Corporate Finance 1B Study Pack CUZ

THE CATHOLIC UNIVERSITY OF
ZIMBABWE
Faculty of Commerce, Innovation and

Technology
Department of Business Management and
Information Technology
Corporate Finance 1B [BM206]
STUDY PACK
[1] Bachelor of Business Management & Information Technology Honours Degree
[2] Bachelor of Business Management Finance Honours Degree
[3] Bachelor of Accounting Honours Degree
Lecturer : F. Kufakunesu
ACMA[UK];CGMA[UK];BComm(Hons)Acc[GZU];BSc(Hons)Econ[UZ];MBA[UZ];MAcc[UZ]
Contacts : +263 786 935 295 / +263 772 676 275

Email : forward.kufakunesu@cuz.ac.zw; fkufakunesu@gmail.com
ARRANGEMENT OF THE STUDY PACK’S CONTENTS
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The Study Pack is organised as follows:
Course Outline
1.0 Advanced Financial Mathematics
2.0 Risk and Return
3.0 Sources and Cost of Capital
4.0 Valuation of Securities
5.0 Valuation of Companies
6.0 Market Efficiency
7.0 Dividend Policy
8.0 Capital Structure Theories
9.0 Advanced Working Capital Management
10.0 Advanced Investment Appraisal
11.0 Risk Management
12.0 Mergers, Acquisitions and Corporate Restructuring
Typical Examination Questions
List of Formulae Financial (Present Value) Tables References
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DEPARTMENT OF BUSINESS MANAGEMENT & INFORMATION TECHNOLOGY
COURSE OUTLINE
Lecturer: Forward Kufakunesu

Contacts: 0786 935 295 / 0772 676 275
Email: forward.kufakunesu@cuz.ac.zw / fkufakunesu@gmail.com
1.0 Course Name: CORPORATE FINANCE 1B

1.1 Course Code : BM 206
1.2 Course Level: YEAR 2: SEMESTER 2
2.0 Pre-requisite(s)
Corporate Finance 1A/Financial Management for Accounting I and all accounting first year
courses are a pre-requisite. This course is an integration of all the concepts learnt in the first year
and second year first semester and how they can be used to solve real world problems. Students
are required to read expected literature as well as passionately take part in lecture attendance,
class exercises, assignments and projects.
3.0 Course Overview

Corporate Finance 1B/Financial Management for Accounting II is a second year second semester
course designed to consolidate the key areas of the financial management knowledge acquired in
Corporate Finance 1A/Financial Management I and to introduce students to the advanced
concepts in the financial management of organizations today in order to make key financial
decisions.
4.0 Course Aims

The aim of the course is to equip students with the advanced skills in the financial management
of an entity by providing them with the following knowledge:
 Capital investment appraisal
 Capital structure theory
 Risk & working capital management
 Valuation of businesses and corporate restructuring
 Dividend policy and market efficiency
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5.0 Course Objectives
At the end of the course, students are expected to:
1. Understand advanced financial mathematics and demonstrate formula derivation.

2. Understand and evaluate the application of advanced capital investment appraisal
techniques.
3. Demonstrate the application of capital structure theory in the finance of an entity
4. Understand the management of working capital, calculate and assess risk in working
capital management.
5. Value securities and businesses and explain the purpose of valuation.
6. Formulate dividend policy and assess the efficiency of financial markets.
6.0 Learning and Teaching Activities (Course Delivery)
Course delivery will include lectures, tutorials, seminars, case studies and discussion. Lectures
are designed to bring about the competence and skills required of a professional accountant.
6.1 Attendance at Lectures and Tutorials

Attendance of tutorials, lectures, discussions and seminars is compulsory, as these are central to
the intended learning outcome of the course. Individual progress as a learner will be assessed
through participation of discussions and presentations.
7.0 Schedule of Teaching Activities

Week Lecture Topic and Content
(Hrs)
1 1(2) Advanced Financial Mathematics
 Recap of the Time Value of Money Concept
2(2)  Annual, non-annual and continuous compounding and
discounting
 Present Value of Ordinary Annuity, Annuity Due and Perpetuity
(8) Self-directed learning
Study groups, Library
 Present Value of a single cashflow

2 3(2)  Future Value of a single cashflow
 Future Value of Ordinary Annuity, Annuity Due and Perpetuity
 Use of the Financial Calculator and Spreadsheet-aided
4(2) computations
 Derivation of Corporate Finance Formulae
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3 5(2) Advanced Investment Appraisal Techniques

 Advanced Aspects of NPV and IRR (reinvestment assumptions)
 The concept of capital rationing
6(2)  Advanced investment appraisal techniques involving inflation,
taxation, real and nominal cash flows and discount rate
 Asset Replacement Decisions
 Lease or buy decisions
 Risk and uncertainty : probability, expected values, certainty
equivalence
4 7(2) Valuation of securities
 Valuation of shares
 Valuation of bonds
8(2)

5 9(2) Valuation of businesses
 Asset-based valuations
 Earnings based share valuation
10(2)  Dividend based share valuation
 Cash flow based share valuation
 Net Operating Income (NOI)

6 Corporate restructuring
11(2)  Mergers
 Acquisitions
 Spin-offs
12(2  Hostile and friendly takeovers
 Pre-offer and post-offer defence mechanisms against takeovers

7 Working Capital Management

13(2)  Recap of inventory and cash management
 Management of receivables and payables
14(2)  Cash operating cycle
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8 Risk Management
15(2)  Foreign exchange hedge
 Money market hedge
16(2)
9 Capital Structure Theory
17(2)  Debt, equity, debt beta, equity beta and cost of capital
18 (2)  Theories of capital structure
 Empirical tests of capital structure on corporate performance
 WACC and MWACC
10 Dividend Policy and market efficiency
19(2)  Dividend policy and financing decision
20(2)  Dividend Theories
 Dividend policies
Market Efficiency
 Random Walk Hypothesis
 Efficient Market Hypothesis
 Weak form, semi-strong form and strong form
 Implications of Market Efficiency
 Practical considerations of EMH
 Empirical studies to test stock market efficiency
11 Capital Restructuring
21(2)  Mergers and acquisitions
22(2)  Post-merger or post-acquisition integration process
 Exit strategies (sell-off and spin-off)
 Management buyouts
 Reconstruction

12 Financial Markets and Derivatives
23(2)  Introduction to Derivatives
24(2)  Derivative markets (OTC and Exchanges)
 Futures and forward contracts
 Swaps and options and swaptions
 Put and call options
 Black and Scholes Option Pricing Model
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(16) Revision and preparation for semester examinations
13 (7) Revision and preparation for semester examinations
(3) Semester examination
(150 Hrs)
7.1 Summary of Student Workload and Total Study Time (TST)

7.1.1 Contact Time (CT)
Activity Time Commitment (hours)
Lectures 48
Presentations 4
Tutorials 2
Google Classroom 2
7.1.2 Independent Study Time (IST)

Reading Course related material 14
Writing Assignments 12
Library 26
Study Groups 22
Revision & prep of exams 13
7.1.3 Assessment Time (AT)
Assignments 4
Examination 3
Sub-Total 7
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Total study time= CT+IST+AT
=56+87+7=150
Number of credits= TST/10
=150/10=15
NB: Activities under CT, IST and AT are only indicative and do not necessarily apply to all
modules/courses in a University.
8.0 Scheme of Assessment
Course Work and Final examination will be used to assess students
8.1 Weighting
The course will be assessed by course work (30 percent) and a three-hour closed book
examination (70percent).The coursework will comprise two written assignments, one test and
one presentation and/or two projects.
8.2 Formative Assessment

The test, assignments and projects will be marked interactively and the students are expected to
learn and further deepen their understanding of the subject matter from the marked tests,
assignments and projects.
8.3 Student Feedback

The faculty will administer feedback instruments during the first half of the semester. The course
outline will be the standard against which delivery will be assessed. Your honest and precise
feedback will help improve service delivery. A second instrument will be administered at the end
of the semester and your feedback will help further improve service delivery
8.4 Summative Assessment

A three-hour closed book examination will be administered at the end of the semester. You are
advised to refer to the course objectives and learning outcomes during your preparation for the
examination.
9.0 Recommended Literature
9.1 Textbooks
1. Megginson W, Smart B and Lucy B (2008): Introduction to Corporate Finance, South
Western Cengage Learning
2. Van Horne J.C. (2006), Financial Management & Policy (International Edition), Prentice
Hall
3. Weston F and Brigham E.F. (2002): Essentials of Managerial Finance, Harcourt Brace
Publishers
9.2 E-Resources
 www.ebscosearch.com
https://books.google.co.zw
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COURSE CONTENT
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1.0
ADVANCED.FINANCIAL
MATHEMATICS
In order to consolidate knowledge on all the potential scenarios in which advanced financial
mathematics can be moulded, the following five different scenarios will be covered under this
topic:
SCENARIO 1 – PV followed by FV, with no instalments (PMTs) in-between

SCENARIO 2 – PV followed by a series of PMTs, with no FV at the end
SCENARIO 3 - PV followed by an infinite series of PMTs into perpetuity
SCENARIO 4 - A series of PMTs followed by FV at the end
SCENARIO 5 – PV followed by PMTs and an FV at the end
1.1 SCENARIO 1
PV followed by FV, with no instalments (PMTs) in-between
Lecture Objectives
 To understand the Time Value of Money Concept
 To understand appreciate how Financial Tables are generated
 To understand annuities and to differentiate between them
 To compute and interpret the following Time Value of Money Concepts:
 Time Line
 Compounding
 Annual compounding
 Semi-annual compounding
 Quarterly compounding
 Monthly compounding
 Weekly compounding
 Daily compounding
 Hourly compounding
 Minutely compounding
 Secondly compounding
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Time Value of Money
Cash has a time value. A $1 received today is worth more than a $1 received in the future. The
difference emanates from the potential interest forgone between today (Period 0) and the future
period concerned (Period n). The following is an illustration of a simple time line:
Cash Flow PV FV
Period 0 n
Scenario 1 is described by the following relationship between PV and FV as mapped by r and n:

FV = PV(1+r)n ……………… Equation 1
Where:
FV = Future Value
PV = Present Value
r = interest rate per period
n = number of periods
Please note that the word period not only represents a year, but it can represent a year, a half-
year, a quarter, a month, a week, a day, an hour, a minute or a second. The following constitutes
a derivation of Equation 1 for a given set of PV, FV, r and n.
End of Period 1;
FV = PV + rPV = PV(1 + r)
End of Period 2;
FV = PV(1+r)(1+r) = PV(1+r)2
End of Period 3;
FV = PV(1+r)2(1+r) = PV(1+r)3
End of Period n;
FV = PV(1+r)n
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Compounding and Discounting
It is important to realize that Equation 1 defines both compounding and discounting as reverse
processes to each other.
Compounding involves finding FV given PV, r and n: FV = PV(𝟏 + 𝐫)
Discounting involves finding PV given FV, r and n: PV = (𝟏 𝐫)
Whilst Compounding makes FV the subject of formula, Discounting makes PV the subject of the
formula.
Worked Example
An investor invests $2000 in a fund that pays 24% per annum. Calculate the value of the fund at
the end of 1 year in each of the following compounding frequencies:
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Class Exercise With Answers
the end of 3 years in each of the following compounding frequencies:
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FURTHER ASPECTS OF FINANCIAL MATHEMATICS

 Continuous Compounding
 Discounting as the opposite of Compounding
 Use of Microsoft Excel to compute PV, FV, r and n at the click of a button
Derivation of Continuous Compounding Formula
FV = PV(1+r)n
FV = PV(1+r)1/r * r * n
FV = PV(1+0.0001%)1/0.0001% * r * n
FV = PV(1.000001)1/0.000001 * r * n
FV = PV(2.718281828) r n
FV = PVe r n or FV = PVe r t
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Another Class Exercise With Answers
the end of 1 year in each of the following compounding frequencies:
 Continuous compounding
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Another Class Exercise With Answers
the end of 3 years in each of the following compounding frequencies:
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Example of Discounting as the opposite of Compounding
Recall that Compounding‟s formula: FV = PV(𝟏 + 𝐫)
Also recall that Discounting‟s formula: PV = (𝟏 𝐫)
Example
A man wishes his investment to grow to $10,000 at the end of the next 2 years in a fund that pays
21% interest per annum. How much should he invest today in each of the following
compounding frequencies?
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THE USE OF MICROSOFT SPREADSHEET FOR SCENARIO 1
FUTURE VALUE (FV)
Monthly compounding
PV= -2000; rate = 1.25% per month; nper = 36 months; pmt = 0
• =fv(rate,nper, pmt,[pv],[type])
• =fv(1.25%,36,0,-2000,0)
• Click Enter
• You get $3,127.89
PRESENT VALUE (PV)

Monthly compounding
FV=3127.89; rate = 1.25% per month; nper = 36 months; pmt = 0
• =pv(rate,nper, pmt,[fv],[type])
• =pv(1.25%,36,0,3127.87,0)
• Click Enter
• You get -$2,000.00
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NUMBER OF PERIODS (NPER)
Monthly compounding
PV = -2000; FV=3127.89; rate = 1.25% per month; pmt = 0
• =nper(rate, pmt,pv,[fv],[type])
• =nper(1.25%,0,-2000,3127.89,0)
• Click Enter
• You get 36
INTEREST RATE PER PERIOD (RATE)

Monthly compounding
PV = -2000; FV=3127.89; pmt = 0
• =rate(nper, pmt,pv,[fv],[type])
• =rate(36,0,-2000,3127.89,0)
• Click Enter
• You get 1.25%
Worked Example
the end of 1 year in each of the following compounding frequencies using both Manual and
Excel Formulae:
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Class Exercise with Answers
the end of 3 years in each of the following compounding frequencies using both Manual and MS
Excel Formulae:
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PRESENT VALUE TABLES OR FINANCIAL TABLES
They are made up of:
PV of $1 Cashflow at the end of Period n

 This is made up of one FV of $1 in period n
 It shows the PV of $1 for each combination of n and r from n =1 and from r = 1%
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PV
PV of ordinary annuity of $1
They are made up of:
 PV of a uniform cashflow (Annuity) of $1 occuring at the end of each period from period
1 up to period n
 It shows the PV of $1 for each combination of n and r from n =1 and from r = 1%
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1.2 SCENARIO 2 – PV followed by a series of PMTs
 Ordinary Annuity
 Annuity Due
 Solving investments/savings/borrowings word problems as a Financial Advisor
 Use of Microsoft Excel to compute PV, FV, PMT, r and n at the click of a button
 It is a series of uniform cashflows occuring either at the end of each period or at the
beginning of each period
 If the cashflows occur at the end of each period, it is called an Ordinary Annuity
 If the cashflows occur at the beginning of each period, it is called an Annuity Due
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PRESENT VALUE OF ORDINARY ANNUITIES [PVOA] FORMULA DERIVATION
Study the timeline below:
PMT PMT PMT PMT PMT ……………………………………………….. PMT
0 1 2 3 4 5 ……………………………………………….. n
The above timeline depicts a series of uniform cashflows (an annuity), PMT, receivable or
payable at the end of each period (ordinary annuity), from end of period 1 to end of period
n. The interest rate per period is r.
The Present Value of the ordinary annuity (PVOA) is the sum of all the PMT equal instalments
discounted to Period 0 terms. See diagram below:
PMT/
(1+r)n
PMT/
(1+r)6
PMT/
(1+r)5
PMT/
(1+r)4
PMT/
(1+r)3
PMT/
(1+r)2
PMT/
(1+r)
PMT PMT PMT PMT PMT PMT .... .... PMT
0 1 2 3 4 5 6 .... .... n
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PVOA = ( +( +( +( +( +………+ ( …………..[1]
) ) ) ) ) )
Multiply both sides by ( )
=( +( +( +( +………+ ( +( ………..[2]
( ) ) ) ) ) ) )( )
Subtract Equation [2] from Equation [1]
PVOA - ( =( -
) ) ( )( )
( )
PVOA(1 - ( ) =
) ( )( )
( )
PVOA( ) =
( ) ( )( )
( )
PVOA( ( ) =
) ( )( )
( ) ( ) ( )
PVOA(( )( )= *
) ( )( )
( ) ( )
PVOA = *
( )( )
( )
PVOA = *
( )
( )
PVOA = *
( )
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( )
PVOA = PMT* *
( )
PVOA = PMT*[1 - *
( )
PVOA = *[1 - ( )
PVOA = *[1 - ( + )
NB
Present Value of Ordinary Annuity Factor (PVAIF) is found using the same formula but with a
PMT of $1 = PVOA OF $1
= *[1 - ( )
= *[1 - ( + )
( )
=
LOAN AMORTISATION SCHEDULE

 It is a schedule that shows all the repayments of the interest and principal portions on a
loan
 It adheres to the frequency of compounding specified on the loan contract itself
 The (PMT) is uniform in each period and is made up of both the interest component and
the principal component
 Interest component is initially low and as the loan is progressively amortised, it decreases
while the principal component increases by the same amount, thereby keeping the
instalment constant
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EITHER
Use the PVOA formula to make PMT the subject of formula
OR
Use Financial Tables
Instalment =
=
= $357.0516
Class Exercise
Find IPMT and PPMT for each of the 6 months in the above Loan Amortisation Example, add
them and comment on your results.
1.3 SCENARIO 3 – PV followed by a series of PMTs forever

 It is a series of uniform or non-uniform cashflows occuring either at the end of each
period or at the beginning of each period forever or to infinity or in perpetuity.
 If the cashflows are uniform and occur at the end of each period, it is called an Ordinary
Pepertuity
 If the cashflows are uniform and occur at the beginning of each period, it is called an
Pepertuity Due
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 If the cashflows are non-uniform but grow at a constant growth rate, g, and occur at the
end of each period, it is called a Growing Ordinary Pepertuity
 If the cashflows are non-uniform but grow at a constant growth rate, g, and occur at the
beginning of each period, it is called a Growing Pepertuity Due
• PVOP = 𝐫
(𝟏 𝐫)
• PVPD = 𝐫
(𝟏 )
• PVGOP = 𝐫
(𝟏 𝐫)(𝟏 )
• PVGPD = 𝐫
1.4 SCENARIO 4 – A series of PMTs followed by FV

