3% of assets in the
UK changed hands as a result of vertical integration, while 57% were a
result of horizontal integration (horizontal integration occurs where firms
acquired are at the same stage of the production process, and the merger
leads to a greater share of a particular market). This is an attractive
feature for firms as it has been shown that a concentration in an industry
leads to a greater level of profit.
Entry into new markets/industries
A merger may allow the acquiring firm to enter into markets where the
acquired firm has the know-how. As the growth through a takeover is
quick, it can provide, almost instantly, the necessary size for a firm to
become an effective and formidable competitor.
110
Chapter 10: Mergers
A B
EPS £1 £1
P/E 10 5
Share Price £10 £5
No. of shares 10m 1m
Market value £100m £5m
Earnings £10m £1m
111
59 Financial management
After the acquisition, the total market value of the combined firm:
= £100m (value of Firm A) – £5m (cash paid out) + £5m (value of
Firm B)
= £100m
Total earnings of the combined firm:
= £10m + £1m = £11m
Total outstanding shares:
= 10m (only Firm A’s shares are counted as Firm B’s shares will be
cancelled on acquisition)
New share price of the combined firm:
= £100m/10m = £10
New earnings per share, EPS:
= new earnings/number of shares
= £11m/10m
= £1.10
It seems that the merger has created a higher EPS for the combined
firm. One might think that the combined firm has become more
profitable than before the merger. However, as we assume that there is
no synergy involved in this merger, the increase in EPS is only cosmetic.
It should not be regarded as a merger benefit. One should also note
that the P/E ratio of the combined firm will be reduced to:
£100m/£11m = £9.09
Activity 10.1
Attempt Question 1 and 2 of BMA, Chapter 31, p.845.
See VLE for solution.
Financing a merger
In the previous section, we discussed the main reasons for mergers and
acquisitions. In this section, we turn our attention to the ways that these
mergers and acquisitions should be financed.
A firm can finance a merger using a combination of the following
methods:
1. Cash purchase.
2. Equity exchange.
A firm can purchase another company in cash. Cash can be raised from an
internal cash reserve, by issuing new shares to existing shareholders, or by
issuing additional debt. Each of these methods presents different benefits
to, and is met with different reservations by, the shareholders in both the
acquired and acquiring firms.
We have discussed the relative advantages of financing with internal cash,
debt and equity in Chapter 6 on capital structure. You should revise that
chapter and familiarise yourself with the concept. In short, the relative
advantages can be summarised as follows:
112
Chapter 10: Mergers
Cash offer
• Acquired firm’s shareholders
In a cash offer, the shareholders of the acquired firm will receive a
certain sum of cash flow in selling their shares to the acquiring firm.
While they can calculate the actual return of the investment, the sale
of the shares will be deemed as a disposal which normally will attract
capital gain taxes. There is therefore a tax consideration that the
acquired firm’s shareholders would need to take into account when
accepting the offer price from the acquired firm.
• Acquiring firm and its shareholders
• If the firm is using idle cash, both free cash flow theory and pecking
order theory suggest that this will increase the value of the firm.
• If the firm can afford to purchase another firm with cash despite the
cash flow implication, it might suggest that the acquiring firm might
still have sufficient cash flows for other future investment. Based
on our discussion of the signalling effect on debt and dividend, this
might suggest that it is a good quality firm. Once again its value
might further be enhanced.
• Another advantage of using cash in acquiring another firm is that
there is no dilution effect to the existing shareholders’ holding in the
acquiring firm.
Share issues
• Issuing new shares to raise additional cash for acquisitions has very
similar advantages as in the cash offer above.
• However, according to the pecking order theory, issuing shares might
lead the market to believe that the existing shares are overpriced. This
might have an adverse effect on the share value if the acquiring firm
issues new shares to raise funds for the acquisition.
• There can be difficulties for the market when trying to evaluate the
resultant combination if it perceives that the target company has part
or all of its operations in a different risk class or classes from that of the
acquiring company.
Debt issues
According to our discussion in the trade-off theory, as long as the firm’s
marginal tax shield benefit exceeds the marginal cost of financial distress,
the debt financing will increase the value of the firm. In a similar way, a
firm which issues debt to finance an acquisition might also increase its
value due to this financial effect.
Share exchange
In this mode of financing an acquisition, the acquiring firm issues new
shares to the shareholders of the acquired firm in exchange for the
control of the acquired firm’s net assets. In return, the shareholders of the
acquired firm will surrender their shares in the acquired firm. The relative
advantages and disadvantages of this method to the different stakeholders
can be summarised as below:
• Acquiring firm and its shareholders
• There is no immediate outflow of cash and therefore it reduces
the burden of raising additional finance. This is especially valuable
when the acquiring firm is facing a capital rationing problem.
113
59 Financial management
Activity 10.2
Examine several recent mergers and identify the principal financing options in each case.
Impact of mergers1 1
See Arnold (2008),
pp.887–93.
There is a significant volume of academic and practitioner research on
mergers and their impact. In Arnold, the impact on different types of
stakeholder is discussed. Here is a brief summary:
Society
Society will benefit from mergers provided that the combined firms will
produce cheaper products as a result of economies of scale and improved
managerial efficiency. Empirical findings seem to suggest that at best
mergers are neutral to society.
114
Chapter 10: Mergers
2. Over-optimism
Acquiring managers often over-estimate the benefits of a merger and its
cost. This explains why acquiring firms seem to lose value in mergers.