This scenario is concerned with determining the future value of an ardinary annuity and the
future value of an annuity due as follows:
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1.5 SCENARIO 5 – PV followed by PMTs and eventually FV
This scenario combines any of the four scenarios considered above. To that extent, it does not
introduce any new formula. Thus, Scenario 5 is a matter of applying the knowledge of the first
four scenario in a combined/complex manner at once. The following class exercise illustrates this
point. All students must attempt this question using all the four methods specified below, and
make sure that their answers are all $28,967.22. The hint is to treat the $5000 deposit separately,
$800 annuity separately and adding the two future values together for the first two methods.
However, the last two methods combine the entire process at once because of their
computational superiority.
Class Exercise
A woman invests an initial deposit of $5 000 at the beginning of January 2018. She then makes
24 monthly deposits of $800 at the end of every month starting at the end of January 2018. The
investment fund pays interest at the rate of 15% per annum compounded monthly. Calculate the
total amount that would accumulate in the fund soon after the last deposit.
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Method 1 – Using first principles $28,967.22
Method 2 – Manual Formula $28,967.22
Method 3 – Financial Calculator $28,967.22
Method 3 – MS Excel FV Function $28,967.22
1.5 RULE OF 72
The Rule of 72 states that 72 is divided by 100*r where r is the compound interest rate per period
if we wish to determine the approximate number of periods required to double an investment in a
situation in which there are no instalments in-between as depicted in Scenario 1 above.
Derivation of the Formula approximated by Rule of 72

FV = PV(1+r)n
For PV to double, it implies that FV = 2PV
2PV = PV(1+r)n
(1+r)n = 2
Applying Log to both sides:
Log[(1+r)n] = Log2
nLog(1+r) = Log2
n= ( )
Example
At an interest rate of 10%; 15%; 20% and 25% per annum, how many years will it take for an
investment to double?
Solution
r Using the formula n = Using the Rule of 72
(𝟏 𝐫)
10% n = Log2/Log1.1 = 7.27 years n = 72/10 = 7.2 years

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1.6 GEOMETRIC MEAN
There are certain situations in which the traditional arithmetic mean is unsuitable ie situations in
which we need to determine the average of a set of percentage observations that embody a
compounding effect. Examples include:
 Percentage salary increases overtime
 GDP or economic growth rate overtime
 Inflation or price increases overtime
 Tariff increases overtime
Example
The following salary increases have been observed at the beginning of each year over the past 5
years at a certain organization.
Year % increase
2011 7%
2012 9%
2013 15%
2014 -4%
2015 3%
Required
(a) Calculate the arithmetic mean
(b) Calculate the geometric mean
(c) Explain why the latter is preferable to the former.
Solution
(a) Arithmetic mean = [∑Xi]/n = [7%+9%+15%-4%+3%]/5 = 30%/5 = 6%
(b) Geometric Mean = √( + )( + )( + ) ( + )] - 1
= √( + )( + )( + )( )( + )] - 1
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= √( )( )( )( )( )] - 1
= [√ ]–1
= 1.0580917173 – 1
= 0.05809
= 5.809% per year
To demonstrate that your answer is correct, to perform the following exercise:

Assume a base figure of 100 in 2010
Year % observed Grows to Geometric Grows to
Mean %
2010 - 100.00000000 - 100.00000000
2011 7% 107.00000000 5.80917173% 105.80917173
2012 9% 116.63000000 5.80917173% 111.95580822
2013 15% 134.12450000 5.80917173% 118.45951338
2014 -4% 128.75952000 5.80917173% 125.34102994
2015 3% 132.6223056 5.80917173% 132.6223056
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2.0 RISK AND RETURN
 Return is the reward for the commitment of resources in an investment
 Measures of RETURN to be considered in the next lecture : Required Rate of Return;
Holding Period Return.
 Risk is the potential departure of actual outcomes from the expected outcome.
 Measures of RISK to be considered : Variance; Standard Deviation; Covariance; Beta
Worked Example
The following historical returns have been observed for two assets, X and Y.
Year Asset X Asset Y
1 18% 30%
2 10% 25%
3 16% 21%
4 25% 10%
5 15% 15%
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Calculate
[a] the expected return of each asset
[b] the variance of each asset
[c] the standard deviation of each asset
[d] the covariance between the two assets.
How to Use the Financial Calculator

 Select the Stock Calculator
 Then select the Expected Return Calculator
 Repeat Class Exercise 1 and compare the answers
 Please take note on the Financial Calculator, type an equally spread probability since it is
historical data
 Take note that some returns can be negative or 0%, they are not always positive.
Class Exercise Without Answers

The following returns and their probabilities are expected to arise in the forthcoming year:
State of the Economy Probability Asset X Asset Y
Very good 12% 37% 42%
Good 10% 29% 31%
Fair 48% 22% 18%
Comatose 30% -12% -6%
Calculate
[a] the expected return of each asset
[b] the variance of each asset
[c] the standard deviation of each asset
[d] the covariance between the two assets.
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Class Exercise
Go back to Class Exercise 1 and assume that the two assets constitute a portfolio with the
following weights:
Asset Weight in the portfolio
X 60%
Y 40%
Calculate
[a] the expected return of the portfolio
[b] the variance of the portfolio
[c] the standard deviation of the portfolio
Class Exercise
Go back to Class Exercise 2 and assume that the two assets constitute a portfolio with the
following weights:
Asset Weight in the portfolio
X 28%
Y 72%
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Calculate
[a] the expected return of the portfolio
[b] the variance of the portfolio
[c] the standard deviation of the portfolio
How to Use Microsoft Excel

+average(
+var.p(
+stdev.p(
+covariance.p(
Geared and Ungeared Beta

Lecture Objectives
 Risk vs Return and CAPM
 Differentiate between Beta [β] and Standard Deviation [σ]
 Risk-Adjusted Rates of Return
 Understand the meaning and application of Beta, both Geared and Ungeared
 Calculation of both Geared and Ungeared Beta
 Calculation of both Geared and Ungeared Beta
 Ability to Ungear Beta and Regear Beta
 Business Risk vs Financial Risk
The Relationship Between Risk and Return

“High-risk high-return” is an old adage that represents the CAPM formula E(R) = Rf + [Rm –
Rf]β. The CAPM Equation is a linear relationship between required return and risk and is called
the Security Market Line (SML)
 If beta = 1.0, the security is just as risky as the overall stock market.
 If beta > 1.0, the security is riskier than the average stock market.
 If beta < 1.0, the security is less risky than the average stock market.
Most stocks have betas in the range of 0.5 to 1.5. Betas are often calculated by regressions on
historical data Ri = αi + βi*Rm.
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Limitations of CAPM
 Investors seem to be concerned with both market risk and total risk.
 CAPM assumes that unsystematic risk is diversified away, yet this may not apply to
entities controlled by individuals or FOBs
 Therefore, the SML may not produce a correct estimate of R .
i
R = R + [R – R ]β + ???
i f m f i
 CAPM/SML concepts are based upon expectations, but betas are calculated using
historical data. Thus, a company‟s historical data may not reflect investors‟ expectations
about future riskiness.
 CAPM is a single-period model such that the discount rate it computes may not be
appropriate to evaluate long-term projects, unless β remains relatively stable over time
39 | P a g e
Risk-Adjusted Measures of Return
[1] Sharpe‟s Ratio =
[2] Treynor‟s Ratio =
Geared and Ungeared Beta – Their Relationship

( )
 β =[ ( )
]β + [ ( )
]β
 Take note that β ≡ β and that β ≡ β
( )
 β =[ ( )
]β + [ ( )
]β ……Ungear β
 β [D( t) + E = [D(1 - t)]β + [E]β
 β = β + [β - β ][1 - t][ ] ……Regear β
( )
 β =[ ( )
]β + [ ( )
]β …Ungear β
 𝑘 = R + β [R R]
 β = β + [β - β ][1 - t][ ] …Regear β
40 | P a g e
 𝑘 = R + β [R R]
The above constitutes the relationship between equity beta of a geared entity and the equity
beta of an ungeared entity within the same systematic risk class.
Worked Example
A Ltd is identical in all operating and risk characteristics to G Ltd, except that A Ltd is all-equity
financed and G is financed by equity and debt in the ratio 75:25 at market valuation. The beta
factor of A Ltd is 0.9. G Ltd‟s debt capital is virtually risk-free, and corporation tax is levied at
the rate of 33%. The expected return on the market is 12% and the risk-free rate is 6%.
Calculate the equity beta of G Ltd and the cost of equity for the entity.
 Identify an all-equity proxy company with a beta factor (observable for listed entities
only). It is an ungeared beta factor
 Gear the proxy entity‟s ungeared beta using the capital structure of the geared entity to
get the geared beta of the geared entity
 Substitute the geared beta into the CAPM formula to get the cost of equity for the geared
entity.
( )
 β =[ ( )
]β + [ ( )
]β = 0.9
 β = β + [β - β ][1 - t][ ] …Regear β
= 0.9 + [0.9 – 0][1-0.33][ ]
= 1.101
 𝑘 = R + β [R R]
= 6% + 1.101[12% - 6%]
= 12.606%
Alternatively;
( )
β =[ ( )
]β + [ ( )
]β
(𝟏 )
0.9 = [ (𝟏 )
]0 + [ (𝟏 )
]𝛃 ; therefore 𝛃 = 1.101
41 | P a g e
DETAILED EXAMPLE – RISK AND RETURN
1. The following historical returns have been observed for the past 10 years for the overall
stock market index (ZSE Returns), Delta Holdings (Delta Share Returns), Dairibord
Zimbabwe Limited (DZL Share Returns) and the risk-free asset (Treasury Bill).
Year ZSE Returns Delta Share DZL Share Treasury Bill

Returns Returns Returns
1 27% 22% 18% 10%
2 31% 17% 13% 10%
3 24% 19% 12% 10%
4 18% 23% 15% 10%
5 17% 14% 16% 10%
6 19% 9% 10% 10%
7 22% 13% 11% 10%
8 30% 16% 14% 10%
9 25% 24% -6% 10%
10 15% 12% -5% 10%
(a) Calculate the following:

Delta DZL Treasury
ZSE
Year Share Share Bill
Returns
Returns Returns Returns
1 27% 22% 18% 10%
2 31% 17% 13% 10%
3 24% 19% 12% 10%
4 18% 23% 15% 10%
5 17% 14% 16% 10%
6 19% 9% 10% 10%
7 22% 13% 11% 10%
8 30% 16% 14% 10%
9 25% 24% -6% 10%
10 15% 12% -5% 10%
∑Xi 228% 169% 98% 100%
ER =
∑
22.8% 16.9% 9.8% 10.0%
42 | P a g e
(i) The Expected Return on the overall stock market E(RZSE)
∑
= = = 22.8%
(ii) The Expected Return on the Delta Share E(RDELTA)

∑
= = = 16.9%
(iii) The Expected Return on the Dairibord Share E(RDZL)

∑
= = = 9.8%
(iv) The Expected Return on the Treasury Bill E(RTBILL)

∑
= = = 10.0%
(v) The Variance of returns on the overall stock market = 0.2756% = 0.002756
ZSE
Year
Returns
1 27% 22.8% 0.1764000%
2 31% 22.8% 0.6724000%
3 24% 22.8% 0.0144000%
4 18% 22.8% 0.2304000%
5 17% 22.8% 0.3364000%
6 19% 22.8% 0.1444000%
7 22% 22.8% 0.0064000%
8 30% 22.8% 0.5184000%
9 25% 22.8% 0.0484000%
10 15% 22.8% 0.6084000%
228% 2.756000%
ER 22.8% VAR 0.2756000%
SD 0.052497619
43 | P a g e
(vi) The Variance of returns on the Delta Share = 0.2289% = 0.002289
Delta Share
Year
Returns
1 22% 16.9% 0.2601000%

2 17% 16.9% 0.0001000%
3 19% 16.9% 0.0441000%
4 23% 16.9% 0.3721000%
5 14% 16.9% 0.0841000%
6 9% 16.9% 0.6241000%
7 13% 16.9% 0.1521000%
8 16% 16.9% 0.0081000%
9 24% 16.9% 0.5041000%
10 12% 16.9% 0.2401000%
169% 2.289000%
ER 16.9% VAR 0.2289000%
SD 0.047843495
(vii) The variance of returns on the Dairibord Share = 0.6356%
DZL
Year Share
Returns
1 18% 9.8% 0.6724000%
2 13% 9.8% 0.1024000%
3 12% 9.8% 0.0484000%
4 15% 9.8% 0.2704000%
5 16% 9.8% 0.3844000%
6 10% 9.8% 0.0004000%
7 11% 9.8% 0.0144000%
8 14% 9.8% 0.1764000%
9 -6% 9.8% 2.4964000%
10 -5% 9.8% 2.1904000%
98% 6.356000%
44 | P a g e
ER 9.8% VAR 0.6356000%
SD 0.079724526
(viii) The variance of returns on the Treasury Bill = 0%

Treasury
Year Bill
Returns
1 10% 10.0% 0.0000000%
2 10% 10.0% 0.0000000%
3 10% 10.0% 0.0000000%
4 10% 10.0% 0.0000000%
5 10% 10.0% 0.0000000%
6 10% 10.0% 0.0000000%
7 10% 10.0% 0.0000000%
8 10% 10.0% 0.0000000%
9 10% 10.0% 0.0000000%
10 10% 10.0% 0.0000000%
100% 0.000000%
ER 10.0% VAR 0.0000000%
SD 0.00000000
(ix) The standard deviation of returns on the overall stock market

SD = √ =√ = 0.0524976
(x) The standard deviation of returns on the Delta Share

SD = √ =√ = 0.047843495
(xi) The standard deviation of returns on the Dairibord Share

SD = √ =√ = 0.079724526
(xii) The standard deviation of returns on the Treasury Bill

SD = √ =√ =0
45 | P a g e
(xiii) The co-variance of returns between the market and Delta = 0.0928%`=0.000928
ZSE Delta Share
Year
Returns Returns
1 27% 22.8% 22% 16.9% 4.2% 5.100% 0.2142000%
2 31% 22.8% 17% 16.9% 8.2% 0.100% 0.0082000%
3 24% 22.8% 19% 16.9% 1.2% 2.100% 0.0252000%
4 18% 22.8% 23% 16.9% -4.8% 6.100% -0.2928000%
-
5 17% 22.8% 14% 16.9% -5.8% 0.1682000%
2.900%
-
6 19% 22.8% 9% 16.9% -3.8% 0.3002000%
7.900%
-
7 22% 22.8% 13% 16.9% -0.8% 0.0312000%
3.900%
-
8 30% 22.8% 16% 16.9% 7.2% -0.0648000%
0.900%
9 25% 22.8% 24% 16.9% 2.2% 7.100% 0.1562000%
-
10 15% 22.8% 12% 16.9% -7.8% 0.3822000%
4.900%
228% 169% 0.928000%
22.8% 16.9% 0.0928000%
(xiv) The co-variance between the market and Dairibord = 0.1116% = 0.001116
ZSE DZL Share

Year
Returns Returns
1 27% 22.8% 18% 9.8% 4.2% 8.200% 0.3444000%
2 31% 22.8% 13% 9.8% 8.2% 3.200% 0.2624000%
3 24% 22.8% 12% 9.8% 1.2% 2.200% 0.0264000%
4 18% 22.8% 15% 9.8% -4.8% 5.200% -0.2496000%
5 17% 22.8% 16% 9.8% -5.8% 6.200% -0.3596000%
6 19% 22.8% 10% 9.8% -3.8% 0.200% -0.0076000%
7 22% 22.8% 11% 9.8% -0.8% 1.200% -0.0096000%
8 30% 22.8% 14% 9.8% 7.2% 4.200% 0.3024000%
-
9 25% 22.8% -6% 9.8% 2.2% -0.3476000%
15.800%
-
10 15% 22.8% -5% 9.8% -7.8% 1.1544000%
14.800%
46 | P a g e
228% 98% 1.116000%
22.8% 9.8% 0.1116000%
(xv) The co-variance between the market and the Treasury Bill = 0%
Treasury
ZSE
Year Bill
Returns
Returns
1 27% 22.8% 10% 10.0% 4.2% 0.0% 0.0000000%
2 31% 22.8% 10% 10.0% 8.2% 0.0% 0.0000000%
3 24% 22.8% 10% 10.0% 1.2% 0.0% 0.0000000%
4 18% 22.8% 10% 10.0% -4.8% 0.0% 0.0000000%
5 17% 22.8% 10% 10.0% -5.8% 0.0% 0.0000000%
6 19% 22.8% 10% 10.0% -3.8% 0.0% 0.0000000%
7 22% 22.8% 10% 10.0% -0.8% 0.0% 0.0000000%
8 30% 22.8% 10% 10.0% 7.2% 0.0% 0.0000000%
9 25% 22.8% 10% 10.0% 2.2% 0.0% 0.0000000%
10 15% 22.8% 10% 10.0% -7.8% 0.0% 0.0000000%
228% 100% 0.000000%
22.8% 10.0% 0.0000000%
(xvi) The co-variance between Delta and Dairibord = 0.0108% = 0.000108

Delta Share DZL Share
Year
Returns Returns
1 22% 16.9% 18% 9.8% 5.1% 8.200% 0.4182000%
2 17% 16.9% 13% 9.8% 0.1% 3.200% 0.0032000%
3 19% 16.9% 12% 9.8% 2.1% 2.200% 0.0462000%
4 23% 16.9% 15% 9.8% 6.1% 5.200% 0.3172000%
5 14% 16.9% 16% 9.8% -2.9% 6.200% -0.1798000%
6 9% 16.9% 10% 9.8% -7.9% 0.200% -0.0158000%
7 13% 16.9% 11% 9.8% -3.9% 1.200% -0.0468000%
8 16% 16.9% 14% 9.8% -0.9% 4.200% -0.0378000%
-
9 24% 16.9% -6% 9.8% 7.1% -1.1218000%
15.800%
-
10 12% 16.9% -5% 9.8% -4.9% 0.7252000%
14.800%
47 | P a g e
169% 98% 0.108000%
16.9% 9.8% 0.0108000%
Students to calculate the following from (xvii) to (xxxii) individually:
(xvii) The co-variance between Delta and the Treasury Bill