3. Failure of integration management
Coopers & Lybrand (1993) surveyed the UK’s top 100 companies and
interviewed senior executives and found that the most commonly cited
reasons for merger failures are:
• Target management attitudes and cultural differences (85%).
• Little or no post-acquisition planning (80%).
• Lack of knowledge of industry or target (45%).
• Poor management and poor management practices in the acquired
company (45%).
• Little or no experience of acquisitions (30%).
Employees
In most merger cases, operating units of the merged firms are fused and
redundancy is inevitable. However, in some cases, mergers actually create
competitive strength in the combined firm and allow jobs to be saved or
created.
Directors
The directors of the acquiring firm will normally enjoy an increase in
status and power in the combined firm. Their salary and remuneration are
increased as a result.
On the other hand, the directors of the acquired firm will often be sacked
as they are regarded as the failed managers. However, these directors are
often given a good redundancy package and are often able to find jobs in
other companies.
Financial institutions
Financial institutions benefit from mergers greatly as they are usually paid
handsome fees for providing advice to both the acquired and acquiring
firms during merger talks.
The net gain of a merger is defined as the gain over the cost of acquisition.
The cost of acquisition is the sum of the cash paid and value of securities
issued for the acquisition. Net cost is the cost of acquisition less the
original value of the acquired firm.
The gain generally comes from the synergies created from the merger.
Examples of synergies are:
• Revenue enhancement
• marketing gains
• strategic benefits
• market or monopoly power.
115
59 Financial management
• Cost reduction
• elimination of inefficient management
• economies of scale
• complementary resources.
A bidder is typically estimating the value of a target company using some
of the valuation methods we outlined in Chapter 9. The following example
illustrates how the cost and gain of a merger can be estimated.
Example 10.1
Wardour Frith
Earnings per share 50p 15p
Dividend per share 30p 8p
No. of shares 40m 24m
Share price £9 £2
116
Chapter 10: Mergers
Activity 10.3
Attempt Question 12 of BMA, Chapter 19, p.847.
See VLE for solution.
117
59 Financial management
Conclusion
In this chapter we discussed the main reasons for companies merging with
each other. We also looked at how the gains of a merger can be estimated.
In short this is an area in which corporate managers need to make three
key decisions:
• Investment decision – does the target company provide benefits to the
merged firm? We can view it as an investment project which should be
appraised in line with Chapter 2.
• Financing decision – how should the acquisition be financed? Does it
add value to the merged firm with the different methods of financing?
This links with what we discussed in Chapter 6.
• Strategic decision – the success of a merger depends on how well the
merger plan can be executed. Coopers & Lybrand (1993) provide a list
of common factors for merger success:
• Detailed post-acquisition plans and speed of implementation.
• A clear purpose for making the acquisition.
• Good cultural fit.
• High degree of management cooperation.
• In-depth knowledge of the acquired firm and its history.
Practice questions
BMA Chapter 31, Questions 12, 13, 16 and 17.
118
Chapter 10: Mergers
The Board of Directors have identified the following options to finance the
proposed acquisition of Jing Ltd.
1. Raise £28 million of new shares to acquire the total control of Jing Ltd.
from its existing shareholders.
2. Raise £28 million of 10% perpetual debentures with £20 million
face value to acquire the total control of Jing Ltd. from its existing
shareholders.
The Board expect that, after the acquisition, the combined company could
reduce operational costs by £4,000,000 while maintaining the same level
of operations as before. Currently both companies are paying corporation
tax at the rate of 30%. The risk-free rate is expected to be 5% per annum
for the foreseeable future. The current market return is 10% per annum.
Required:
a. What are the main motives for mergers and acquisitions?
b. What are the effects on Bei plc’s stock price, capital structure, return
on equity and return on debt under each of the two funding options?
Advise whether the acquisition should go ahead and which funding
option would maximise the company’s value. Explain your answer
carefully and state any assumptions that you make.
119
59 Financial management
Notes
120
Chapter 11: Financial planning and working capital management
Essential reading
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York:
McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapter 25 and
Chapters 28–30.
Aims
This chapter examines the importance of financial planning and how
carefully chosen techniques may improve the value of a firm.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• describe the core concepts of financial planning
• evaluate the approaches to, and methods of, financial planning
• explain the importance of working capital management
• discuss techniques used to assist planning and management.
Introduction
This chapter covers three key areas in financial planning:
1. Financial analysis.
2. Financial planning.
3. Working capital management.
Financial analysis
A company’s financial statements provide shareholders, bondholders,
bankers, suppliers, employees and management with information about
how well their interests are protected. Naturally, it is important for each of
these stakeholders to understand the performance of their company. In 25
Principles of accounting, you would have already come across how
we can use financial ratios to assess a firm’s performance. BMA Chapter 28
provides a very detailed explanation of how these common financial ratios
can be calculated and used in interpreting a firm’s profitability, efficiency,
liquidity, financial risk and leverage. We are not going to repeat this
material here. You should revise Chapter 28 thoroughly before proceeding
with the rest of this section. In particular, you should refer to the summary
of financial ratios on p.748.
A company’s set of accounts, its profit and loss account, cash flow
statement and balance sheet are only of limited value when read in
isolation and without analysis and evaluation. Therefore it is important
to give meaning to results portrayed by accounts via analysis and
interpretation. The analysis of financial information can perhaps be best
broken down into two elements, each with their own parts. These are the
process and the context elements, and each influences the other.
121
59 Financial management
The process of analysis will be heavily influenced by its mode and its
purpose. The structure, depth and detail of work undertaken will be
influenced similarly. A very detailed review will start by strategically
analysing the company and then use the ratios to address strategic elements
within each area of enquiry. Most books delineate four areas: profitability,
liquidity and solvency, activity and efficiency, and financial structure.
Each of these areas can be broken down further, for example in the case
of profitability it can cover trading profitability, the margin on sales, the
proportions of sales taken by the different types of costs, etc. Profitability
also includes the return on the investment made. As to what constitutes
investment depends on the reviewers’ perspective. Is it the return on
the long-term funds invested – capital employed ‒ or is it the return on
the total assets used to generate the profit or the return to the ordinary
shareholders for their investment in the company? Each of the areas has its
own family of ratios, providing information for answers to the appropriate
strategic questions. Remember the process is generally to prepare a set of
ratios, analyse them, and use them for a review of the past performance
with the view of helping in the projections for the future. Also a comparison
with competitors or industry sector benchmarks can be useful. The
following table summarises the key ratios and their interpretation.
122
Chapter 11: Financial planning and working capital management
Efficiency
Measures how well the company 3
We can also define
Asset
Sales/total assets3 generates revenues from its assets asset turnover as sales/
turnover
employed in the year. average level of total
assets for the year.
Provides an estimate of how long
Inventory
Average4 inventory/cost of on average goods purchased from 4
In most cases, the
holding
sales 365 days suppliers would be held in the year-end figures are
period used for debtors (trade
company before they are sold.
receivables), creditors
(trade payables) and
Debtors This measure indicates on average
Average debtors/credit closing stock (inventory)
collection how long it takes for a company to
sales 365 days instead.
period collect its debts from credit customers.
123
59 Financial management
in a price war between competitors, and see if it has helped improve the
net asset turnover enough to result in an overall improvement in return to
the net assets employed.
Example 11.1
(This example is adapted from the 2008 subject guide)
The accounts for Chemistrand plc for the two financial years ended 31
December 2007 and 2008 are given below.
CHEMISTRAND PLC
Profit and loss account for years ended 31 December 2008 and 2007
2008 2007
£’000 £’000
Turnover 12,000 13,200
Interest 108 –
9,768 10,440
Current assets
Stock 1,140 1,020
Debtors 1,320 1,140
Bank – 60
2,460 2,220
124
Chapter 11: Financial planning and working capital management
Less
Creditors due within one year
Tax creditors 600 540
Taxation 630 1,470
Bank 720 –
Net current assets 510 210
Net assets 8,880 8,190
Note 3 No sales of assets took place during the year (NBV – Net Book Value)
Note 4 All dividends were paid during the financial year at the rate of £0.15 per share.
125
59 Financial management
The following information from a credit rating agency for the industry is also
available for the two years 2008 and 2007.
2008 2007
LQ M UQ LQ M UQ
Return on net assets (%) 15.0 20.0 25.0 15.0 20.0 25.0
Net assets turnover (times) 1.0 1.5 1.7 1.1 1.5 1.7
Current ratio (times) 1.0 1.9 2.8 1.1 2.0 3.4
Acid test (times) 0.8 1.2 2.1 0.7 1.2 2.0
Collection period (days) 30 45 65 35 50 70
Total owing to total assets (%) 20 50 65 25 49 67
Long-term debt to capital employed (%) 5 15 40 5 15 35
Return on sales 11.5 13.3 14.7 11.0 13.3 14.7
LQ – Lower Quartile (25% of group had ratios same as or lower than figure given)
M – Median (50% of group had ratios same as or lower than figure given)
UQ – Upper Quartile (75% of group had ratios same as or lower than figure given)
Required:
a. Compute a full set of basic financial ratios which will help give a rounded
assessment of Chemistrand’s performance in 2008.
b. Using a subset of the ratios calculated in (a) above, comment on the
performance of Chemistrand plc in comparison with the statistics provided
by the agency.
c. Write a short commentary on what additional information has been
obtained from the results of the computations in (a) which were not used in
(b) above.
2008 2007
Return on net assets 2,232 × 100 = 25.2% 33.7%
8,880
Return on sales 2,232 × 100 = 18.6% 20.9%
12,000
Net asset turnover 12,000 = 1.35× 1.61×
8,880
Return on equity 1,590 × 100 =17.9% 22.0%
8,880
Gross profit margin (12,000 – 7,020) × 100 = 41.5% 40.5%
12,000
Other ratios such as the various costs can be computed as percentages of
turnover, or annual growth rates of turnover, profit etc. Divisional and regional
breakdowns of profit, turnover and net assets can be evaluated similarly if it is
useful to the task.
126
Chapter 11: Financial planning and working capital management
127
59 Financial management
the balance sheet, namely that there is no long-term debt. The company is
distinctly under-geared compared with its competitors. Not knowing what
the future holds, or what the present lending situation is like, one can
probably still recommend that the company takes out a long-term loan. This
would improve the gearing, probably cost less than short-term borrowing
and reduce the risk of financial distress. Given the asset cover and the fact
that the assets are recent acquisitions bankers would, in the light of the
company’s overall profitability, be more than willing to make a medium or
long-term loan to the company.
c. To complete the analysis and interpretation this section was added to
give the reader further insight into interpreting the accounts. Additional
operating profitability ratios indicating how different types of costs
have changed in proportion to turnover would have been useful. Note
that gross profit had actually improved so perhaps the company has
some internal strengths and some weaknesses, since return on sales had
declined (i.e. could it be that production had become more efficient, but
the administration and selling etc. had got less effective?). The increase in
collection and inventory periods reinforces this point though the financial
effects of this are lessened by the effects of increasing the creditor period.