(xviii) The co-variance between Dairibord and the Treasury Bill
(xix) The Beta of returns on the overall stock market
(xx) The Beta of returns on the Delta Share
(xxi) The Beta of returns on the Dairibord Share
(xxii) The Beta of returns on the Treasury Bill
(xxiii) The Alpha of returns on the overall stock market
(xxiv) The Alpha of returns on the Delta Share
(xxv) The Alpha of returns on the Dairibord Share
(xxvi) The Alpha of returns on the Treasury Bill
(xxvii) The coefficient of correlation between the market and Delta
(xxviii)The coefficient of correlation between the market and Dairibord
(xxix) The coefficient of correlation between Delta and Dairibord
(xxx) The coefficient of determination between the market and Delta
(xxxi) The coefficient of determination between the market and Dairibord
(xxxii) The coefficient of determination between Delta and Dairibord
[48 marks]
(b) Using the procedure of inserting a scatter plot and fitting the regression line of best
fit, displaying the regression equation and the R2 on the chart, generate the
following graphs in Microsoft Excel Spreadsheet and copy and paste it onto your
Word document:
(i) Stock market returns (horizontal axis) against Delta Share Returns (vertical axis).
State Alpha, Beta and R2 and briefly comment on them.
48 | P a g e
Delta's Characteristic Line
30%
25%
y = 0.3367x + 0.0922
Delta Returns
20%
R² = 0.1365
15%
Series1
10%
Linear (Series1)
5%
0%
0% 5% 10% 15% 20% 25% 30% 35%
ZSE Returns
α = 0.0922 [intercept]
A positive alpha indicates that the Delta share can outperform the overall ZSE stock market
during periods in which the ZSE returns are 0%.
β = 0.3367 [slope]
Being less than 1, the beta of DZL shares indicates a security which is less volatile than the
overall stock market ZSE.\
R2 = 13.65% [coefficient of determination]
13.65% of the variability in Delta share returns is explained by the variability in the ZSE Stock
Market returns, while the other 86.35% is explained by other factors apart from ZSE returns.
(ii) Stock market returns (horizontal axis) against Dairibord Share Returns (vertical
axis). State Alpha, Beta and R2 and briefly comment on them.
49 | P a g e
DZL's Characteristic Line
20%
15% y = 0.4049x + 0.0057

R² = 0.0711
10%
DZL's Returns
5% Series1
Linear (Series1)
0%
0% 10% 20% 30% 40%
-5%
-10%
ZSE Returns
α = 0.0057 [intercept]
A positive alpha indicates that the DZL share can outperform the overall ZSE stock market
during periods in which the ZSE returns are 0%.
β = 0.4049 [slope]
Being less than 1, the beta of DZL shares indicates a security which is less volatile than the
overall stock market ZSE.
R2 = 7.11% [coefficient of determination]
7.11% of the variability in Dairibord share returns are explained by the variability in the ZSE
Stock Market returns, while the other 92.89% is explained by other factors apart from ZSE
returns. This low value of R2 depicts a very weak explanatory power between DZL and ZSE
returns
[8 marks]
(c) Assuming that an investor would like to construct a portfolio of Delta (with ¾
weighting) and DZL (with ¼ weighting), calculate:
(i) The Portfolio Expected Return
(ii) The Portfolio Variance
(iii) The Portfolio Standard Deviation [10 marks]
(d) Use the Capital Asset Pricing Model to deduce the required rate of return and
comment on the differences with the respective Expected Returns computed in 1(a)
above, for each of the following:
50 | P a g e
(i) Delta Share
RRR = Rf + β[Rm – Rf]
= 10% + [0.3367][22.8% - 10%]
= 10% + [0.3367][12.8%]
= 10% + 4.30976%
= 14.30976%
This is lower than the 16.9% expected return based on the past 10 years’ historical returns.
The Delta Stock is generating a much higher average return than the one otherwise
required to compensate the investor of the riskiness involved.
(ii) Dairibord Share
RRR = Rf + β[Rm – Rf]

= 10% + [0.4049][22.8% - 10%]
= 10% + [0.4049][12.8%]
= 10% + 5.18272%
= 15.18272%
This is higher than the 9.8% expected return based on the past 10 years’ historical returns.
The DZL Stock is therefore generating a pittance, lacklustre investment performance,
which is substantially lower than the rate of return that would otherwise be commensurate
with the stock’s volatility or riskiness. [12 marks]
2(a) Using a diagram to illustrate your answer, show that the relationship between β A, βD and βE
reduces to βG = βU + (βU – βD)(1 - t) . [10 marks]
• βA is the weighted average of βD and βE
( )
• β =[ ( )
]β + [ ( )
]β
• Since β ≡ β and β ≡ β
( )
• β =[ ( )
]β + [ ( )
]β ……Ungear β
• β [D( t) + E = [D(1 - t)]β + [E]β
• β = β + [β - β ][1 - t][ ] ……Regear β
51 | P a g e
(b) AZ plc is identical in all operating and risk characteristics to GP plc, except that AZ plc is
all-equity-financed and GP plc is financed by equity and debt in the proportion 3:2 respectively,
at market valuation. The beta factor of AZ plc is 0.85. GP plc‟s debt capital is virtually risk-free,
and corporate tax is levied at the rate of 25.75%. The expected return on the market is 12% and
the risk-free rate is 6%.
You are required to show that GP plc’s equity beta = 1.27075 and its geared cost of equity
= 13.6245%. [12 marks]
β = β + [β - β ][1 - t][ ]
= 0.85 + [0.85 – 0][1-0.2575][
= 0.85 + [0.85][0.7425][
= 0.85 + 0.42075
= 1.27075
Keg = Rf + [Rm – Rf]βg
= 6% + [12% - 6%][1.27075]
= 6% + [6%][1.27075]
= 6% + 7.6245%
= 13.6245%
52 | P a g e
3.0 SOURCES AND COST
OF CAPITAL
Lecture Objectives
 Ability to calculate value of equity and cost of equity
 Ability to calculate value of debt and cost of debt
 Ability to calculate WACC (weighted average cost of capital) in the following stages :
Current WACC; Revised WACC and Marginal WACC
 Identify circumstances that require the use of MWACC rather than WACC
Source of Capital Cost of Capital
[1] Equity
[2] Debt (1-t)
[3] Preferred Share Capital
[4] Bank Loans (1-t)
The cost of Debt and Bank Loans are reduced by factor (1-t) because interest cost is an allowable
deduction for tax purposes whilst equity dividends and preference dividends are not. This is
called tax-deductibility of debt interest or tax shield or tax savings arising from debt rather than
equity or preferred share capital.
The WACC Formula
WACC = [ ]+ [ ][1-t]
+ [ ]+ [ ][1-t]
EQUITY
Equity is raised through issuing shares. The issuer issues shares and receives cash whilst the
holder pays cash in exchange of shares. In a publicly listed entity, shares exchange hands
through buying and selling existing shares via the secondary market [eg ZSE].
Share Valuation Methods

 Dividend Valuation Model
 Dividend growth model
53 | P a g e
– Constant growth stocks
– Non-constant growth stocks
Share price cum-div includes the dividend just declared and usually to be paid in the next few
days. Share price ex-div excludes the dividend just declared. It is share price ex-div that we use
in financial analysis
Example
The current price of the ordinary shares is 135 cents cum-div. A dividend of 10 cents is
payable in the next few days. Thus, the current price ex-div = 135c – 10c = 125c per
share or $1.25 per share.
54 | P a g e
The Importance of Intrinsic Value of Shares
We can spot mispriced shares, that is undervalued shares and overvalued shares
If Intrinsic value < Market Price →overvalued
If Intrinsic value > Market Price →undervalued
If Intrinsic value = Market Price →correctly valued
55 | P a g e
Cost of Equity
We can determine cost of equity using either of two methods as demonstrated below:
First [GCDGM]:
𝟏 (𝟏 )
ke = +g= +g
NB
If there are issue costs use Po(1-F) in place of Po.
Second [CAPM]:
ke = rf + β[rm – rf]
It all depends on which information is available to enable you to calculate ke.
56 | P a g e
Debt
It is raised through issuing debt instruments such as debentures or bonds. The issuer issues debt
and receives cash. The holder pays cash in exchange of debt instruments.
Pre-tax Cost of Irredeemable Debt
Kd =
Post-tax Cost of Irredeemable Debt
Kdnet = [1-t]
NB If there are any issue costs use Po(1-F) in place of Po.
Pre-tax Cost of Redeemable Debt
( )
YTM = YTR = Kd =
Post-tax Cost of Redeemable Debt
( )
Kdnet = [ [1-t]
Cost of Irredeemable Preference Shares
Kp = [without issue costs]
Kp = [with issue costs]

(𝟏 )
Cost of Redeemable Preference Shares
Kp =
57 | P a g e
Pre-tax Cost of Bank Loan
KbL = interest rate on loan
Post-tax Cost of Bank Loan
KbL = [interest rate on loan]*[1-t]
A WORKED EXAMPLE
FK (Pvt) Ltd has asked you to help management to determine the cost of financing the company.
Relevant extracts from the most recent Statement of Financial Position as at 30th November
2019 are as follows:
Equity $[millions]
Ordinary Shares of $0.50 each 2.0
Retained Earnings 1.5
Non-Current Liabilities
7.5% Redeemable Debentures of $1000 each 2.2
6% Irredeemable Preference Shares of $100 each 1.4
7.1
The following additional information is relevant:
FK (Pvt) Ltd‟s ordinary shares are currently trading at $2.60 cum-div per share and $2.00 ex-div
per share. The most recent dividend just declared will be paid in the next 5 working days. Since
the company‟s product lines are now predominantly in their decline stage in accordance with the
Product Life Cycle (PLC) Model, the Board of Directors has seen it fit to reduce the annual
dividend per share by 5% per annum forever, starting with the forthcoming financial year ended
30th November 2020. Debentures are presently valued at 10% below their par value and will be
58 | P a g e
redeemed on the 30th November 2026. Preference shares are trading at 20% above their par
value. The prevailing corporate tax rate is 25.75%.
REQUIRED
(a) Calculate FK (Pvt) Ltd‟s Weighted Average Cost of Capital (WACC) using the following
weighting bases:
(i) Book values [7]
(ii) Market values [10]
(b) Which weighting base is superior and why? [4]
(c) Explain any four factors that influence a company‟s weighted average cost of capital
(WACC). [4]
Source of capital Book values Market Values Cost of Capital
Equity Pick from SOFP VE = Po*number of Using Constant

[Ordinary Share Capital ordinary shares Dividend Growth
+ All Reserves] = 2*2m/0.5 Ke = Do(1+g)/Po + g
= 2m+1.5m = $3.5m =2*4m = 0.60(1-0.05)/2.00 –
= $8m 0.05
= .57/2 -0.05
=23.5%
Preference Share Pick from SOFP VP = Po*number of Irredeemable
Capital =$1.4m preference shares Kp = d/Po
=120*1.4m/100 = 6/120
=120*14000 = 5%
=$1.68m
Debentures Pick from SOFP VD = Po*number of Redeemable

=$2.2m debt units Kd =
=900*2.2m/1000 [75 + [1000-900]/7]
=900*2200 [(1000+1800)/3]
=$1.98m =89.285714286/933.33
= 9.56632653%
59 | P a g e
Using Book Values
WACC
=[ [Ke] +[ [Kd(1-t)] + [Kp]
=[ [0.235] +[ [0.0956632653(1-0.2575)] + [0.05]
= = 0.4929577465*0.235 + 0.3098591549*0.095663*0.7425 + 0.1971830986*0.05
= 0.1158450704 + 0.0220092879 + 0.0098591549
= 14.771%
Using Market Values
WACC
=[ [Ke] +[ [Kd(1-t)] + [Kp]
=[ [0.235] +[ [0.0956632653(1-0.2575)] + [0.05]
= 0.6861063465*0.235 + 0.1698113208*0.095663*0.7425 + 0.1440823328*0.05
= 0.1612349914 + 0.0120616938 + 0.0072041166
= 18.05%
CLASS EXERCISE
A client company Sun (Pvt) Ltd has asked you to help management better understand the cost of
financing the company. Relevant extracts from the Statement of Financial Position as at 30 April
2017 are as follows:
60 | P a g e
Equity $000
Ordinary shares of $2 each 500
Accumulated Profits 400
900
Non-Current Liabilities
10% Debentures Redeemable 30 April 2021 500
12% Irredeemable Preference Shares $100 each 200
1600
Your investigations have revealed the following relevant information:
The most recent dividend declared was 50 cents per share. This dividend will be paid in the next
2 weeks. The average compound rate of growth in dividends over the last five years has been
20% and is expected to continue in the foreseeable future. Sun (Pvt) Ltd‟s ordinary shares
presently trade at $5 ex-div. Debentures are presently valued at 90% of their par value and
preference shares are trading at $120 each. The prevailing corporation tax rate is 40%.
REQUIRED
(d) Calculate Sun (Pvt) Ltd ’s Weighted Average Cost of Capital (WACC) using market
values as weighting factors.
[19]
(e) Explain why market values are preferred as weighting factors as compared to book
values in the calculation of WACC. [6]
WACC and MWACC
Appropriateness of WACC as a discount rate in investment appraisal
To use WACC as the discount rate to evaluate a project, three conditions must be met as follows:
[1] The project being appraised must be small relative to the size of the company
[2] The project has the same business risk as the company
[3] The existing capital structure must be maintained such that the financial risk remains
the same
61 | P a g e
Once these three conditions are violated, WACC ceases to be appropriate in evaluating a
particular project
We use MWACC instead (ie Marginal Weighted Average Cost of Capital)

In other words, the following conditions require the use of MWACC in evaluating a
project:
[1] The project must be large relative to the size of the company
[2] A major issue of capital is required to fund the project, such that the capital structure
(and hence financial risk) will be significantly altered
[3] The project has different business risk characteristics from the company‟s existing
operations.
Steps involved in Calculating MWACC
[1] Calculate current WACC (Scenario prior to raising of new capital)

[2] Calculate Revised WACC (Scenario after raising of new capital)
[3] Calculate Marginal WACC (Depicting the additional cost of capital vis-a-vis the additional
capital).
Step 1
∑
Current WACC = ∑ where Kc is the % cost of current components of capital and Vc is the
market value of current components of capital.
Step 2
∑
Revised WACC = ∑ where KR is the % cost of revised components of capital and VR is the
market value of revised components of capital.
Step 3
∑ ∑
Marginal WACC = ∑ ∑
62 | P a g e
4.0 VALUATION OF
SECURITIES
The basic underlying principle that defines the valuation of securities if the fact that a security‟s
intrinsic value or intrinsic price is the present value of the security‟s future cashflows discounted
to present value terms using the investor‟s required rate of return as the discount rate.
4.1 VALUATION OF EQUITY

Equity shares are always considered as having a perpetual or infinite stream of dividends since
they are a financial instrument without a predetermined redemption date. The future cashflows
are therefore dividends from Year 1 up to infinity, with no face value being taken into
consideration as equity shares are irredeemable by their very nature. Share valuation is therefore
based on either a dividend-growth share or a dividend non-growth share. These two scenarios are
examined in the following two sections namely 4.1.1 and 4.1.2.
4.1.1 Gordon’s Constant Dividend Growth Model
The diagrammatic representation below shows dividend cashflows that grow by factor g annually
from Year 1 into perpetuity. The same cashflows are each discounted to present value terms
(Year 0) using the equity-holders‟ required rate of return denoted by Ke.
Do(1+g)5/(1+ke)5
Do(1+g)4/(1+ke)4
Do(1+g)3/(1+ke)3
Do(1+g)2/(1+ke)2
Do(1+g)/(1+ke))
Do(1+g) Do(1+g)2 Do(1+g)3 Do(1+g)4 Do(1+g)5 ..... .....
0 1 2 3 4 5 ..... ∞
63 | P a g e
( ) ( ) ( ) ( ) ( )
Po = + + + + + ……….. to infinity ……….[1]
( ) ( ) ( ) ( ) ( )
( )
Multiply both sides by ( )
( ) ( ) ( ) ( ) ( )
= + + + + ……….. to infinity ………..[2]
( ) ( ) ( ) ( ) ( )
Equation[1] Less Equation [2] yields the following:
( ) ( )
P0 - =
( ) ( )
( ) ( )
P0 [1 - ( ]=
) ( )
( ) ( )
P0 [ ]=
( ) ( )
) ( )
P0 [ ]=
( ) ( )
) ( )
P0 [ ( ]=
) ( )
) ) ( ) )
P0 [ ( ]/[( ]= /[( ]
) ) ( ) )
64 | P a g e
( ) )
P0 = *[( ]
( ) )
( )
P0 = =
( ) ( )
4.1.2 Non-Growth Shares

Shares with no growth can be valued by substituting g with 0 thereby giving the following
expression of share valuation:
( ) ( )
P0 = = =
( ) ( )
4.2 VALUATION OF DEBT

Debt instruments such as bonds or debentures are either redeemable or irredeemable. Their
valuation thus differ because of different cashflow streams associated with these two scenarios.
Irredeemable debt instruments have a perpetual or infinite stream of debt interest whilst their
redeemable counterparts have a predetermined redemption date. The future cashflows of
redeemable bonds or debentures are therefore interest from Year 1 up to the time of maturity and
the face or par value of the security is also discounted, taking great care as to whether the
compounding frequency is annual or semi-annual. The debtholder‟s required rate of return is also
known as the Yield To Maturity (YTM) or Yield To Redemption (YTR) or effective cost of debt
or annual yield. The yield to maturity is also identical to the security‟s internal rate of return
(IRR).
Worked Example
(a) For each of the four $1000 bond instruments tabulated below, calculate, amortise and
interpret the value of each bond using the following formula:
VB = [ ∑ ] + [ ] in each of the following two

( ) ( )
circumstances:
65 | P a g e
(i) if the interest is compounded on an annual basis. [10]
(ii) if the interest is compounded on a semi-annual basis. [10]
Bond Coupon Rate Per Yield to Maturity Time to Maturity