The shareholders will not be pleased, as return on equity and earnings per
share declined, not something you wish to see when a company has just
doubled its called up share capital. So even though the cash dividend cover
hinted at insufficient funds to maintain the dividend level it was probably
felt necessary in order to steady the share price.
Notice how the introduction of the cash based ratios has provided much
more meaningful information on interested dividend cover. The cash
interest cover highlights the security lenders can feel over sufficient cash for
the payment of interest.
N.B. Note when answering these sorts of questions you may have
to make some reasonable assumptions in order to make your
interpretations. If so, state the assumptions. Do remember when you
are asked to interpret, do not just describe a change or an event, try to
give the actual, or a possible, reason for it.
Activity 11.1
Attempt Questions 2–4 of BMA, Chapter 28, p.753.
See VLE for solution.
Financial planning
Managers need to ensure that their firm does not run out of cash.
Therefore it is important to understand how cash can be generated
from its operations and how it can be managed. In 25 Principles
of accounting, you would have already learned the concept of cash
budgeting and its use in internal management. The key points are
summarised here:
1. There are three main sources of cash. They are cash flows from
operating activities, investment activities and financing activities.
2. Operating activities involve the purchase of raw materials and other
goods for resale, the selling of finished goods and receipts from trade
receivables and payments to trade payables.
3. A cash cycle (operating effect) measures the period during which a
company receives cash from its customers to the point when it has to
pay its suppliers. The longer the cash cycle, the more working capital
would have to be raised to finance the company in the short run.
128
Chapter 11: Financial planning and working capital management
days
days
days
It measures the average duration for a firm to pay its debt to its trade
creditors.
8. A cash budget provides a forecast of cash inflows and outflows
based on the company’s estimates of the sales, collection of debts,
purchases (including inventory policy) and payments to suppliers. It
also incorporates other planned expenses such as capital expenditure,
administration and operating charges. Any forms of distribution
of profits, interest and taxes are also considered. A full example is
available in BMA, Chapter 29 (pp.766–67).
9. The cash budget should provide an indication of how much cash
would be available to the business. Corporate managers should then
develop a short-term and long-term financing plan.
10. A short-term financing plan should identify how a company may
utilise surplus cash flows to reduce the burden of short-term working
capital and long-term finance. On the other hand, short-term cash
flow deficit should draw managers’ attention to the need for raising
short-term finance such as bank overdraft, short-term bank loans or
extended credit terms from suppliers.
11. A long-term financing plan focuses on three functions:
a. Contingency planning – would the company have sufficient finance
to cover an unexpected shortfall of cash in the long run? Would the
company be able to cope with unexpected changes in government’s
fiscal policies, tax rates and competitive environment?
b. Flexibility and options – would the company have sufficient
cash flows for future investments should it decide to expand its
current operations or extend its existing investments beyond their
intended investment periods? Would the company be able to repay
the long-term loans when they fall due?
c. Alignment – the long-term financing plan should be consistent
with the company’s long-term objectives and link strategic goals
together.
129
59 Financial management
Example 11.2
(This example is adapted from the 2008 subject guide)
Plantree plc prepares long-term financial plans. In order to achieve its long-
term financial objectives the planning team will be faced with decisions on
investment policy, financing policy and dividend policy.
Required:
a. Comment on the nature of these three types of decisions.
b. Comment on the interrelationship of these three types and how they will be
affected by the choice of the long-term financial objective(s) of the business.
c. Describe briefly some of the main examples of forecast information needed
for each type of decision.
130
Chapter 11: Financial planning and working capital management
Activity 11.2
Attempt Question 17 of BMA, Chapter 29, p.782.
See VLE for solution.
Bank borrowing
You should note the type of loans that the clearing banks and merchant
banks are prepared to make. When making a decision concerning a
business loan application, a bank will take a number of factors into
account. These include the:
• quality and integrity of the management of the business
• quality of the case made in support of the loan application
• period of the loan and the security being offered
• nature of the industry in which the business operates
• financial position and performance of the business.
131
59 Financial management
Specialist finance
There are numerous short and medium-term sources available which are
only provided with a specific end in view. For example, there are a number
of ways of getting money to support exports, or finance for specific
projects, or the more general hire purchase. General knowledge of their
existence is all that is required.
Leasing
Read BMA, Chapter 25 (pp.653‒67). When reading these sections you
should note carefully the distinction between an operating and a finance
lease and the reasons put forward to explain the growth of this form
of financing in recent years. In addition, you should study carefully the
techniques of lease evaluation.
In brief, a company that arranges to hire an asset under a finance lease
agreement is effectively borrowing from the lessor the equivalent of the
lower of the fair value of the asset and the present value of the lease
payments. Therefore the decision whether to lease or buy rests upon the
cash planning of the company.
Sale and lease back arrangements offer an opportunity for a business
with valuable property to raise new finance. You should compare the
advantages and disadvantages of this form of financing with that of a
mortgage.
Activity 11.3
Attempt Question 24 of BMA, Chapter 25, p.672.
See VLE for solution.
132
Chapter 11: Financial planning and working capital management
Example 11.3
Suppose the annual demand of a product is 10,000 units. The cost per order,
C, is £300 and the annual unit storage cost is £5. The economic order quantity
(EOQ) is therefore:
Activity 11.4
In BMA, Chapter 30, p.788, the authors mentioned the terms just-in-time and build-
to-order. Explain what these terms are and what potential problems a company may
encounter if it introduces these concepts of inventory management in its operations.