Annum
1 12% 9% 5 years
2 8% 8% 7 years
3 0% 10% 8 years
4 10% 14% 6 years
(b) Explain how each of your answers above can be verified using both an Excel Spreadsheet
and the Financial Calculator. [5]
BOND 1 – VALUATION
ANNUAL COMPOUNDING
VB = [ ∑ ]+[ ]
( ) ( )
= [∑ ]+[( ]
( ) )
= [1 - +[ ]
( ) ( )
= $1,116.6895
SEMI-ANNUAL COMPOUNDING
VB = [ ∑ ]+[ ]
( ) ( )
= [∑ ]+[( ]
( ) )
= $1,118.6908
66 | P a g e
BOND 1 - ANNUAL COMPOUNDING
SUB-
YEAR OPENING INTEREST TOTAL INSTALMENT CLOSING
BALANCE CHARGES BALANCE
1 $1,116.6895 $100.5021 $1,217.1916 ($120.0000) $1,097.1916
2 $1,097.1916 $98.7472 $1,195.9388 ($120.0000) $1,075.9388
3 $1,075.9388 $96.8345 $1,172.7733 ($120.0000) $1,052.7733
4 $1,052.7733 $94.7496 $1,147.5229 ($120.0000) $1,027.5229
5 $1,027.5229 $92.4771 $1,120.0000 ($120.0000) $1,000.0000
BOND 1 - SEMI-ANNUAL
COMPOUNDING
SUB-
HALFYEAR OPENING INTEREST TOTAL INSTALMENT CLOSING
1 $1,118.6908 $50.3411 $1,169.0319 ($60.0000) $1,109.0319
2 $1,109.0319 $49.9064 $1,158.9383 ($60.0000) $1,098.9383
3 $1,098.9383 $49.4522 $1,148.3905 ($60.0000) $1,088.3905
4 $1,088.3905 $48.9776 $1,137.3681 ($60.0000) $1,077.3681
5 $1,077.3681 $48.4816 $1,125.8497 ($60.0000) $1,065.8497
6 $1,065.8497 $47.9632 $1,113.8129 ($60.0000) $1,053.8129
7 $1,053.8129 $47.4216 $1,101.2345 ($60.0000) $1,041.2345
8 $1,041.2345 $46.8556 $1,088.0900 ($60.0000) $1,028.0900
9 $1,028.0900 $46.2641 $1,074.3541 ($60.0000) $1,014.3541
10 $1,014.3541 $45.6459 $1,060.0000 ($60.0000) $1,000.0000
ANNUAL COMPOUNDING
VB = [ ∑ ]+
( )
[ ]
( )
= [∑ ]+[ ]
( ) ( )
= $1,000
67 | P a g e
VB = [ ∑ ] + [
( )
]
( )
= [∑ ]+[( ]
( ) )
= $1,000
SUB-
1 $1,000.0000 $80.0000 $1,080.0000 ($80.0000) $1,000.0000
2 $1,000.0000 $80.0000 $1,080.0000 ($80.0000) $1,000.0000
3 $1,000.0000 $80.0000 $1,080.0000 ($80.0000) $1,000.0000
4 $1,000.0000 $80.0000 $1,080.0000 ($80.0000) $1,000.0000
5 $1,000.0000 $80.0000 $1,080.0000 ($80.0000) $1,000.0000
6 $1,000.0000 $80.0000 $1,080.0000 ($80.0000) $1,000.0000
7 $1,000.0000 $80.0000 $1,080.0000 ($80.0000) $1,000.0000
COMPOUNDING
SUB-
1 $1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000
2 $1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000
3 $1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000
4 $1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000
5 $1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000
6 $1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000
7 $1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000
8 $1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000
9 $1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000
10 $1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000
11 $1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000
12 $1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000
13 $1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000
14 $1,000.0000 $40.0000 $1,040.0000 ($40.0000) $1,000.0000
68 | P a g e
ANNUAL COMPOUNDING
VB = [ ∑ ]+
( )
[ ]
( )
= [∑ ]+[( ]
( ) )
= $466.5074
VB = [ ∑ ] + [
( )
]
( )
= [∑ ]+[( ]
( ) )
= $458.1115
SUB-
1 $466.5074 $46.6507 $513.1581 $0.0000 $513.1581
2 $513.1581 $51.3158 $564.4739 $0.0000 $564.4739
3 $564.4739 $56.4474 $620.9213 $0.0000 $620.9213
4 $620.9213 $62.0921 $683.0135 $0.0000 $683.0135
5 $683.0135 $68.3013 $751.3148 $0.0000 $751.3148
6 $751.3148 $75.1315 $826.4463 $0.0000 $826.4463
7 $826.4463 $82.6446 $909.0909 $0.0000 $909.0909
8 $909.0909 $90.9091 $1,000.0000 $0.0000 $1,000.0000
69 | P a g e
COMPOUNDING
SUB-
1 $458.1115 $22.9056 $481.0171 $0.0000 $481.0171
2 $481.0171 $24.0509 $505.0680 $0.0000 $505.0680
3 $505.0680 $25.2534 $530.3214 $0.0000 $530.3214
4 $530.3214 $26.5161 $556.8374 $0.0000 $556.8374
5 $556.8374 $27.8419 $584.6793 $0.0000 $584.6793
6 $584.6793 $29.2340 $613.9133 $0.0000 $613.9133
7 $613.9133 $30.6957 $644.6089 $0.0000 $644.6089
8 $644.6089 $32.2304 $676.8394 $0.0000 $676.8394
9 $676.8394 $33.8420 $710.6813 $0.0000 $710.6813
10 $710.6813 $35.5341 $746.2154 $0.0000 $746.2154
11 $746.2154 $37.3108 $783.5262 $0.0000 $783.5262
12 $783.5262 $39.1763 $822.7025 $0.0000 $822.7025
13 $822.7025 $41.1351 $863.8376 $0.0000 $863.8376
14 $863.8376 $43.1919 $907.0295 $0.0000 $907.0295
15 $907.0295 $45.3515 $952.3810 $0.0000 $952.3810
16 $952.3810 $47.6190 $1,000.0000 $0.0000 $1,000.0000
ANNUAL COMPOUNDING
VB = [ ∑ ]+
( )
[ ]
( )
= [∑ ]+[( ]
( ) )
= $844.4533
VB = [ ∑ ]+[ ]
( ) ( )
= [∑ ]+[( ]
( ) )
= $841.1463
70 | P a g e
SUB-
1 $844.4533 $118.2235 $962.6768 ($100.0000) $862.6768
2 $862.6768 $120.7747 $983.4515 ($100.0000) $883.4515
3 $883.4515 $123.6832 $1,007.1347 ($100.0000) $907.1347
4 $907.1347 $126.9989 $1,034.1336 ($100.0000) $934.1336
5 $934.1336 $130.7787 $1,064.9123 ($100.0000) $964.9123
6 $964.9123 $135.0877 $1,100.0000 ($100.0000) $1,000.0000
COMPOUNDING
SUB-
1 $841.1463 $58.88 $900.0265 ($50.0000) $850.0265
2 $850.0265 $59.50 $909.5284 ($50.0000) $859.5284
3 $859.5284 $60.17 $919.6954 ($50.0000) $869.6954
4 $869.6954 $60.88 $930.5740 ($50.0000) $880.5740
5 $880.5740 $61.64 $942.2142 ($50.0000) $892.2142
6 $892.2142 $62.45 $954.6692 ($50.0000) $904.6692
7 $904.6692 $63.33 $967.9961 ($50.0000) $917.9961
8 $917.9961 $64.26 $982.2558 ($50.0000) $932.2558
9 $932.2558 $65.26 $997.5137 ($50.0000) $947.5137
10 $947.5137 $66.33 $1,013.8396 ($50.0000) $963.8396
11 $963.8396 $67.47 $1,031.3084 ($50.0000) $981.3084
12 $981.3084 $68.69 $1,050.0000 ($50.0000) $1,000.0000
71 | P a g e
5.0 VALUATION OF
COMPANIES
5.1 Introduction
The valuation of companies is based on either the MM Proposition 1 (without taxes), MM

Proposition 2 (with taxes), both of which are known as the Net Operating Income (NOI)
Approach, or based on the Net Income (NI) Approach. NOI = EBIT(1-T) whilst NI = PAT.
In general;
[1] The value of an ungeared company (Vu) is the present value of an entity‟s future post-tax
earnings discounted at the entity‟s ungeared cost of equity (Keu).
( )
Vu =
[2] The value of a geared company (Vg) is the present value of an entity‟s future post-tax
earnings discounted at the entity‟s ungeared cost of equity (Keu) plus the present value of future
tax shields discounted at the entity‟s cost of debt (Kd)
( )
Vg = +
Where;
Vg is the value of a geared entity
NOI is the Net Operating Income = Post-tax Profit before interest = EBIT(1-T)
Keu is the ungeared cost of equity
rDT is the annual tax shield of which Rd is the annual interest amount
Kd is the cost of debt
Please Take Note of The Following Relationship Between Keu and Keg
[1] Without Taxes
Keg = Keu + (Keu – Kd) …………………….[i]
72 | P a g e
[2] With Taxes
Keg = Keu + (Keu – Kd)(1-T) ………………….[ii]***
Recall the following from Risk and Return (Section 2.0)

Geared and Ungeared Beta – Their Relationship
( )
 β =[ ( )
]β + [ ( )
]β
 Take note that β ≡ β and that β ≡ β
( )
 β =[ ( )
]β + [ ( )
]β
 β [D( t) + E = [D(1 - t)]β + [E]β
 𝛃 = 𝛃 + [𝛃 - 𝛃 ][1 - t][ ] ……………………..[iii]***
***TAKE NOTE OF THE STRIKING SIMILARITY BETWEEN EXPRESSION [ii] AND

[iii] ABOVE.
5.2 Earnings Based Valuation Bases
In the first two formulae below, [1] and [2], you make Market Price Per Share (MPS) the subject
of the formula if you are given EY & EPS or P/E & EPS respectively.
[1] Earnings Yield =
[2] Price Earnings (P/E) Ratio =
( )
[3] Market Value of a Company (Earnings with growth) =
73 | P a g e
Worked Example
A company currently has the following financial information:
Earnings Before Interest and Tax $16.8m
Interest $ 3.2m
Tax (40%) $ 5.44m
Earnings After Tax $8.16m
The cost of equity of an equivalent ungeared firm in the same risk class is 24% and debt capital
has a yield of 16%.
(a) Calculate the value of the firm according to MM Proposition 1

(b) (i) Determine the value of the geared firm according to MM Proposition 2
(ii) Determine the cost of equity of the geared firm according to MM Proposition 2
Solution
Rearrange the financial information as follows:
EBIT 16,800,000
Interest ( 3,200,000)
EBT 13,600,000
Tax (40%) (5,400,000)
EAT 8,160,000
(𝟏 ) 𝐫
(a) Vg = + but T = 0 under MM Proposition 1 (without taxes)
( )
= +0
= $70,000,000
74 | P a g e
(b) (i) Value of geared firm = Value of ungeared firm + Value of Tax Shield
Value of ungeared firm = EBIT(1-T)/Keu = 16,800,000*0.6/0.24 = 10,080,000/0.24 =

42,000,000
Value of Tax Shield = Value of Debt * Tax Rate
Value of debt = 3,200,000/0.16 = 20,000,000
Value of Tax shield = 20,000,000*0.4 = 8,000,000
Value of the firm under MM Proposition 2 = 42,000,000 + 8,000,000 = 50,000,000
(b)(ii) Cost of equity of geared entity with taxes is:
Keg = Keu + (Keu – Kd)(1-T)
= 24% + (24%-16%)(1-40%)*
= 27.2%
75 | P a g e
6.0 MARKET EFFICIENCY
6.1 Introduction
Market efficiency can be thought of as either:
• Informational efficiency (the flow of information among market participants and
market‟s reaction to news)
• Allocative efficiency (the allocation of capital to most productive uses)
• Operational efficiency (in terms of low transaction costs)
We are concerned with Informational Efficiency only.
It is important to take note that the notion of market efficiency was popularised by Eugine Fama
(1965). In an efficient stock market, investors are assured that they can recover a fair value if
they are to dispose of their investments. EMH provides a theoretical underpinning of how share
prices react to new information about an entity. Share price reaction to news is dependent upon
the stock market‟s level of informational efficiency. In an efficient market it is not possible to
earn a profit based on past share price information. The more efficient a stock market is, the
more random and unpredictable the share prices and market returns would be. In the most
efficient market the future prices will be totally random and the price formation can be assumed
to be a stochastic process with mean in price change equal to zero. The objective of this section
is to investigate whether share prices on the Zimbabwe Stock Exchange follow a random-walk
process as required by stock market efficiency. The presence or absence of random walk in the
price generation process in a stock market is evaluated using stock market indices.
EMH has three levels or forms of efficiency:

• Weak form efficiency
• Semi-strong form efficiency
• Strong form efficiency
Definition of Terms
Random walk is the notion that future share prices or returns cannot be predicted by using
historical share prices or returns.
76 | P a g e
Efficient market is a financial market which fully reflects all information and is free from
mispricing tendencies by market participants.
6.2 Efficient Market Hypothesis

The efficient market hypothesis (EMH) is concerned with informational and pricing efficiency.
In an efficient market, prices fully and instantaneously reflect all available information. There
are three forms of efficiency associated with the EMH hypothesis and these levels depend on the
amount of information available to market participants. They are namely weak form efficiency,
semi-strong form efficiency and strong form efficiency.
6.2.1 Weak Form Efficiency

The weak form states that the current share price reflects all the historical information. This form
of efficiency implies that no investor is able to consistently beat or outperform the market by
consistently earning above-average returns by following trading rules developed by technical
analysis. The weak form of EMH can be tested by subjecting a series of share prices or stock
market indices to statistical tests so as to determine whether any correlation exists between past
and present share prices or indices. Sunde (2008) postulates that the weak-form efficiency is
represented mathematically as:
Pt = Pt-1+Expected return+Random error (1) and this expression says that the price today is equal
to the sum of the last observed price plus the expected return on the stock plus a random
component occurring over the interval. Sunde (2008) further asserts that the last observed price
could have occurred yesterday, last week, or last month, depending on one's sampling interval.
The expected return is a fraction of a security‟s risk. The random component is due to new
information on the stock. It could be either positive or negative and has an expectation of zero.
The random component in any one period is unrelated to the random component in any past
period. Hence, this component is not predictable from past prices. If the stock prices follow
Equation 1 above, Sunde (2008) argues that they are said to follow a random walk. Weak-form
efficiency constitutes the weakest type of efficiency that we would expect to be exhibited by a
financial market because historical price information is the easiest kind of information about a
stock to acquire. Had it been possible to make extraordinary profits simply by finding the
77 | P a g e
patterns in the stock price movements, everyone would jostle thereby leading to an instant
disappearance of abnormal gains.
6.2.2 Semi-Strong Form Efficiency

The semi-strong variant of EMH states that the current share price will not only reflect historical
information, but will also reflect all published current information also. This form of EMH can
be related to fundamental analysis. Fundamental analysis attempts to identify mispriced entities
through studying publicly available information. The speed at which the market captures news is
so rapid that public information is instantaneously reflected into share prices the moment such
news is released, thereby explaining why it is not possible to outperform a semi-strong efficient
market by acting on publicly available current information. Those market participants with
insider information are the only ones who can profit from possessing such privileged
information. A market is semi-strong efficient if prices incorporates all publicly available
information, including information such as published accounting statements, wire news,
announcements as well as historical price information (Sunde, 2008). Sunde (2008) further
asserts that fundamentalists use the above information when buying or selling stocks. If
fundamental analysis works, the efficient market hypothesis (semi-strong form) is wrong. The
distinction between semi-strong efficiency and weak-form efficiency is that semi-strong
efficiency implies weak-form efficiency in that semi-strong efficiency requires not only that the
market be efficient with respect to historical price information, but all the information available
to the public be reflected in price.
6.2.3 Strong Form Efficiency

The strong form of EMH states that the current share price incorporates all information, both
past, present and private non-published insider information. This would include views and
opinions being held by directors about their companies‟ prospects. If this form of stock market
efficiency holds, it follows that no investor can be able to generate above-average returns using
any information whatsoever since all market participants have access to all information, both
past and present and both public and private. Ogilvie (2009) posits that it is difficult to test the
strong form of EMH since insider trading is illegal in most jurisdictions throughout the world.
This form says that anything that is pertinent to the value of the stock and that is known to at
78 | P a g e
least one investor is in fact, fully incorporated into the stock value. In other words, security
prices reflect all available information that is public and private data. A precondition for this
strong version of the hypothesis is that information and trading costs, the costs of getting prices
to reflect information, are always zero. Its advantage, however, is that it is a clean benchmark
that allows to sidestep the problem of deciding what are reasonable information and trading
costs. Since there are surely positive information and trading costs, the extreme version of the
market efficiency is unattainable. If one can make money by inside trading (assuming that you
don‟t get caught), the strong EMH is wrong, but may be weak or semi-strong EMH is still
correct.
6.3 Random Walk Hypothesis

The random walk model was first developed by Bachelier (1900) in which he asserts that
successive price changes between two periods is independent with zero mean and its variance is
proportional to the interval between the two time periods. Accordingly, the variance of weekly
changes should be five times the variance of the daily changes (assuming the market remains
closed on weekends). This concept is exploited in the variance ratio tests, which has been widely
used to test the random walk hypothesis in various markets.
The more efficient a stock market is, the less will be the opportunity to generate speculative
profit from trading market instruments. The concept of stock market efficiency has generated a
lot of debate ever since Eugene Fama first introduced it a couple of decades ago. Random walk
of share prices is considered to be a sufficient condition for market efficiency to occur. However,
rejection of random walk model does not necessarily imply the inefficiency of stock-price
formation, so a dose of caution is required to avoid misinterpretation in this regard. Random
walk is the path of a variable over time that exhibits no predictable patterns pertaining to the next
successive step. The random walk hypothesis (RWH) states that the present market price is the
best indicator of the future market prices with an error term that is stochastic in nature. Hence the
next time period price is anybody‟s guess.
Random Walk Hypothesis refers to the notion that stock prices are so unpredictable that
historical stock prices cannot be utilised in charting the future trajectory (Fama, 1995). The study
of rejection of random walk in the share prices due to mean reverting tendency which is a
79 | P a g e
consequence of persistence of one sided volley in share prices was first presented by De Bondt &
Thaler (1985). The presence of mean reverting tendency and absence of random walk in US
stocks was confirmed by the studies of De Bondt & Thaler (1989) and Poterba & Summers
(1988). The variance ratio test was proposed by Lo and MacKinlay in 1988 to test the random
walk hypothesis. The study compared variance estimators derived from data at various levels of
frequencies for weekly stock market returns in the New York Stock Exchange and American
Stock Exchange for a period of over 32 years. They improved the variance ratio statistic by
taking overlapping period and corrected the variances used in estimating the statistic for bias.
They also proposed a test statistic Z*, which is robust under the heteroscedastic random walk
hypothesis, hence can be used for a longer time series analysis.
An extensive Monte Carlo simulation was conducted by Lo & MacKinlay (1989) to find out the
size and power of these tests in infinite samples. They identified that the variance of random
walk increments was linear in all sampling intervals. Their findings provided evidence to reject
the random walk model for the entire sample period of 1962-1985 and for all sub-periods for a
variety of aggregate returns indexes and size-sorted portfolios. Their results also indicated
positive autocorrelation for weekly holding-period returns not only for the entire sample but also
for all sub-periods.
The rejection of the random walk model by Lo & MacKinlay (1988) was mainly due to the
behaviour of small stocks. But this could not be attributed entirely to the effects of infrequent
trading or time-varying volatilities. They used simple specification test based on variance
estimators to prove that stock prices did not follow a random walk. The Lo & MacKinlay
finding of positive autocorrelation was inconsistent with the negative serial correlation found by
Fama & French (1988). Fama & French discovered that for the U.S. stock market, 40 percent of
the variations of longer holding-period returns were predictable from the information on past
returns. Campbell in 1991 used variance decomposition method for stock returns and concluded
that the expected stock return changes through time in a fairly persistent fashion. Parameswaran
(2000) performed variance ratio tests corrected for bid-ask spread and nonsynchronous trading
on the weekly returns derived from CRSP daily returns file for a period of 23 years. His results
show that eight out of ten size sorted portfolios do not follow a random walk. He observed that
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non-trading is not a source of serial correlation in the large sized firms. Kim, Nelson & Startz
(1991) examined the random walk process of stock prices by using weekly and monthly returns
in five Pacific-Basin stock markets. The findings provided evidence that the mean reversion was
only a phenomenon of the pre-World War II period, and not a feature of the post-war period.
They found that the variance ratio tests produced positive serial correlation. Studies based on the
Lo & Mackinlay‟s simple volatility based specification test have indicated rejection of random
walk in the stock markets of developing countries and newly developed countries as well.
Pan, Chiou, Hocking & Rim (1991) applied the variance ratio test on daily and weekly returns
for a five-year sample period in five Asian stock markets, namely, Hong Kong, Japan,
Singapore, South Korea, and Taiwan. They rejected the null hypotheses of randomness for both
daily and weekly market returns for Korea and Singapore and accepted the null hypothesis in
case of Japan. The null hypotheses for Hong Kong daily returns index and the Taiwan weekly
returns index were also rejected. Their results indicated that all the returns based on the five
market indices were positively auto correlated except for Japan.
6.4 Empirically Testing the Validity of EMH

• Subjecting a series of share prices or indices to statistical tests to determine whether
there is any correlation between past and present prices
• On the ZSE, information is impounded slowly into share prices (Bonga, 2008),
thereby indicating the weak form.
Sunde (2008)‟s study‟s main intention was to investigate, using monthly data, whether prices in
the Zimbabwe Stock Exchange (ZSE) follow a random-walk process as required for there to be
market efficiency. The study applied the unit root tests to establish if the ZSE followed a random
walk or not. The ZSE was chosen because it represents a typical emerging stock market in Sub-
Saharan Africa. The study used the Augmented-Dickey Fuller (ADF) tests with a lag length that
was necessary to remove autocorrelation from residuals. Using monthly data from January 1998-
November 2006 he found that the ZSE did not follow a random walk and therefore was not
efficient in the weak form. This meant that past prices had an influence in the determination of
future prices and this provided an opportunity for out-performance by skilful financial managers
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and investment specialists. During the period studied investment analysts and managers of
companies were able to take advantage of these investment opportunities to make abnormal
returns from the ZSE.
Jakata et al (2013) carried out a similar study to examine whether the share prices of companies
listed on the Zimbabwe Stock Exchange follow the Random Walk Hypothesis. The research was
motivated by the fact that investors are interested in knowing whether past share prices have a
propensity to forecast future share prices. The period covered by the research was January 2014
to December 2014. The main objective of the study investigated the possibility that share prices
follow the Random Walk Hypothesis. The data was analysed using the Chi-square Test, the
Runs Test and the Auto-correlation Test. Their findings revealed that changes in share prices on
the ZSE refute the Random Walk Hypothesis. The study concluded that share price shifts follow
some pattern or trend and that historical price changes can be used to predict future price
movements. The study also concluded that the ZSE provides an opportunity for investors to
create wealth as they take advantage of its weak-form inefficiency.
Insider trading is illegal in most jurisdictions throughout the world as it potentially destabilises
financial markets. Regulation is the best form of government intervention whenever
informational inadequacies are undermining the efficient operation of markets. Japan is a typical
country that doesn‟t criminalise insider trading, arguing that it bolsters the informational
efficiency of capital markets
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6.5 Implications of Efficient Capital Markets
If capital markets are efficient, once a company that makes an investment in a +ve NPV project,
investors will immediately know and the share price instantaneously reflects this information by
rising. The following are implications of efficient capital markets in addition to the one above:
 You cannot outperform (or beat) an efficient market

 An entity cannot mislead an efficient market through window dressing or creative
accounting (lipstick and make-up on a frog)
 If capital markets are efficient, financing decisions cannot not create value
 If capital markets are efficient, managers can make investment decisions that generate
+ve NPV through the disequilibria that exist in real markets
 On the other hand, poor investment decisions (eg in –ve NPV projects) will lead to a nose
dive in share prices
 Seeking to takeover entities with “undervalued” shares is a waste of time since efficient
capital markets always price financial instruments accurately
 An entity‟s dividend decisions must be made with a dose of caution as rapid changes in
dividends have a signalling effect on the entity‟s share prices
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7.0 DIVIDEND POLICY
7.1 Lecture Objectives
 To examine the nature of dividend decisions

 To discuss the theories that explain dividend decisions
 To examine the various dividend policies
 To evaluate factors that influence dividend decisions
 To evaluate other forms of dividends
7.2 The nature of dividend decisions
Dividends paid to shareholders in companies are analogous to drawings effected by the owner of
a business in sole proprietorship. Post-tax earnings = dividend payments + retained earnings.
Thus payout ratio + retention ratio = 100% of post-tax earnings. Resultantly, dividend decisions
constitute the flipside of financing decisions because retained earnings support business growth
without resorting to borrowing or issuing new equity.
7.3 Dividend Theories and Hypotheses
[1] Bird-In-The-Hand Theory
[2] Tax Preference Theory
[3] Dividend Irrelevance Theory
[4] The Clientele Effect
[5] The Information Content or Signalling Hypothesis
[6] The Residual Distribution Model
The above six theories and hypotheses are in turn further explained below:
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[1] Bird-In-The-Hand Theory
Investors think that dividends are less risky than potential future capital gains, hence place
preference on dividends to capital gains. Investors would therefore value high-payout firms more
highly than low-payout firms.
[2] Tax Preference Theory
The tax rate on dividends is usually higher than the tax rate on capital gains. The tax on capital
gains is deferred until the capital gains are eventually realised after the sale of shares. This can
lead to investors preferring low-payout firms to high-payout firms.
[3] Theory of Dividend Irrelevance
This theory is attributable to Modigliani and Miller (MM) (1961). Their argument underpins the
fundamental principle of valuation that the price of each share must be such that the rate of
return (Dividend Yield +Capital Gains Yield) on every share will be the same throughout the
market over any given time interval. This principle is supported by three assumptions:
First, perfect capital markets in which no buyers or issuers of securities are large enough to alter
the share price. Information is freely and costlessly available to all market participants, no taxes,
no transaction costs such as transfer or brokerage fees are incurred in trading securities.
Second, all investors are rational ie they prefer more wealth to less and they are indifferent as to
whether any increment in their wealth is in the form of dividend payments or in the form of an
increase in the market value of their shares (capital gains).
Third, perfect certainty about future investment programmes and future profits of every
company with this assurance, there is no need to distinguish between equity and debt or bonds as
sources of funds.
In other words, dividend is irrelevant for equity valuation in a perfect world without taxes,
transaction costs, freely available and costlessly acquired information by all stock market
participants, rational investors and perfect certainty.
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[4] The Clientele Effect. This hypothesis posits that different groups of investors prefer different
dividend policies. A firm‟s past dividend policy determines its current clientele of investors.
These clientele effects impede changing of the dividend policy because such dividend policies
match their clientele. Boards of Directors should be mindful of this whenever they propose
dividend policy changes.
[5] Information Content or Signalling Hypothesis
Investors view dividend changes as signals of management‟s prospects about the company‟s
future. Thus, increasing dividends signals good future prospects. On the contrary, reducing
dividends signals poor futute prospects. A cut in dividend must therefore be clearly
communicated to the financial markets so that is in not interpreted negatively.
[6] Residual Distribution Model
According to this model, firms determine their capital budgets and reinvest earnings to meet the
capital budget. Any leftovers (residue) or residual earnings can then be deployed to pay
dividends. This model subscribes to the need to avoid or minimise floatation costs associated
with raising new sources of finance such as debt or new equity
7.4 Dividend Policies
A dividend policy is a framework that guides an entity as to how it divides its post-tax earnings
between distributing dividends and retentions to fund viable investment opportunities to bolster
the company‟s market valuation. The use of internally generated funds this way has a cost in the
form of the opportunity cost associated with retention instead of distributing dividends (see cost
of equity in Section 4 of this Study Pack).
There are three different forms of dividend policy listed and further explained below:
[1] Constant Payout Ratio
[2] Stable Dividend Policy
[3] Residual Dividend Policy
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[1] Constant Payout Ratio
This is whereby Boards of Directors establish a dividend policy that maintains a certain dividend
cover (Earnings /Dividends) that is they declare dividends which represent a constant percentage
of post-tax profits. Inflation, however, distorts this policy as to whether the historical cost
accounting (HCA) basis is used or inflation adjustment would have been effected in the
preparation of financial statements.
[2] Stable Dividend Policy
This policy involves maintaining a trend in the absolute level of dividend payout. To determine
this year‟s dividend per share, a certain fixed percentage is applied to the previous year‟s
dividend per share.
Example of a Stable Dividend Policy
The most recent dividend per share is $5 per share. It will grow by 8% per year under the stable
dividend policy. Usung MS Excel as the most commonly available curve-fitting software, fit the
dividend per share curve.
Solution
Year Dividend
per share [$]
0 5.00000
1 5.40000
2 5.83200
3 6.29856
4 6.80244
5 7.34664
6 7.93437
7 8.56912
8 9.25465
9 9.99502
10 10.79462
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12
y = 5e0.077x
10 R² = 1
Series1
6
Expon. (Series1)
4
0
0 2 4 6 8 10 12
The above graph is fitted using the following procedure in MS Excel:
 Insert
 Scatter
 Right-click any point on the scatter
 Format trendline
 Select Exponential Trend Option
 Display Equation on chart
 Display R-squared on chart
 Click Close
Make sure that $5 corresponds to Year 0 and not Year 1.
The advantage associated with the stable dividend policy is that it constitutes a powerful signal
to the market about the directors‟ confidence in the entity‟s future growth prospects. On the other
hand, a major drawback of the stable dividend policy is that the Board of Directors may end up
neglecting +NPV projects in order to appease shareholders with constant dividend growth,
thereby forgoing an opportunity to increase shareholders‟ wealth through undertaking the +NPV
opportunities.
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[3] Residual Dividend Policy
The residual approach argues that if an entity has opportunities to invest for a return in excess of
the cost of capital, it should retain earnings to fund such opportunities. If on the other hand, the
entity has funds in excess of its identifiable investment opportunities, then it should distribute
these excess funds to its shareholders in the form of dividends in order to enable them to invest
elsewhere. The disadvantage is that such a dividend policy can result in volatile dividend levels.
7.5 Factors influencing Dividend Policy [RRRIILLSSO]
[1] Repayment of borrowings
[2] Restrictive Covenants
[3] Rivals‟ dividend policies
[4] Interest rates
[5] Inflation rates
[6] Liquidity
[7] Legal factors
[8] Signalling effect
[9] Stability of profits
[10] Ownership and control preservation
The above-mentioned ten factors influencing dividend policy decisions are in turn explained in
greater detail below:
[1] Repayment of borrowings
If debt is scheduled for repayment eg bonds or debentures approaching time to maturity, firms
may not be willing to issue additional new bonds or raise new equity or bank loans, so they will
see it prudent to use internally generated funds to effect the redemption or repayment and hence
declare little or no dividends. Otherwise dividends can be declared if repayment of such
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borrowings can be met by raising new cheaper sources of long term finance. On the other hand,
an entity‟s existing gearing ratio constitutes an important determinant of the level of the
payout/retention mix.
[2] Restrictive Covenants
Some forms of borrowings may have restrictive covenants or “strict binding restrictions” on the
amount of dividend payments or on the annual dividend growth rate per share (g). Such
restrictions impose a limit on the level of dividend that an entity can declare.
[3] Rivals’ dividend policies
It is important to observe what rival entities pay in terms of their dividends. Declaring a nil
dividend when rivals are paying high dividends does not augur well for the entity‟s share price
which can have detrimental effects on the entity‟s market valuation.
[4] Interest rates
Interest rates have a direct bearing on the cost of capital. Low interest rates will make it easier
for companies to raise external funding and hence use current earnings to pay dividends. High
interest rates, on the other hand, increase the cost of external finance which prompts companies
to resort to retained earnings to finance their viable opportunities and hence dividend payouts
suffer.
[5] Inflation rates
High levels of inflation erode real earnings and place a ceiling on the dividends that entities pay
to avoid “distributing capital in real terms”. A simple example of the income statement prepared
on the basis of both the Historical Cost Accounting (HCA) basis and Current Cost Accounting
(CCA) basis is shown below:
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HCA CCA
Revenue 1,000 1,000
Cost of sales (400) (600)
Gross Profit 600 400
Expenses (300) (300)
Profit before interest and tax 300 100
Interest charges (100) (100)
Profit before tax 200 0
Taxation (50) (50)
Profit after tax 150 (50)
Dividends (100) (100)
Earnings for the year 50 (150)
The simple example above illustrates that financial statements prepared on the historical cost
basis without an inflationary adjustment such as CCA which uses replacement cost in lieu of
original cost of sales may mislead entities into “distributing capital in real terms”. The example
therefore illustrates the impact of inflation, particularly hyperinflation, on divedend policy
decisions.
[6] Liquidity
Dividend payments require the necessary cash resources. An entity may be profitable but if funds
are tied up in inventory or receivables, it may find it difficult to effect dividend payments. To
that extent, an entity‟s liquidity plays an important role in determining the level of dividends that
it can pay to its shareholders.
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[7] Liquidity factors
Laws restrict dividend payments to distributable reserves such as retained earnings and general
reserves but prohibits dividend distribution out of non-distributable capital reserves such as
revaluation reserves, capital redemption reserves, share premium, etc. this legal aspect in in the
spirit of protecting creditors and to effect the capital maintenance concept. The idea is to curb a
tendency for entities to distribute capital back to shareholders without regulatory approval. The
law makes it only permissible for entities to distribute dividends out of current earnings.
[8] Signalling Effect
This is the information content of dividends in the sense that dividends are viewed as signals
from the entity to the financial markets. Dividend announcements can trigger share price
reactions as they signal bright or dull future prospects eg announcement of an increase or a cut in
dividends respectively. The Board of Directors must therefore be mindful of this signalling effect
when they set dividend policies and when they make and announce their dividend decisions.
[9] Stability of profits
If profits are stable, the prospect of paying higher dividends are higher. On the other hand, if
profits are unstable or fluctuate a lot, it would be prudent to pay low or even no dividends at all.
[10] Ownership and control preservation
The use of internally generated funds (retained earnings) in financing new projects preserves
ownership and control. This is opposed to issuing new shares that would dilute ownership and
control. Entities in pursuit of ownership and control preservation normally pay little or
sometimes no dividends in order to retain as much earnings as possible to avoid issuing external
finance.
7.6 Other Forms of Dividends
[1] Scrip Dividends
[2] Share Repurchases
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[1] Scrip Dividends
These are shares-in-lieu of dividends often offered when directors feel obliged to pay dividends
but cannot due to cashflow constraints. Once dividends are capitalised this way, they become
non-distributable.
[2] Share Repurchases
This is a scheme which involves returning capital to investors. Reasons for embarking on a share
repurchase scheme include availability of surplus cash, to reduce WACC, to bolster EPS, to
increase MPS, to prevent the likelihood of unwelcome takeover bids, to adjust gearing
(debt/equity mix) towards optimal capital structure, to reduce the amount of cash needed to pay
dividends in the future. However, such a scheme is note spared from drawbacks. First, a share
repurchase scheme may be interpreted as failure of management to identify +NPV projects.
Second, it is difficult to determine a price for the share repurchase which is fair to all parties.
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8.0 CAPITAL STRUCTURE
THEORIES
8.1 Introduction
In their ground breaking paper, Modigliani and Miller (1958) argue that the value of a firm is
independent of its capital structure decision. Although their hypothesis has been criticised for
oversimplifying the real world through a plethora of unrealistic assumptions, there is some sound
logic in their propositions. This inherent logic has been echoed by Milton Friedman who argues
that such a hypothesis constitutes a sound foundation of a more practical analysis. Modigliani
and Miller (1958) themselves also defended their irrelevance hypothesis by pointing out that if
one knows what is irrelevant, it becomes easier to know what is relevant.
8.2 Definition of terms
8.2.1 Capital structure refers to the relative proportions of debt and equity in the long term
sources of the financing of an entity.
8.2.2 Agency costs are the sum total of monitoring expenditures by the principal, bonding costs
by the agent, and a residual loss.
8.2.3 Value of a firm is the sum of the market values of all its securities namely debt and equity.
8.2.4 Debt is a long term liability that constitutes part of the long term sources of finance with
preferential treatment in terms of interest and principal repayment in the event of the winding up
of the issuer‟s operations
8.2.5 Equity is the common stock provided by ordinary shareholders.
8.3 Background
Modigliani and Miller have carried out their analysis in three distinct stages in 1958, 1961 and
1963, culminating into three propositions namely Proposition I, Proposition II and Proposition III
respectively. In Proposition I they argue that the market value of an entity is independent of its
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capital structure and is given by capitalising its expected return at the rate appropriate to its risk
class. In Proposition II they relate the rate of return on equity in an entity whose capital structure
includes some debt. Thus, as gearing increases, the equity cost of capital to a geared entity will
also rise in order to exactly offset the advantages accruing from the lower cost of debt relative to
equity due to debt interest‟s tax-deductability. In Proposition III they argue that the weighted
average cost of capital is completely unaffected by the type of security used to finance the
investment.
Ogilvie (2009) summarises the three propositions as follows:
Proposition I : Vg = Vug
Proposition II : keg = keu + (D/E)(keu – kd)
Proposition III : WACCg = WACCug
Where :
Vg = value of geared entity
Vug = value of ungeared entity
keg = cost of equity in geared entity
keu = cost of equity in ungeared entity
kd = cost of debt (pre-tax)
WACCg = weighted average cost of capital of a geared entity
WACCug = weighted average cost of capital of an ungeared entity
The three propositions above clearly indicate that a geared firm and an ungeared firm will have
the same value and the same weighted average cost of capital as long as they are similar. The
level of debt in a firm‟s capital structure is irrelevant in determining the market value of a firm.
These sentiments were also echoed by Van Horne and Wachowicz (2001).
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8.4 Assumptions of the Modigliani-Miller’s irrelevant hypothesis
Modigliani-Miller‟s assumptions can be classified into five broad categories namely frictionless
markets, homogeneous expectations, atomistic market participants, fixed and known investment
programmes and fixed capital structure. These five categories of assumptions are unpacked and
examined individually below:
8.4.1 Markets are frictionless
Market participants face no transaction costs or taxes. Investors face no brokerage commissions
and fees on trades and short-selling is unrestricted. Firms face no transaction costs in issuing or
retiring securities and also there are no costs associated with bankruptcy.
8.4.2 All market participants share homogeneous expectations
Value-relevant information is costlessly available to all market participants and all participants
rationally process such information to determine the value of any security. Hence all participants
share common expectations about the prospect of investment.
8.4.3 All market participants are atomistic
All market participants are assumed to simulate atoms by being completely independent of each
other. It is further assumed that no single market participant can affect the market price of a
security via trades.
8.4.4 The firm’s investment programme is fixed and known in advance
This assumption states that since the firm‟s investment programme is fixed and known in
advance, its assets, operations and strategies are therefore known to all investors.
8.4.5 The firm’s financing is fixed
It is assumed that the firm‟s financing is fixed. Once chosen, the firm‟s capital structure becomes
fixed.
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8.5 Critical Evaluation of the Assumptions of the MM Irrelevance Hypothesis
Sections 8.5.1 to 8.5.5 below are a detailed critical evaluation of the applicability of the five
broad categories of assumptions that were used by Modigliani and Miller in their analysis.
8.5.1 Markets are frictionless
According to Brealy and Myers (2013), frictionless markets can be unpacked into no transaction
costs, no taxes, unrestricted short-selling and no bankruptcy costs. While these assumptions have
been largely argued to be too simplifying and unrealistic to deploy in practice, Milton Friedman
argues that one can use them as a starting point to come up with a very good analysis. These
assumptions associated with frictionless markets are critically evaluated below.
8.5.1.1 No transaction costs
The issuing or retiring of debt and equity instruments is usually associated with costs being
incurred. There are always underwriting costs, advertising costs, prospectus costs and advisory
costs and these cannot be avoided whenever a firm issues or retires its securities. Specifically,
Hove and Chidoko (2012) identify the costs of trading on the Zimbabwe Stock Exchange as
being in the form of charges, commissions and taxes that include a basic charge on both „buy and
sell‟ transactions, stamp duty on shares purchased or sold, and a transfer fee on purchases. The
Zimbabwe Stock Exchange-listed Zimbabwe Newspapers Limited incurred several thousands of
dollars worth of costs in a share repurchase transaction of $464,000 worth of shares in 2010. The
company incurred further costs in issuing these same shares to its employees. This practical
example confirms that the Modigliani-Miller‟s irrelevant hypothesis does not hold in the real
world because transactions involving issuing and retiring securities will always incur costs
separately.
8.5.1.2 No taxes
Taxes are common in practice and the tax-deductibility of debt interest introduces a complication
in the Modigliani-Miller hypothesis. As the proportion of debt within the capital structure
increases, the firm will benefit from an increasing tax shield and this will obviously make capital
structure relevant in determining a firm‟s value. A world without taxes is an imaginary
assumption which can hardly apply in practice. Hove and Chidoko (2012) argue that apart from
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corporate taxes in Zimbabwe, other taxes are in the form of withholding taxes on dividends that
are deducted at source and capital gains tax. They further posit that such taxes put together
would create a tax bias against equity in favour of debt financing which offer interest expense
tax-deductibility through reducing taxable income and the eventual tax liability. Whilst there are
a few tax havens in the world in which the “no taxes” assumption of Modigliani-Miller
hypothesis may apply such as Bahamas, Bermuda and the British Virgin Islands among others,
the majority of countries across the globe are, however, non-tax-havens. For example the fact
that corporation tax rates are 40% in USA, 33% in UK, 25.75% in Zimbabwe and so on, it
follows that the existence of taxes in most countries of the world militates against the
applicability of a no-tax world envisaged by Modigliani and Miller in their work.
8.5.1.3 Unrestricted short-selling
Van Horne (2002) opines that short selling occurs when a short takes place at either a price
above the last traded price of the security or at the last traded price when the most recent
movement between traded prices would have been an upward movement. This implies that the
security would have traded below the last-traded price more recently than above that price. Such
short-selling is assumed to be unrestricted in the stock market.
8.5.1.4 No bankruptcy costs
It can be argued that bankruptcy costs are positively correlated with the debt/equity ratio. Thus as
firms attempt to reduce their tax burdens through shifting their capital structure in favour debt,
they increase their likelihood of incurring bankruptcy costs. The risk of bankruptcy increases
with the increased debt burden. With the addition of debt in a firm‟s capital structure, the
weighted average cost of capital (WACC) will initially fall as the benefits of the tax shield are
realised and this happens until the optimal capital structure is reached. Beyond the optimal
capital structure, the WACC begins to rise sharply and so are bankruptcy costs. Too much
leverage may ignite some restrictions on the firm‟s freedom of action by its lenders and creditors
and can damage profitability as a lot of resources will be channelled towards debt servicing
costs. It therefore follows that the „no bankruptcy costs‟ assumption by the Modigliani-Miller
hypothesis is practically unrealistic. In other words, the MM hypothesis is countered by the
Bankruptcy Cost View which is a theory that refers to the argument that the expected direct and
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indirect costs of bankruptcy will offset any of the other benefits that are received from leverage
so that the optimal amount of leverage is less than 100% of debt financing.
8.5.2 Homogeneous expectations
The Modigliani-Miller assumption on homogeneous expectations is considered in the following