See VLE for discussion.
Example 11.4
(This example is adapted from the 2008 subject guide)
Pinewood Supplies Ltd. produces a pine bookcase which is sold to retailers
throughout Scotland. The accountant of Pinewood Supplies Ltd. has provided
the following information concerning the product:
£ £
Selling price 70
Variable costs 42
Fixed cost apportioned 6 48
Net profit 22
133
59 Financial management
The annual turnover of the business is currently £1.4m and it is believed that
this can be increased in the forthcoming year by increasing the time given for
trade debtors to pay. All sales are on credit and the average collection period
for the business is 40 days. The business is considering an increase in the
average collection period by 15 days, 30 days or 45 days.
The effect on sales from adopting each option is as follows:
Option
1 2 3
Increase in average collection period (days) 15 30 45
Expected increase in sales (£,000) £120 £150 £325
134
Chapter 11: Financial planning and working capital management
Debt factoring
Read BMA, Chapter 30(p.793). When reading the relevant sections on
debt factoring note the services offered by a factor and the fee structure
employed. You must be clear about the distinction between debt factoring
and invoice discounting. Debt factoring is often a long-term arrangement
because of the administrative arrangements required to deal with the
transfer of the sales ledger accounting function. Invoice discounting, on
the other hand, may be a temporary arrangement.
Factoring can prove to be expensive and so it is important to identify the
relevant costs and benefits before entering into such an arrangement.
Study the worked example below.
Example 11.5
(This example is adapted from the 2008 subject guide)
Aztec Electronics Ltd. has an annual turnover of £25 million of which £0.2
million prove to be bad debts. Credit controls within the business have been weak
in recent years and the average settlement period for its trade debtors is currently
70 days. All sales are on credit and turnover has been stable in recent years. The
business has been approached by a debt factoring business, which has offered
to provide an advance equivalent to 80% of its debtors (based on an average
settlement period of 30 days) at an annual interest charge of 14%. The factor will
take responsibility for the collection of credit sales and will charge a fee of 2.5%
of sales turnover for this service. The use of a factoring service is expected to lead
to cost savings in credit administration of £120,000 per annum and will reduce
bad debts by half. The settlement period for debtors will be reduced to an average
of 30 days which is in line with the industry norm. The business currently has an
overdraft of £6.2 million and pays interest at the annual rate of 15%.
Required:
Calculate the net annual cost or savings resulting from a decision to employ the
services of the factor.
£’000 £’000
Existing investment in trade debtors
4,795
{(70/365)£25m}
Expected future investment in trade debtors
2,055
{(30/365)£25m}
Reduction in investment 2,740
Factor costs
2.5% of sales turnover 625
Interest charge on advance {(£2,055,000 ×
230
80%)14%}
855
Factor savings
Bad debt savings (£0.2m × 0.5) 100
Credit admin savings 120
Reduction in trade debtors (£2,740,000 × 15%) 411
Reduction in overdraft interest through advance
{(2,055,000 × 80%)15%} 247 878
Net annual savings 23
135
59 Financial management
We can see that, in this case, the employment of a factor will lead to net savings
for the business.
We can see that the cost of foregoing discounts can be very high and,
therefore, other forms of short-term finance may prove to be cheaper.
When reading the relevant sections on trade credit you should note in
particular, the five factors which determine the length of the credit period
given to customers.
Activity 11.5
Attempt Question 21 of BMA, Chapter 30, p.815.
See VLE for solution.
Cash management
Read BMA, Chapter 30 (pp.794–810). Cash has been described as the
‘lifeblood’ of a business. In order to survive, a business must retain an
uninterrupted capacity to pay its maturing obligations. The efficient
management of cash is, therefore, of critical importance to a business.
When reading the relevant chapter you should note the importance
of controlling the cash collection and payments cycle and the cash
transmission techniques available.
136
Chapter 11: Financial planning and working capital management
Example 11.6
(This example is adapted from the 2008 subject guide)
Danton Ltd. began trading recently on 1 April 2008 with a balance at the bank
of £300,000. The business is both a wholesaler and retailer of carpets and floor
coverings. During the first month of trading the business will make payments
for fixtures and fittings of £15,000 and £8,000 for motor vehicles. In addition,
the business will acquire an initial stock on credit costing £24,000. The business
has agreed with its bank an overdraft facility of £20,000 to cover the first year
of trading.
Danton Ltd has provided the following estimates:
1. The gross profit percentage on all goods sold will be 25%.
2. Sales during April are expected to be £10,000 and to increase at the rate
of £4,000 per month until the end of July. From August onwards, sales are
likely to remain at a stable level of £24,000 per month.
3. The business is concerned that supplies will be difficult to obtain later in the
year and so, during the first six months of the year, it intends to increase the
initial stock level of £24,000 by purchasing an additional £2,000 worth of
stock each month in addition to the monthly purchases required to satisfy
monthly sales. All stock purchases, including the initial stock, will be on one
month’s credit.
4. 60% of sales are expected to be on credit with the remainder being for cash.
Credit sales will be paid two months after the sale has been made.
5. Administration expenses are likely to be £1,000 per month and selling
and distribution expenses will be £700 per month. Included in the
administration expenses is a charge of £200 per month for depreciation and
included in selling and distribution expenses is a charge for £300 per month
depreciation. Administration expenses and selling and distribution expenses
are payable in the month incurred.
6. The business intends to buy more fixtures and fittings in June for £8,000 cash.
7. The initial bank balance arose from the issue of 60,000 ordinary shares
payable in instalments. The second instalment of £0.50 per share is payable
in September 2008.
Required:
a. Prepare a cash flow forecast for the six months ended 30 September 2008
showing the cash balance at the end of each month.
b. State what problems the business is likely to face in the forthcoming six
months and how might these be dealt with?
137
59 Financial management
Payments
Fixtures 15.0 8.0
Motor vehicles 8.0
Initial stock 24.0
Purchases 9.5 12.5 15.5 18.5 20.0
Admin expenses 0.8 0.8 0.8 0.8 0.8 0.8
Selling expenses 0.4 0.4 0.4 0.4 0.4 0.4
24.2 34.7 21.7 16.7 19.7 21.2
Cash surplus /(deficit) (20.2) (29.1) (8.5) 0.5 0.7 31.6
Opening balance 30.0 9.8 (19.3) (27.8) (27.3) (26.6)
Closing balance 9.8 (19.3) (27.8) (27.3) (26.6) 5.0
Notes:
1. Purchases represent 75% of the sales for the relevant month plus an extra
£2,000 for stockbuilding.
2. Depreciation is a non-cash item and therefore is excluded from the relevant
expense figures.
b. The cash flow forecast above reveals that the agreed overdraft limit of
£20,000 will be exceeded in three consecutive months. However, the
proceeds of the second instalment of the share issue will bring the business
into cash surplus by the end of the six month period under review. It
may, therefore, be possible to negotiate an increase in the overdraft limit
to deal with this short-term problem. If this is not possible the business
must consider other options. For example, it may be possible to defer the
purchase of the fixtures and fittings in June until a later date. (It is this
purchase which pushes the business over its overdraft limit.)
However, if this is not possible, then the business might consider other
options such as the deferring of payments to trade suppliers, reducing the
credit period to customers, and reducing the level of credit sales. These
options, however, may involve some cost to the business.
138
Chapter 11: Financial planning and working capital management
Practice questions
BMA, Chapter 29, Question 24.
BMA, Chapter 30, Questions 14 and 23.
139
59 Financial management
Notes
140
Chapter 12: Risk management
Essential reading
Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York:
McGraw-Hill, 2010) tenth edition [ISBN 9780071314268] Chapters 20–22,
26 and 27.
Further reading
Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice
Hall, 2008) fourth edition [ISBN 9780273719069] Chapters 24 and 25.
Works cited
Haushalter, D, ‘Financial policy, basis risk and corporate hedging’, Journal of
Finance 55, 2000, pp.107–52.
Aims
Companies undertake investments with various levels of risk. In Chapter
3 we discussed how risk could be diversified. In this chapter, we examine
other techniques in risk management.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
• describe the reasons for companies managing risk
• identify the different risks that companies are exposed to
• evaluate the techniques to reduce risk exposure.
Introduction
Managing financial risk of a company is essential. There are roughly three
types of financial risk which companies need to focus on:
• Translation risk: This is the risk that a company may face when
translating foreign currency based assets, liabilities and profits on
consolidation. Exchange rate movements may result in the company
experiencing a gain or loss. Even though the translation gain or loss
is only an accounting treatment on paper, it may affect investors’
perception of the profitability of those companies.
• Economic risk: This is the risk relating to the long-term exchange rate
movements affecting a multinational company’s competitive advantage
or reducing the NPV of its operations. This is a risk that companies
would probably not be able to avoid.
Therefore it is important to manage exchange rate risk to stabilise
operating cash flows.
142
Chapter 12: Risk management
Buyer Seller
Call option Right to buy Obliged to sell
Put option Right to sell Obliged to buy
An option is said to be in-the-money if it would lead to a profit for its
holder when it is exercised.
An option is said to be out-of-the-money if it would be unprofitable for
its holder when it is exercised.
Example 12.1
A typical option written on a stock can be traded on the Chicago Board Options
Exchange. It might have different exercise prices such as the options below:
Exercise
Options Expiry Call price Put price
price
1 May 2011 45 10.50 1.97
2 May 2011 50 6.75 3.15
3 May 2011 55 3.85 5.25
Pay-off of an option
The pay-off of an option depends on the cash position at the time when
the option is exercised. Suppose the price of the underlying asset on
which the call option is written is ST at any time T. Upon exercising the
option, the buyer will get either 0 (if the asset price is lower than the
143
59 Financial management
exercise price) or ST – X if the asset price is higher than the exercise price.
Consequently the pay-off of a call option is Max [0, ST – X]. The pay-off of
a put option, on the other hand, is Max [0, X – ST].
The value of an option at the expiry date can be expressed as a function of
the stock price and its exercise price.
Example 12.2
Suppose today is 1 February 2011. Option 3 in Example 12.1 expires in three
months’ time. It has an exercise price of $55. The pay-offs of a call and a put
against the future share price in three months’ time are:
Pay-off ($)
20
0 Share price
55 75
Pay-off to a call holder
Figure 12.1: Pay-off to a call holder diagram
Activity 12.2
Now try to draw the pay-off diagrams for Options 1 and 2 in Example 12.1.
See VLE for solution.
144
Chapter 12: Risk management
Put-call parity
Suppose we have a call and a put (both with the same exercise price = X)
and both are written on the same underlying stock, S. We can combine them
to form a riskless portfolio. Let’s look at the pay-off of the following strategy:
T0 T1
Cash flows S1 < X S1 = X S1 > X
Write a call –C 0 0 S1 – X
Sell a put P – (X – S1) 0 0
Sell the stock S – S1 – S1 – S1
Net cash flows S+P–C –X –X
As long as the future share price moves away from the exercise price, this
strategy will ensure that an investment will earn a positive cash flow at T0
and repay X at T1. The cash flow at T0 is equivalent to a risk-free borrowing
of X/(1 + rf). Therefore we have the put-call parity:
Activity 12.3
Attempt Question 19 of BMA, Chapter 20, p.549.