two sub-sections namely „free and costless availability of value-relevant information‟ as well as
„rational investors‟.
8.5.2.1 Free and costless availability of value-relevant information
Van Horne and Wachowicz (2001) opine that it can be noted that in practice, individual and
institutional investors cannot exhibit homogeneous preferences between dividends and capital
gains, hence the counter-argument that dividends are relevant in practice. It can also be argued
that in the real world, institutional investors are more informed than individual investors because
the former have more resources to invest in acquiring market information than the latter.
Dividends have an informational content as they give the market an indication of the future
growth prospects, thereby sending signals that the market will act upon to influence the
respective share‟s market price. Most stock exchanges in the world are at most semi-strong
efficient such as London Stock Exchange and New York Stock Exchange. Some empirical
studies of the Zimbabwe Stock Exchange and other underdeveloped stock exchanges have
revealed that underdeveloped stock exchanges are in their weak form of the efficient market
hypothesis. In such cases, information cannot be freely and costlessly available to all market
participants as unrealistically assumed by Modigliani and Miller.
8.5.2.2 Rational investors
The Modigliani-Miller hypothesis assumes that all market participants rationally process the
costlessly available information to determine the value of any security. This implies that they all
share common expectations about the prospects of investments. In practice, however, some
investors will not be rational and therefore the assumption of rationality cannot apply in the real
world. In the real world, there are snowbish and bandwagon effects that militate against
Modigliani-Miller‟s assumption about rational investors. Socio-economic and political
backgrounds as well as disposable income and education are factors that skew investor
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rationality in practice such that different investors will end up with heterogeneous expectations
about the prospect of an investment. In addition, not all investors are rational except for those
who are risk averse. Some investors are irrational in the sense that they are either risk-
neutral/indifferent or are risk seekers/lovers.
8.5.2.3 Atomistic market participants
8.5.2.3.1 Independence
It can be argued that market participants are interdependent on each other in practice, thereby
refuting the assumption of independence.
8.5.2.3.2 Security prices cannot be affected by any single investor
This is a clearly flawed assumption because a single investor can potentially affect the market
price of a security via trades. This is particularly true in the case of wealthy individual and/or
institutional investors. Institutional investors such as Old Mutual Pension Fund in Zimbabwe
often transact in voluminous trades.
8.5.4 Fixed and known investment programme of a firm
It is not practical for any firm‟s investment programme to be fixed and known to all investors.
No investment programme is sacrosanct because it depends on a number of factors such as
availability of funds, tastes and preferences of the investors, the investors‟ attitude towards risk.
Econet Wireless Limited invests several millions of dollars every year in upgrading their
infrastructure but this information will only appear as a historical expenditure on their published
financial results, but the expenditure plans are never availed to the public. This very fact
indicates that firms‟ investment programmes are never made public in practice.
8.5.4.1 Fixed strategies and operations
Strategies and operations of firms in the real world are not necessarily fixed because the business
environment itself is dynamic and hence requires continuously evolving strategies and
operations.
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8.5.4.2 Investment programmes known to all investors
Van Horne (2002) argues that investment programmes of various firms in the real world are
usually a guarded secret and it is not true that they are known to all investors. As strategies are
not fixed because the business environment itself is dynamic, it follows that firms‟ investment
programmes are subject to continuous changes. The availability and cost of funds greatly
influence investment programmes and the assumption that such investment programmes are
fixed is therefore unrealistic.
8.5.5 Fixed capital structure
This is an overly simplifying assumption and does not hold in the real world in which firms are
always changing their sources of long-term finance and hence resulting in capital structure
revisions.
8.5.6 Individuals and Corporates Face the Same Cost of Debt
Copeland et al (2005) posit that individual and corporate leverage are seldom equivalent, because
corporate entities definitely enjoy higher credit ratings than individual investors. This will result
in differences in the cost of debt that these two investor categories face in the real world and
these differences will be in favour of corporate borrowers as compared to their individual
counterparts.
8.6 Theories in Support of Modigliani-Miller’s Irrelevance Hypothesis
The theories that have been in support of Modigliani-Miller‟s irrelevance hypothesis are the
Modigliani-Miller Dividend Irrelevance Theory and the Residual Theory of Dividends which are
in turn explained below:
8.6.1 Modigliani-Miller Dividend Irrelevance Theory
According to Modigliani and Miller (1958), this theory states that the firm‟s dividend policy has
no impact on the firm‟s value or its stock price. This theory is based on several unrealistic
assumptions such as perfect financial markets and that shareholders can construct their own
dividend policy by simply buying or selling shares in the market as they wish. If they want cash,
they can costlessly sell shares, if they don‟t they can hold on to their shares. In other words,
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investors are not concerned with firms‟ dividend policies. Once the assumptions on which the
Modigliani-Miller Dividend Irrelevance Theory is based are relaxed, then dividends begin to
matter. Modigliani and Miller conclude that the firm‟s value is determined solely by its basic
earning power and its business risk – that is its ability to produce risk-adjusted cash flows going
forward. Thus the value of the firm depends on the productivity of its assets, not on how the cash
flow from these assets is split between dividends and retained earnings.
8.6.2 Residual Theory of Dividends
According to Brealy and Myers (2013), this theory suggests that the dividends paid by a firm
should be viewed as a residual – the amount left over after all viable positive-NPV investment
opportunities have been undertaken. In other words, a firm first utilises earnings to finance new
viable projects, then distributes the remaining „residue‟ as dividends. Since the residual theory of
dividends assumes that dividends and capital gains are two forms of the same value, dividend
policy has no impact on a firm‟s market value.
8.7 Theories Against MM’s Irrelevance Hypothesis
8.7.1 Tax Preference Theory
This theory was first developed by Litzenberger and Ramaswamy (1979). They claim that
investors prefer lower payout companies for tax reasons. The tax preference theory draws
heavily from differential tax rates and because of these differential tax rates and deferment of tax
liability and payment, investors prefer capital gains to dividends. This is because dividends are
taxed when paid. To the extent that it is not consistent with the Dividend Irrelevance Theory, the
Tax Preference Theory is therefore against the Modigliani-Miller irrelevance hypothesis.
8.7.2 The Signalling Effect
This theory suggests that when a firm announces an increase in dividend payout, it is an
indication that it possesses positive future prospects. Thus the firm is basically conveying some
information about itself to the stock market. Security prices can therefore respond to the „signal‟
with some degree of volatility.
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8.7.3 The Clientele Effect
This is the idea that the set of investors attracted to a particular kind of security will affect the
price of the security when policies or circumstances change. The theory therefore explains how a
company‟s stock price moves according to the goals and demands of investors in reaction to a
tax, a dividend or any other policy change.
8.7.4 The Agency Theory
The agency theory focuses on information asymmetry problem at both the firm and market level.
The theory states that in every principal-agent relationship, one party (the agent) has information
that is superior to the other party (the principal).
8.7.5 The Pecking Order Hypothesis
Under the pecking order hypothesis, imperfections in the financial markets are crucial. Due to
adverse selection, firms prefer to finance their activities using retained earnings as far as
possible. If retained earnings are inadequate, then they issue debt thereby making equity a last
financing resort
8.8 Summary
The foregoing analysis has looked at the ground-breaking work that Modigliani and Miller
carried out in the field of finance since 1958. A critical examination of the five broad categories
of their assumptions was carried out with a view to analysing their applicability to the real world.
It has been noted that a relaxation of these assumptions will reverse Modigliani-Miller‟s
irrelevance hypothesis as the various „irrelevant‟ factors begin to matter. However, although their
assumptions were found to be largely unrealistic in practice, Modigliani and Miller‟s work
constitutes a useful foundation of a more realistic analysis of the determinants of a firm‟s market
value.
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9.0 ADVANCED WORKING
CAPITAL MANAGEMENT
9.1 Management of Receivables/Credit/Debtors
Debtors represent the capital of the company placed in the hands of others in the form of goods
over which the company has effectively lost all control.
The specific purposes of receivable management are as follows:
 To evaluate the creditworthiness of customers before granting or extending the credit.
 To minimize the cost of investment in receivables.
 To minimize the possible bad debt losses.
 To formulate the credit terms in such a way that results into maximization of sales
revenue and still maintaining minimum investment in receivables.
 To minimize the cost of running credit and collection department.
 To maintain a trade-off between costs and benefits associated to credit policy.
Actions Available to the Company

Broadly there are five areas of attention to which the company can pay heed in attempting to
influence the level of indebtedness of its customers and the inherent risks that this brings.
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These are:
 Checking out the credit standing of the customer, and re-checking for any adverse
changes periodically.
 Setting a limit to the level of credit granted to individual customers and laying out terms
of trading clearly in writing.
 Implementing formal collection procedures for delinquent accounts.
 Negotiating cash discounts for the most valued accounts.
 Taking out credit insurance.
Worked Example
Kendal PLC specialises in the manufacture of footwear. Sales in the current year have been
$6.8m and the terms of sale are 3% discount if paid within 21 days, otherwise no discount
available. Those customers not taking the discount take on average 28 days to pay.
The current level of debtors is $800,000, which includes 40% of Kendal PLC‟s customerswho
take advantage of the 3% discount available. 1% of credit sales become bad debts.
The net operating profit (excluding bad debts and discounts) for Kendal PLC is 20% of sales.
The company is considering a change in its credit policy as follows:
– 5% discount for payment within 21 days, instead of the current 3%.
It anticipates there would be the following effects of this change:
– Sales to increase by 10% per annum
– 60% of customers to take advantage of this 5% discount
– The period of time before payment for customers not taking the discount to
increase by 7 days
– Bad debts to fall to 0.75% of sales.
Kendal PLC‟s cost of finance is 8%.
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Required:
(a) Calculate the financial implications of this change in credit policy and give your advice
on the proposed change. (20 marks)
(b) Name five factors that a business might consider before deciding to give credit to a
new supplier. (5 marks)
Solution
The financial implications are:
(i) Increase in net operating profit
Current level of sales – $6.8m x 20% = $1.36
New policy – $7.48 x 20% = $1.496
Increase in OP = $0.136
(ii) Increase in discount allowed

Current level – $6.8m x 3% x 40% = $0.0816m
New policy – $7.48m x 5% x 60% = $0.2244m
Increase in discount allowed = ($0.1428)
(iii) Savings on debtors

Assume average time to pay (customers not taking cash discount) = “y” weeks
ie Current level
Debtors = {40% ($6.8m / 52)x 3 } + {60% ($6.8m / 52) x y} = $0.8m
Therefore y = 8.2 weeks
New policy (taking one week longer to pay)

Debtors = {60% ($7.48 / 52) x 3} + {40% ($7.48 / 52) x 9.2} = $0.7883m
Reduction in debtors = $800,000 – $788,300

= $11 700
Saving = (11 700 x 8 %)
= .0009
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(iv) Reduction in bad debts
Current level – $6.8m x 1% = $0.068m
New policy – $7.48m x 0.75% = $0.0561
Reduction $0.0119m
Summary of changes
(i) Net operating profit 0.1360

(ii) Discount allowed (0.1428)
(iii) Debtors 0.0009
(iv) Bad debts 0.0119
0.0060
Overall saving = $0.006m ie $6,000
This is a relatively small benefit and Kendal PLC would need to consider whether the
proposed changes are financially beneficial overall. The saving is relatively modest
given the figures involved.
Alternatively you can use the following Change in Residual Income Formula:
∆RI = [∆S - v∆S - bn∆S][1 - t] - k∆I = [∆S (1 - v) - bn∆S][ 1 - t] - k∆I where ∆I =
If ∆RI > 0, accept the proposed change in credit policy
If ∆RI < 0, reject the proposed change in credit policy
(b) – Prior experience with the particular customer.