See VLE for solution.
145
59 Financial management
Option pricing
An option (call or put) gives the rights to the holders to buy or sell an
asset at a pre-determined price within a pre-determined period. It derives
its value from the underlying asset on which it is written.
T1
T0 S = £105 S = £95
Buy a call –C S – X = £105 – 100 = £5 Not exercise, £0
Now consider an alternative investment – borrow £45/1.03 now and buy half a
share at £50. The cash flow implication of this alternative would be:
T1
T0 S = £105 S = £95
Buy half a share – £50 £52.5 £47.5
Borrow then repay +£47.5/1.03 – £47.5 – £47.5
– £50+47.5/1.03 £5 £0
Since the future cash flows of buying a call now and buying half a share and
borrow at the risk-free rate are identical, the initial cash positions must be
identical, too (in an efficient market where arbitrage opportunity is eliminated).
The cost of the call value must be:
C = 50 – 47.5/1.03 = 3.88
How do we know how many shares we need to buy and how much we need to
borrow to create a replicated portfolio for the call?
Assume that we can rewrite C as:
(12.1)
B = The PV of the difference between the pay-offs from the option and the pay-
offs from ∆ of the share.
146
Chapter 12: Risk management
where
(12.2)
Activity 12.4
Attempt Question 17 of BMA, Chapter 21, p.575.
See VLE for solution.
Pricing
You should refer to BMA Chapter 26, pp.684–88. It should be noted that
the pricing formulae are different for a commodity and financial futures
contract.
147
59 Financial management
Activity 12.5
Attempt Question 6 of BMA, Chapter 26, p.698.
See VLE for solution.
Risk management
Interest rate risk
Internal management
Interest rate risk can be hedged internally by the following techniques:
Smoothing – This involves a balanced financing with floating and fixed
rate debt. When the interest rate rises, the increased cost of floating rate
debt is cancelled by the lower cost of fixed rate debt. Likewise, when
the interest rate falls, the higher relative cost of fixed rate debt will be
balanced out by the decreased cost of floating rate debt.
Matching – This involves matching assets and liabilities with similar
interest rates. When the interest rate changes, the change in values of
both assets and liabilities will be cancelled out by each other. Matching is
mainly used by financial institutions.
External management
Companies can purchase futures to hedge against a fall in interest rates
and sell futures to hedge against a rise in interest rates. Interest rate
futures often run in a three-month cycle (March, June, September and
December) and are priced by subtracting the interest rate from 100. A
futures contract with an interest rate of 5% is sold at £95. Profits and
losses are calculated from the changes in the futures prices.
Example 12.4
A firm is going to borrow £950,000 in three months’ time for three months. The
current interest rate is 5% and is expected to rise in the future.
Current position
• The interest rate future is traded at £95 (100 – 5).
• Number of contracts sold to hedge the total borrowing =
£950,000/95 = 10,000 contracts.
• A one tick price change = the value of the futures contract one tick1 1
One tick is equivalent
number of months covered by the contracts/12; i.e. £950,000 to 1 basis point; i.e.
0.01%
0.0001 3/12 = £23.75.
Future position
• Suppose the interest rate has risen to 7% in three months’ time. The
futures price will be 93 (100 – 7).
• Gain on futures = No. of ticks the price change per tick = 200
£23.75 = £4,750
• Increase in borrowing cost = Amount of borrowing increase in
interest rate number of months of the loan/12 = £950,000 0.02
3/12 = £4,750
Interest rate hedge has exactly offset the higher borrowing cost. This is a perfect
hedge.
148
Chapter 12: Risk management
Exchange risk
Internal management
Matching – Translation risk can be hedged if foreign currency based assets
and liabilities are matched. Transaction risk can be hedged if inflows and
outflows are in the same currency.
Netting – Companies can net off foreign currency transactions that
occur at the same time and in the same currency, and hedge only the net
exposure.
Invoicing in the domestic currency – One easy way to reduce exchange
rate risk is to avoid receipts and payments in foreign currency. An exporter
who purchases and pays for supplies in domestic currency may invoice
foreign customers in its own domestic currency.
External management
Forward/futures contracts.
Example 12.5
Suppose a UK exporter is expecting to receive a payment of $100,000 from a
US customer in three months’ time. The current (spot) exchange rate is £1 to
$1.60. A forward contract to sell $ in three months gives a rate of £1 to $1.65.
The exporter can engage in this forward contract and lock into an exchange
rate of £1 to $1.65. So in three months’ time, the exporter, upon receiving
$100,000, would then sell it at £1:$1.65. Effectively he will receive £60,606 in
three months’ time.
Alternatively the exporter can hedge the exchange risk via the money markets.
Knowing that he will receive $100,000 in three months’ time, the exporter can
borrow $X now at a borrowing rate of r% for three months. When the loan
is due, the exporter will repay the loan plus interest (i.e. $X(1+r)) out of the
proceeds from the US customer. If this payment can be covered entirely by the
$100,000 expected to be received from the US customer in three months’ time,
then we have a perfect hedge. The exporter can borrow $X now and convert
it into £ at the spot rate and the repayment of the loan and interest will be
covered by the future receipt.
Activity 12.6
How much should the exporter borrow now in Example 12.5?
See VLE for solution.
100,000 100,000
u 1 R 60,606
1 r1.6 1.65
1 r 1.65
1 R 1.6
149
59 Financial management
Conclusion
Risk management is a very advanced topic in financial management. In
this chapter we have only briefly discussed the various methods that a firm
may engage in to hedge risk against price movements. We examined the
use of options, forwards and futures contracts in risk management and
discussed their advantages and disadvantages. You should work through
the practice questions and familiarise yourself with the risk management
concept.
Practice questions
BMA Chapter 26, Questions 3, 4 and 16.
BMA Chapter 27, Questions 5, 6, 8 and 9.
150
Chapter 12: Risk management
151
59 Financial management
Notes
152
Appendix 1: Sample examination paper
Important note: The format and structure of the examination may have
changed since the publication of this subject guide. You can find the most
recent examination papers on the VLE where all changes to the format of
the examination are posted.
153
59 Financial management
the three bonds. What further information would you require in order
to refine your valuation of these bonds? (15 marks)
b. Explain clearly why companies such as Yamamoto Ltd. might issue
bonds with different maturities, coupon rates and face value?
(10 marks)
Total 25 marks
Question 3
Lion plc is a newly set up IT company. It has very few capital assets.
However, the directors are committed to spend a significant amount on
research and development activities every year. Currently the company
is operating at a loss. The profit forecast indicates that it will become
profitable in three years’ time. Profit will rise rapidly at a rate of 20% per
annum thereafter for a period of no more than 5 years. It is then expected
to have a more moderate growth of 5% per annum. The company has a
cost of capital of 10% and it is 100% equity financed.
Required:
Advise the management of Lion plc what capital structure policy it
should adopt for the next 3, 8 and 20 years. Your advice must include an
explanation of the appropriate financial theory on capital structure.
(25 marks)
Total 25 marks
Question 4 (Answer both parts)
a. Explain clearly the following terms:
i. Weak form efficiency.
ii. Semi-strong form efficiency.
iii. Strong form efficiency.
What are the implications for the market to be informationally efficient to
both the investors and companies?
(13 marks)
b. Identify and explain which forms of efficiency are adhered to and/or
violated in each of the following hypothetical situations:
i. Weekly returns appear to be weakly but positively correlated with
each other.
ii. The top 10 investment funds in the UK out-performed the UK
market by an average of 5% in 2009.
iii. A group of students from a famous Business School has created a
trading rule which appears to out-perform the UK market.
iv. Royal Petrol plc has just revealed that it has discovered a new
method to turn domestic waste into petrol. Its share price rises
by 5%.
(12 marks)
Total 25 marks
Question 5
Apple Inc. is one of the most talked-about companies in recent years. From
154
Appendix 1: Sample examination paper
its success in iPod to the latest iMac, the company has enjoyed a healthy
increase of earnings for the past years. However, the company has decided
to maintain its no dividend policy.
Required:
Critically discuss the various financial theories on dividend policy. In your
answer, you should also discuss the implications of a no dividend policy,
such as the one adopted by Apple Inc., on the company and its investors.
(25 marks)
Total 25 marks
Question 6 (Answer all parts)
a. Explain clearly the factors that affect the price of a European call
option. (8 marks)
b. Suppose Shadow plc, a construction company financed by both debt
and equity, is considering a project. If the project succeeds, the value of
the company in one year’s time will be £25 million. If the project fails,
the company’s value in one year’s time will only be worth £16 million.
The current value of Shadow plc is £20 million which takes into
consideration the prospect of the proposed new project. The company
has an outstanding zero-coupon bond which matures in one year’s time
with a face value of £19 million. The company pays no dividends and a
UK gilt that matures in a year has a yield of 7%.
Using the binomial (or two-state) option-pricing model, find the value
of the bond and equity of Shadow plc respectively.
(8 marks)
c. Explain how you can use options and futures to hedge risk. Give
examples to illustrate your argument.
(9 marks)
Total 25 marks
Question 7
West Central plc has been quoted on the London Stock Exchange for 10
years. A regression analysis using the last 10 years of data reveals the
observed equity beta of 1.20 for the company. The company has 60% of
equity and 40% debt. The current market value of West Central plc is £100
million.
The company is going to undertake a risky project which has an estimated
beta of 2.5. The project is expected to be financed entirely by equity. As
a result of this financing option and the undertaking of the project, the
company will have 70% of equity and 30% of debt measured at market
values. The risk-free rate is expected to be 5% per annum and the
expected return on the market is approximated to be 10% per annum.
West Central plc pays corporate tax at 40%. The company’s debt is thought
to be risk-free.
Required:
a. Calculate the company’s beta before the proposed project. (4 marks)
b. Calculate the company’s market value after the proposed project and
the funding option. (5 marks)
c. Calculate the net present value of the project. (2 marks)
d. Calculate the company’s beta after the project. (4 marks)
e. Advise the management if the project should be funded entirely with
155
59 Financial management
equity. What further information would you seek before you finalise
your advice? (10 marks)
Total 25 marks
Question 8 (Answer all parts)
a. What are the main motives for mergers and acquisitions? (8 marks)
b. As a finance director of Tudor plc, you are examining a proposal to
acquire Windsor plc. The following current data is available:
Tudor Windsor
Earnings per share 100p 30p
Dividend per share 60p 16p
No. of shares 20m 12m
Share price £18 £4
156
Appendix 1: Sample examination paper
157
59 Financial management
Notes
158
Notes
Notes
159
59 Financial management
Notes
160