– Analysis of the customer‟s accounts and credit reports.
– Bank / trade references.
– Credit bureau reports.
– Capacity – does the client have the capacity to repay the debt?
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– Character – will the customer repay the debt in accordance with the terms of the
contract?
– Capital – what is the financial health of the client?
– Collateral – what security (if any) should be taken?
– Conditions – consideration of the normal terms for the industry.
9.2 Management of Creditors

A firm needs to determine what policy to adopt in the management of its creditors. In doing this
it must consider the following factors:
 The need to ensure continuing supplies as and when required, by maintaining good
relations with regular suppliers.
 The level of credit required, and the ability to extend it when the firm has a cash flow
shortfall.
 The advantages of having a high level of trade credit as a method of reducing the level of
working capital required.
 The possibility of extending credit, but this provides the firm with a poor credit rating and
problems in obtaining additional credit.
 Whether to accept or reject early payment discounts (this decision is made in the same
way as offering discounts to a firm's customers – the benefits of accepting the discount
(additional cost) must outweigh the costs (interest foregone) of paying the debt early).
Working capital is the total amount of cash tied up in current (i.e. short term) assets and current
(i.e. short term) liabilities, and is calculated by deducting the total amount of current liabilities
from the total
amount of current assets.
9.3 Current Assets Investment and Financing Policies
Two basic questions are relevant:
1.. What is the appropriate level for current assets, both in total and by specific accounts
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2…How should current assets be financed
After establishing the level of current assets, the firm must determine how these should be
financed. What mix of long term capital and short term debt should the firm employ to support
its current assets?
Current assets can be temporary (seasonal) or permanent.
Permanent current assets can be defined as the base level of cash, accounts receivable , and
inventory and are determined by their low point through several sales cycles.
Temporary current assets are sudden increases in accounts receivables and inventory due to
seasonal fluctuations in sales.
The current asset financing strategy focuses on determining the best method of financing both
temporary and permanent current assets.
Given the temporary and permanent nature of current assets, they can be financed with either
short- or long-term sources of funding.
9.4 Operating Cycle and Cash cycle
The investment in working capital is influenced by four key events in the production and sales
cycle
 Purchase of raw material

 Payment of raw material
 Sale of finished goods
 Collection of cash for sales
The following is an example of a working capital cycle:
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Raw materials in stock 20 days
Work-in-progress 21 days
Finished goods stock 38days
Period between dispatch and invoice to customer 10days
Period from invoicing to customer payment 60days
Total 149days
Cash conversion cycle
"The cash conversion cycle is the length of time elapsing between parting with cash and getting
it back from customers".
Example
X ltd has the following figures from its recent accounts
$m
Receivables 4
Trade Payables 2
Raw material Inventory 1
Finished goods inventory 2
Sales (80 % on Credit) 30
Materials Usage 20
Material purchases (all on credit) 18
Cost of sales 25
Calculate the relevant ratios.

Calculate the length of the cash operating cycle
Receivables = receivables/credit sales *365
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4/30*80% *365
61 days
Trade payables = Trade payables/material purchases on credit*365
2/18*365
41 days
Raw material inventory days = inventory /material usage
1/20*365
19 days
Finished goods inventory = inventory/cost of sales
2/25*365
29 days
Operating cycle
Trade payables (41)

Raw material inventory days 19
Finished goods inventory 30
Receivables 61
Length of operating cycle 69 days

Tight Ltd‟s liquidity has declined significantly over the last 12 months. The following
financial information is provided:
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Year to 31 December 2013 2014
$ $
Sales 773,000 843,000
Cost of goods sold 570,000 680,000
Cash (overdraft) 15,000 (20,000)
Debtors 93,400 126,800
Creditors 18,700 58,200
Stocks 106,500 194,000
All purchases and sales were made on credit.
Assume a 365 day year for the purpose of your calculations and assume that all
transactions take place at an even rate.
Required:
(a) Analyse the above information using appropriate working capital ratios including
theoperating cycle for 2013 and 2014.
(b) Explain the implications of the changes which have occurred between 2013 and 2014.
(c) Identify and briefly explain at least four sources of short term business finance that could be
available for Tight limited.
9.5 OVERTRADING
An increase in a company's turnover is basically good, but it should be part of a planned strategy
with a permanent increase being supported by a matching permanent increase in the working
capital of the company.
This will most commonly be achieved by retention of profits and/or an injection of share capital.
Inflation could increase the requirement more than the funding injected.
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Overtrading is a common phenomenon for growing companies, and occurs when a business
overextends itself by having insufficient capital to match increases in turnover.
Typical symptoms of overtrading would include the following:
 A significant increase in turnover over the period
 A decrease in gross profit and net profit ratios over the same period
 A deterioration in stock turnover ratios
 Increasing liquidity problems shown by the current asset and acid test ratios
 Increasing reliance on short term finance such as an increase in bank overdraft and
creditors payment period
 A rapid increase in the volume of current assets
 Only a small increase in the owners capital
 Some debt ratios alter significantly
And future action needed to address these issues could include the following:
 Efforts to increase stock turnover, such as an advertising campaign or marketing

initiatives.
 Reduction in expenses to improve net profit percentage
 Seeking of alternative methods of finance to fund any expansion
 Consider a reduction in the rate of expansion
 Consider new capital from the owners of the business
 Improve control systems, particularly cost control systems
 Consider having to abandon any ambitious plans for the immediate future
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 Look at loan requirements –for example, has the business repaid a loan without replacing
it? This has the effect of reducing the long term capital of the business
 Consider the use of credit and factoring agencies.
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10.0 ADVANCED
INVESTMENT APPRAISAL
10.1 Incorporating Risk in Investment Appraisal
1. What is the relevant risk in terms of capital budgeting decisions?
2. How should risk be incorporated into capital budgeting analysis?
There are two fundamental reasons to perform a project risk analysis before making a final
accept/reject decision:
1. Project cash flows are risky and may not be equal to the estimates used to
compute NPV.
2. Forecasts are made by humans who can be either too optimistic or too pessimistic
when making their cash flow forecasts. Risk analysis will help guard against such
biases.
Method 1: Adjust the cash flows (ACFs)
Method 2: Adjust the discount rate (k)
– Certainty-equivalent approach
– Risk-adjusted discount rate
Simply adjust the discount rate (k) to reflect higher risk
Riskier projects will use higher risk-adjusted discount rates
Calculate NPV using the new risk-adjusted discount rate
How do we determine the appropriate risk-adjusted discount rate (k*) to use?
Many firms set up risk classes to categorise different types of projects
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Examples of Typical Risk Classes
Risk Risk-Adjusted Discount Rate Project Type

Class
1 12% Replacement Equipment
2 15% Modification or Expansion of Existing Product Line
3 18% Unrelated New Products
4 25% Research and Development
10.2 Certainty-Equivalent Approach
Steps Involved
[1] Adjust all cashflows by certainty equivalent coefficients to get certain cashflows
[2] Discount the certain cashflows by the risk-free rate of interest
[3] Apply normal capital budgeting decision criteria.
Worked Example
A company with a 10% required rate of return is considering building new research facilities
with an expected life of 5 years. The initial outlay associated with this project involves a certain
cash outflow of $130,000. The risk-free rate is 6%. The expected cash inflows and certainty-
equivalent coefficients are as follows:
Year Expected Net Cash Flows Certainty Equivalent Coefficient

0 (130,000) 1
1 10,000 0.95
2 20,000 0.9
3 40,000 0.85
4 80,000 0.75
5 80,000 0.65
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Solution
Year Expected Net Cash Certainty Riskless DF @ 6% Risk- DCF
Flows Equivalent Cash free rate
Coefficient Flows
0 (130,000) 1 (130,000) 1.000000 (130,000.00000)
1 10,000 0.95 9,500 0.943396 9,962.2641508
2 20,000 0.9 18,000 0.889996 16,019.93592
3 40,000 0.85 34,000 0.839619 28,547.055622
4 80,000 0.75 60,000 0.792094 47,525.619792
5 80,000 0.65 52,000 0.747258 38,857.424986
NPV OF
RISKLESS 10,912.300471
CASHFLOWS @
6% RISK-FREE NPV > 0,
DISCOUNT ACCEPT THE
RATE PROJECT
10.3 Scenario Analysis - Use of Probability Distribution in NPVs
The following probability distribution has been established in respect of Project X:

Probability 10% 40% 30% 20%
NPV $75,000 $90,000 $150,000 $200,000
Calculate the project‟s Expected Net Present Value (ENPV), Variance, Standard Deviation and
Coefficient of Variation.
Expected Net Present Value (ENPV) Calculation
ENPV = ∑[Pi*NPVi]
Probability [Pi] NPVi Pi*NPVi
0.10 $75,000 $7,500
0.40 $90,000 $36,000
0.30 $150,000 $45,000
0.20 $200,000 $40,000
ENPV = ∑[Pi*NPVi] $128,500
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Variance Calculation
VarNPV = ∑[Pi*(NPVi-ENPV)2]
Probability [Pi] (NPVi – ENPV)2 Pi*(NPVi – ENPV)2
0.10 $2,862,250,000 $ 286,225,000.00
0.40 $1,482,250,000 $ 592,900,000.00
0.30 $ 462,250,000 $ 138,675,000.00
0.20 $5,112,250,000 $1,022,450,000.00
VARNPV = ∑[Pi*(NPVi-ENPV)2] $2,040,250,000.00
σ NPV = √[VARNPV] σ NPV = √[VARNPV] $ 45,169.13
CVNPV = 0.351510713
10.4 Sensitivity Analysis
It shows how changes in a variable such as price or volume affect NPV or IRR. One variable is
changed whilst the rest are assumed to be fixed and the impact of that change on NPV and IRR is
noted.
10.5 Value Drivers
Value drivers are the basic determinants of an investment‟s cash flows and consequently its
performance.
 Value drivers may consist of determinants of project revenues (e.g., market share, market
size, and price) and costs (e.g., variable and cash fixed costs)
 Identification of value drivers allow the company to:
Allocate more time and money toward refining their forecasts of these key
variables.
Monitor the key value drivers regularly so that prompt corrective action can be
taken in the event that the project is not proceeding as expected.
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Sensitivity analysis occurs when a financial manager evaluates the effect of each value
driver on the investment‟s NPV.
It helps identify the variable that has the most impact on NPV.
10.6 Inflation
Nominal or money cashflows must be discounted using a nominal or money discount rate whilst
real cashflows must be discounted using a real discount rate. The relationship between nominal
and real discount rate can best be explained using Fisher Effect.
[1 + real cost of capital] x [1 + general inflation rate] = [1 + nominal (inflated) cost of capital]
or (1 + r) (1 + h) = (1 + i)
The working capital requirement each year is a function of sales and purchases. It therefore
follows that if the sales and purchases figures are to be inflated, then any figure resulting from
them (receivables, payables, inventory) should also be inflated. Only once the total working
capital required has been calculated should you calculate the incremental cash flows for DCF
calculations.
10.7 Lease or Buy Decisions
There are two main types of leases, finance leases and operating leases.
10.7.1 Operating lease (a) Short term rental (b) No initial capital outlay (c) No risk of
obsolescence (d) Often maintained & insured by the lessee (e) Off balance sheet finance (f)
Expensive
10.7.2 Finance lease (a) Long term rental (b) No need for initial capital outlay (c) Simply an
alternative source of finance (d) May be cheaper (see below)
10.7.3 The benefits of any type of lease to the lessee can be:
(a) Availability; a firm that cannot get a bank loan to fund the purchase of an asset (capital
rationing – see next section for further discussion); the same bank that refused the loan will often
be happy to offer a lease.
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(b) Avoiding tax exhaustion; if a firm cannot use all of their capital allowances (the lessor can
use the capital allowances and then set a lease that transfers some of the benefit to the lessee).
(c) Avoiding covenants; restricting future borrowing capability. Leases in the real world
(d) Projects (plant hire) where an expensive asset is only needed for a specific job (a) Used in
vehicle rental (planes, trains, cars) where the lessor has the opportunity to obtain bulk purchase
discounts that are not available to the lessee or where the lessor can borrow at a lower rate of
interest.
(e) High tech equipment (computer leasing) where leases often offer protection against
technological risk and break down.
10.7.4 The benefits of leasing vs purchasing (with a loan) can be assessed by an NPV
approach:
Step 1 the costs of leasing (payments, lost capital allowances and lost scrap revenue)
Step 2 the benefits of leasing (savings on loan repayments = PV of loan = initial outlay)
Step 3 discounting at the post tax cost of debt.
Step 4 calculate the NPV – if positive it means that the lease is cheaper than the post tax cost of a
loan
An alternative method is to evaluate the NPV of the cost of the loan and the NPV of the cost of
the lease separately, and to choose the cheapest option.
Note that the cost of the loan should not include the interest repayments on the loan eg the NPV
of the repayments on a loan for $10,000 repayable in 1 year at 10% interest is $10,000 when
discounted at 10% - so the cost of a loan is just its initial time 0 value, here $10,000.
Example 1
J Plc intends to use a lease agreement to acquire a machinery on 31 May 2020. The lease term is
5 years and lease rentals of $10,000 each year are payable annually in advance. Calculate the
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present value of the lease rental payments at 31 May 2020 using an annual discount rate of 10%.
Ignore taxation.
Solution
PVAD = [1+r][1 - ( ]
)
= [1+0.1][1 - ( ]
)
= 100,000[1.1][0.379078677]
= $41,698.65
Example 2
C Plc is considering whether to lease or buy an asset which has a 10-year economic life with a
nil residual value. It can be purchased for $80,000 payable immediately. Alternatively, it can be
leased for 10 lease rentals of $12,000 per annum payable annually in advance. Should the entity
lease or buy the asset if their required rate of return is 10% per annum?
Solution
Buying Option
Buy = $80,000
Leasing Option
PVAD = [1+r][1 - ( ]
)
= [1+0.1][1 - ( ]
)
= 120,000[1.1][0.614456711]
= $81,108.29
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Decision
The entity should buy the assets because it is cheaper to buy the machine at $80,000 than to incur
$81,108.29 lease rentals expressed in present value terms.
Example 3
R Plc is considering whether to lease or buy an asset which has a 5-year economic life. It can be
purchased for $81,000 payable immediately, and will have a residual value of $40,000 after 5
years. Alternatively, it can be leased for five lease rentals of $14,000 per annum payable
annually in arrears, and the asset will be handed back to the lessor at the end of this 5-year
contract. How should the entity finance the asset? The required rate of return is 10% per annum.
Ignore taxation.
Solution
Buying Option
PV of the cost of buying = $80,000 – PV of the residual value
= $80,000 - (
= $80,000 - $24,836.85
= $55,163.15
Leasing Option
PVOA = [1 - ( ]
)
= [1 - ( ]
)
= 140,000[0.379078677]
= $53,071.01
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Decision
Since the leasing option is cheaper than the buying option in present value terms, the entity
should ideally lease the asset.
Adjusting for Corporate Tax in Lease or Buy Decisions
The above examples have ignored taxation. It is important to understand a question properly as
to how taxation is to be treated, depending on the tone of the question. The examiner may require
you to account for the following tax effects, unless you are advised to ignore taxation
 Capital allowances may be claimed and hence the tax shield on those capital allowances
[t*capital allowances] payments will reduce the cost of leasing
 Interest payments on loans may also qualify for tax relief [t*interest payments]
Example 4
A leisure operator is considering to invest in a new piece of equipment. The entity can either
borrow the necessary funds from its bank at 9% interest rate and purchase the equipment, or
enter into a finance lease involving five annual year-end payments of $24,000. The new
equipment costs $100,000 and would attract tax depreciation allowances (capital allowances) at
25% on a reducing balance basis, not straight line basis, over its 5-year life for its owners.
Corporate tax is 33%, payable in the year in which the taxable profits arise. Which option,
leasing or buying, is optimal for the entity?
Solution
Borrow and Buy Option
Calculate the capital allowances associated with the purchase of the equipment.
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Year Capital Allowance Calculation Capital Tax Shield @ Timing of
Allowance 33% [t*CA] Tax Shield
1 $100,000 *25% $25,000 $8,250 T1
2 [$100,000-$25,000]*25% $18,750 $6,188 T2
3 [$75,000-$18,750]*25% $14,063 $4,641 T3
4 [$56,250-$14,063]*25% $10,547 $3,481 T4
$68,360
5 Balancing Allowance $31,640 $10,441 T5
[$100,000-$68,360]
$100,000
The post-tax cashflows associated with the financing option should be discounted at the post-tax
cost of borrowing = 9%[1-t] = 9%[1-33%] = 6%. The interest charges from borrowing are
excluded from relevant cashflows in the following computation because they are reflected in the
discount rate in line with the separation principle of investment appraisal.
Year Investment Tax Shield Discount Factor Present Value

@ 6%
0 ($100,000) 1.000 ($100,000)
1 $8,250 0.943 $7,780
2 $6,188 0.890 $5,507
3 $4,641 0.840 $3,898
4 $3,481 0.792 $2,757
5 $10,441 0.747 $7,799
($72,259)
Leasing Option
The post-tax cashflows associated with this financing option should also be discounted at the
post-tax cost of borrowing of 6%.
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Year Lease Payment Tax Shield @ Net Cash Discount Present
33% Factor @ 6% Value
1 ($24,000) $7,920 ($16,080) 0.943 ($15,163)
2 ($24,000) $7,920 ($16,080) 0.890 ($14,311)
3 ($24,000) $7,920 ($16,080) 0.840 ($13,507)
4 ($24,000) $7,920 ($16,080) 0.792 ($12,735)
5 ($24,000) $7,920 ($16,080) 0.747 ($12,012)
($67,728)
Decision
The finance lease option is financially more advantageous than the borrow and buy option.
10.8 Capital Rationing
Capital rationing refers to a restriction on an entity‟s ability to invest capital funds. This can
emanate from internal budget ceiling imposed by management (soft capital rationing) or from
external limitations such as when additional borrowings are not available (hard capital rationing).
Capital rationing can be either single-period CR (rationed at Year 0 only) or multi-period CR. If
capital is not rationed, there is nothing to worry about, all +ve NPV projects are accepted
because they increase shareholders‟ wealth. However, if capital is rationed, then ranking of
projects becomes important. The rule of thumb under conditions of capital rationing is to
maximise NPV per unit of the scarce resource, ie per $1 invested. This is called the Profitability
Index and constitutes the basis of ranking the projects.
10.8.1 Single Period – Mutually Exclusive Projects
The decision rule changes if any two or more projects are mutually exclusive, ie cannot be
implemented simultaneously. Assume that Projects C and E are mutually exclusive, then the
ranking will be performed twice in which the 1st ranking excludes Project C while the 2nd
ranking excludes Project E.
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10.8.2 Single Period – Indivisible Projects
The Profitability Index can lead to an incorrect ranking in the case of indivisible projects. There
is therefore need to use Trial and Error by calculating the total NPV for each possible
combination of whole projects that do not exceed the available capital funds, and consider any
surplus funds‟ investment income in PV terms
10.8.3 Multi-period Capital Rationing
10.8.3.1 Multi-Period, Divisible Projects

Use Linear Programming
10.8.3.2 Multi-Period, Indivisible Projects

Use Integer Programming
10.9 Practical steps to deal with capital rationing
(a) Leasing
(b) Entering into a joint venture with a partner
(c) Delaying one of the projects to a later period
(d) Issuing new capital (if possible)
10.10 Optimal Asset Replacement Cycle

This is an advanced investment appraisal technique which helps management to make informed
decisions on optimising the timing of asset replacement. As the asset gets older, it becomes less
efficient, operating costs worsen and resale value diminishes. Annualised Equivalent is used by
making use of cumulative PV Factors or PV of Ordinary Annuity Factors. Annualised
Equivalent = PV / PVOAF.
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Example
XYZ Ltd operates a delivery vehicle which cost $20,000 and has a useful life of 3 years. XYZ
Ltd has a cost of capital of 5%. The details of the vehicle‟s cash operating costs for each year and
the resale value of at the end of each year are as follows:
Year 1 Year 2 Year 3
Cash operating costs $9,000 $10,500 $11,900
End-of-year resale value $14,000 $11,500 $ 8,400
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10.11 NPV and IRR Re-investment Assumptions
10.11.1 NPV Re-investment Assumption
It states that a project‟s interim cashflows are re-invested at the entity‟s cost of capital. This
sounds more appropriate because the cost of capital (WACC) is calculated using Ke, Kd(1-t),
Kp, etc which are themselves respective costs of sources of capital that are accessed from
financial markets. Hence the NPV re-investment assumption closely resembles what financial
markets offer entities that invest their excess cash resources.
10.11.2 IRR Re-investment Assumption
It states that a project‟s interim cashflows are re-invested at the project‟s IRR. This assumption is
largely problematic because there is no guarantee that such a re-investment rate is offered at the
time when those cashflows are generated throughout the project‟s lifespan.
10.12 Modified Internal Rate of Return (MIRR)
Although it takes into account the time value of money, IRR suffers from a myriad of
shortcomings explained below:
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IRR suffers from an unrealistic re-investment assumption that states that a project‟s interim
cashflows are re-invested at the project‟s IRR as explained in Section 10.11 above. This gives
the IRR investment appraisal technique an unrealistically over-optimistic view of a project under
consideration. Multiple IRRs are possible for a project with non-conventional cashflows ie a
project with positive and negative cashflows that alternate and this leads to confusion and
ambiguity.
The Modified Internal Rate of Return (MIRR) is a modification of IRR in order to resolve IRR‟s
shortcomings. It gives a more conservative picture of a project‟s viability as opposed to IRR‟s
overly optimistic nature which overstates the re-investment rate assumed . MIRR is only one for
a given project as opposed to the possibility of multiple IRRs.
( )
MIRR = [ √ ]–1
(
Example
A company faces a re-investment rate of 10% and financing rate of 15%. It is considering
investing in a project with the following cashflow projections:
Year Post-Tax Cashflows
0 (425,000)
1 140,000
2 140,000
3 140,000
4 140,000
5 240,000
Required
Calculate MIRR.
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Solution
Make sure you get MIRR = 17.57% using the following three methods:
Method 1
Manual Formula
Reinvested cashflows
Year Reinvested to end of Year n Future Value

0 $0(1+10%)5 $0
1 $140,000(1+10%)4 $204,974
2 $140,000(1+10%)3 $186,340
3 $140,000(1+10%)2 $169,400
4 $140,000(1+10%)1 $154,000
5 $240,000(1+10%)0 $240,000
∑FV $954,714
Financed cashflows
Year Reinvested to end of Year n Future Value

0 -$425,000/(1+15%)0 (425,000)
1 $0/(1+15%)1 $0
2 $0/(1+15%)2 $0
3 $0/(1+15%)3 $0
4
4 $0/(1+15%) $0
5 $0/(1+15%)5 $0
∑PV ($425,000)
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( )
MIRR = [ √ ]–1
(
=[ √ ]–1
( )
=[ √ ]–1
=[ √ ]–1
= 1.1757009584 – 1
= 0.1757
= 17.57%
Method 2
Financial Calculator
 IRR NPV Calculator

 MIRR Calculator
 Finance Rate, type 15
 Re-investment rate, type 10
 Enter the six cashflows from Year 0 to Year 5
 Click CALCULATE
 YOU GET MIRR = 17.57%
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Method 3
Microsoft Excel
 Go to any blank MS Excel worksheet and list the figures in a column as follows:
-425000
140000
140000
140000
140000
240000
 Go to ant blank cell and type +mirr( and it will show you the following:
+mirr(values, finance_rate,reinvest_rate)
 You highlight the six figures, put a comma or semicolon as appropriate, then type 15%,
comma or semicolon as appropriate, 10% and then close bracket and Click Enter.
 You get 17.57%
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11.0 RISK MANAGEMENT
11.1 Risk Categories
Risk falls into four main categories namely:
[1] Translation risk
[2] Transaction risk
[3] Economic Risk
[4] Political risk
These are further explained below:
[1] Translation risk is an accounting issue and of little consequence as far as the investment
decision is concerned. If, however, foreign borrowings constitute very huge figures, translation
risk becomes more pronounced.
[2] Transaction risk is the risk of adverse exchange rate movements between the transaction
date and the settlement date. This can be managed using internal or external hedging techniques
eg forward-rate contracts (external) or netting (internal).
[3] Economic risk is the risk of actions by governments and reactions of markets that trigger
economy-wide shocks eg interest rates, exchange rates, tax rates, exchange controls, etc. The
best way to manage such a risk is to raise finance from the host foreign country or by
manufacturing in the host country.
[4] Political risk is the risk that political actions will adversely affect an entity‟s operations and
valuation. Such actions may include import/export quotas/restrictions/bans, unfavourable health
and safety regulations, nationalisation or expropriation of assets.
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11.2 Risk Management - Hedging Techniques
Internal Hedging Techniques External Hedging Techniques

Invoicing in home currency Forward markets
Bilateral and multilateral netting Fixed forward exchange contract
Leading and lagging Option forward exchange contract
Matching Money market hedge
Futures
Options
11.2.1 Internal Hedging
Internal hedging involves utilising techniques available within the entity to manage exchange-
rate risks. These techniques do not operate through financial markets and hence save the
attendant transaction costs.
11.2.1.1 Invoicing in home currency
By invoicing in an entity‟s home currency, the transaction risk is not avoided but it is merely
transferred to the customer. The drawback of this technique is that the entity may be
outcompeted by its rivals.
11.2.1.2 Bilateral and Multilateral Netting
This is a form of matching popular among multinational enterprises with subsidiaries located in
many overseas countries. Bilateral netting is basically intra-group netting of payables and
receivables among two entities within the sage group of companies, often bypassing central
treasury. On the other hand, multilateral netting passes through central treasury and Head Office.
In multilateral netting, a base currency is identified and all intragroup transactions are indexed to
that currency, each subsidiary would then report its obligations to other subsidiaries or Head
Office to central treasury. The central treasury will then perform the intra-group nettings and
advises each subsidiary of their respective net positions within the group of companies. This
technique reduces exposure by minimising or even eliminating currency flows, although certain
jurisdictions outlaw netting involving international boundaries.
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11.2.1.3 Leading and Lagging
This method involves changing the timing of payments in an attempt to take advantage of
changes in the relative values of the currencies involved. Leading could be an immediate
payment in which the recipient‟s currency is weakening against the payer‟s currency. The
technique is mainly suitable for intra-group transactions among subsidiaries within the same
group of companies or also externally among frequently trading entities.
11.2.1.4 Matching
This is the use of receipts in a particular currency to match payment obligations in the same
currency. Matching is also common among subsidiaries within the same group who trade with
each other.
11.2.2 External Hedging Techniques
This involves the use of financial markets to hedge foreign currency movements.
11.2.2.1 Forward Markets
A forward contract involves one party agreeing to buy something and another party agreeing to
sell it at some future date, eg a specific currency, a specific good or a specific financial
instrument. An investor who takes a position by buying a forward contract is said to be in a long-
position, otherwise a position involving selling is known as a short-position.
11.2.2.2 Fixed Forward Exchange Contract
This is an agreement entered into today involving the purchase or sale of a fixed quantity of a
commodity, currency or other financial instrument on a fixed future date at a fixed price fixed
today. The fixed settlement date is problematic, and this problem can be overcome by using a
more flexible technique, an option forward exchange contract highlighted below:
11.2.2.3 Option Forward Exchange Contract
It is the same as its fixed counterpart explained above, except for an element of flexibility with
respect to choice of dates on which to exercise the contract.
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11.2.2.4 Money Market Hedge
This involves hedging using the money market.
11.2.2.5 Futures
Futures in the context of foreign exchange rates are contracts to buy or sell a certain amount of
foreign currency at a future date. Futures are tradable on a futures market such as Chicago
Merchantile Exchange.
11.2.2.6 Options
Options give the client the right, but not the obligation, to buy (call) or sell (put) a specific
amount of currency at a specific price on a specific date. An American Option can be exercised
at any time up to the exercise date while a European Option can only be exercised on the
exercise date.
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12.0 MERGERS,
ACQUISITIONS AND
CORPORATE
RESTRUCTURING
12.1 Introduction
Zimbabwe registered a surge in the incidence of mergers in 2011 in which it recorded a total of
eleven and these were mainly in the petroleum and fast moving consumer goods sectors. Notable
cases were the BP-Shell/FMI merger, Chevron Zimbabwe/Engen Holdings merger and the
Pioneer/Unifreight merger. Brealy and Myers (2013) posit that in 1998, American car maker
Chrysler Corporation merged with German car maker Daimler-Benz to form DaimlerChrysler.
This was described as a merger of equals as the chairmen in both companies became joint leaders
in the new organisation. The merger proved quite beneficial as it gave Chrysler an opportunity to
reach more European markets and Daimler-Benz gained a greater presence in North America
(Copeland et al, 2005). The Zimbabwean banking sector, on the other hand, witnessed numerous
mergers as banks battled to meet the minimum capital requirements thresholds. Before it went
belly up in 1999, the Korean conglomerate, Daewoo, had nearly 400 different subsidiaries and
150 000 employees. It built ships in Korea, manufactured microwaves in France, televisions in
Mexico, cars in Poland, fertilisers in Vietnam and managed hotels in China and a bank in
Hungary.
12.2 Definition of Terms
Merger refers to the fusion together, whether voluntary or forced, of two or more entities such
that the two entities join together to submerge their separate identities into a new entity.
Horizontal merger means a fusion that takes place between firms producing essentially similar
products ie operating in the same industry.
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Vertical merger involves the marriage of companies at different stages in the supply chain such
as an upstream supplier or a downstream customer.
Synergy is when the net present value of the combined entity is deemed to be greater than the net
present value of the individual firms, that is NPVAB > NPVA + NPVB
Earnings Per Share (EPS) is a portion of a company‟s post-tax profits that are attributable to
each equity share.
Market Price Per Share (MPS) refers to the fair value at which a share can be bought or sold on
the stock exchange.
12.3 Why Mergers Make Economic Sense
Oglivie (2009) posits that mergers would result in significant operational advantages including
efficiency improvement, increased market share, economies of scale, combining complementary
resources, conduit for deployment of surplus funds, enhanced synergies, tax efficiency and debt
capacity and all these benefits can potentially boost earnings per share and market price per
share.
The above-mentioned benefits arising from a merger are discussed in turn below:
12.3.1 Efficiency Improvement
Oglivie (2009) argues that one motive for a merger is to replace the existing management team.
He further argues that poorly performing firms tend to be targets for acquisition. However, firms
also acquire other firms for reasons that have nothing to do with inadequate management. Many
mergers and acquisitions are motivated by possible gains in efficiency from combining
operations.
12.3.2 Increased Market Share
The new entity formed through a merger will emerge with a stronger market share. In December
2013, American Airways and US Airways merged to create the world‟s biggest airline namely
the American Airlines. The deal brought American Airways out of the state of bankruptcy that it
had been in since 2011. Such a merger made it easier for the new combined entity to gain access
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to routes that would otherwise have been expensive and difficult to obtain, thereby increasing
market share and market dominance.
12.3.3 Economies Of Scale and Scope
Van Horne (2002) argues that many managers always seem to believe their firm would be more
competitive if only it were just a little bigger. He further posits that such managers hope for
economies of scale, that is, the opportunity to spread fixed costs across a larger volume of
output. These economies of scale are the natural goal of horizontal mergers. These emanate from
sharing central services such as accounting, financial control and top-level management.
Economies of scale also emerge in the form of higher bargaining power. This arises if former
competitors merge in a horizontal merger transaction amd, assuming that they were formerly
buying raw materials or inputs from the same suppliers, the new merged entity will wield a
higher bargaining power against its suppliers, thereby putting itself in a position that can attract
lower prices from such suppliers. Large industrial companies commonly like to gain as much
control and co-ordination as possible over the production process by expanding back towards the
output of the raw materials and forward to the ultimate consumer. One way to achieve this is to
merge with a supplier or a customer. Du Pont‟s purchase of an oil company, Conoco was vertical
integration because petroleum is the ultimate raw material for much of Du Pont‟s chemical
production.
Economies of scope or changes in product mix are another potential way in which mergers might
help improve the performance of the new entity. Economies of scope occur when it is more
economical to produce two or more products jointly in a single production facility than to
produce the products in separate specialising firms. Scope economies arise from two sources
namely the spreading of fixed costs over an expanded product mix and cost complementaries in
producing the different products. Economies of scope have triggered many mergers in the
financial sector the world over. A bank‟s computer systems are more fully utilised when they
issue not just banking products such as loans and deposits but also insurance, mobile money and
investment services. These additional services allow the spreading of fixed costs over a large
number of activities, thereby reducing the unit cost of each activity.
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12.3.4. Combining Complementary Resources
Many small firms merge with large firms that can provide the missing ingredients necessary for
the firm‟s success (Van Horne and Wachowicz, 2001). The small firm may have a unique
product but lack the engineering and sales organisation necessary to produce and market it on a
large scale. The firm could develop engineering and sales talent from scratch, but it may be
quicker and cheaper to merge with a firm that already has ample talent. The two firms have
complementary resources – each has what the other needs – so it may make sense for them to
merge. Also the merger may open up opportunities that neither firm would pursue otherwise. For
example, Federal Express‟ purchase of Caliber System, a trucking company, is an example.
Federal Express specialises in shipping packages by air, mostly for overnight delivery. Caliber‟s
RMS subsidiary moves non-express packages by truck. RMS greatly increases Federal
Express‟capability to move packages on the ground. At the same time, RMS-originated business
can move easily on the Federal Express system when rapid or distant delivery is essential.
12.3.5. Mergers As a Conduit For Deployment Of Surplus Funds
Suppose a firm is in a nature industry, generating a substantial amount of cash, but it has few
profitable investment opportunities. Ideally, such a firm should redistribute the surplus cash to
shareholders by increasing its dividend payment or repurchase its shares. Unfortunately,
energetic managers are often reluctant to shrink their firm in this way. If the firm is not willing to
purchase its own shares, it can instead purchase someone else‟s. Thus firms with a surplus of
cash and a lack of viable investment opportunities often turn to mergers financed by cash as a
way of deploying their capital. Firms that have excess cash and do not pay it out or redeploy it by
mergers/acquisition often find themselves targets for takeover by other firms that propose to
redeploy the cash for them.
During the oil price slump of the early 1980s, many cash-rich oil companies found themselves
threatened by takeovers. It therefore perfectly makes sense for a company with excess cash and
no viable investment opportunities to merge with a cash-poor firm with viable investment
opportunities. The additional value of combining these two firms lies in the present value of the
projects that would not have been undertaken if the two firms had stayed apart, but can now be
undertaken because of the availability of cash in the now merged entity.
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12.3.6. Enhanced Synergies
Oglivie (2009) opines that mergers enhance synergies such that the net present value of the
combined entity is deemed to be greater than the net present value of the individual firms, that is
NPVAB > NPVA + NPVB. Kumara and Satyanarayana (2013) argue that the 2006 merger
between Corus and Tata has resulted in the attainment of enhanced synergies and increased
capitalisation, both of which have given rise to higher earnings per share. Their sentiments have
been echoed by Gosh (2001) who found mergers and acquisitions to cause an improvement in
the concerned firms‟ operating performance. Pawaskar (2001) and Hitt et al (1998) posit that
during the post-merger period, liquidity performance improves and positive impact on financial
performance is realised.
12.3.7. Tax Efficiency and Debt Capacity
Gosh (2001) argues that an entity may be unable to claim tax relief as a result of its failure to
generate sufficient profits to do so. This has been echoed by Oglivie (2009) and Van Horne
(2002) who claim that such an entity may therefore wish to merge with another entity which
generates such profits so as to optimise the overall tax efficiency of the combined entity. It
follows that the tax paid by two firms combined together may be lower than the taxes paid by
them as separate individual firms. If one of them has tax deductions that it cannot claim because
it is losing money, while the other firm has income on which it pays significant taxes, the
combining of the two firms can lead to a tax benefit that can be shared by the two firms. The
value of this synergy is the present value of the tax savings that accrue because of this merger.
As far as debt capacity is concerned, combining two firms in a merger, each of which has little or
no capacity to carry debt, it is possible to create a firm that may have the capacity to borrow and
create value. Conglomerate merger leads to diversification which will in turn lead to an increase
in debt capacity and an increase in the value of the new entity. Another source of value when two
firms in different businesses merge is that the combined firm will have less variable earnings and
may be able to borrow more than would have been possible if they were to continue operating
separately. The new debt capacity will introduce the merged firm to tax-deductibility of debt
whose cash flow savings will enhance the firm‟s value.
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12.4 Impact on Earnings Per Share And Market Price Per Share Of The Acquiring
Company
Brealy et al (2003) argue that as long as the merger makes sense, that is if it results in an increase
in shareholders‟ wealth, it will result in increased earnings per share and a higher market price
per share as the market perception would assign a higher market value. On the other hand, in
cases where a merger does not lead to an increase in shareholders‟ wealth for the acquirer in a
Bootstrap Game, some conglomerate companies make acquisitions with no evident economic
gains. Despite this, the earnings per share (EPS) increases following the acquisition. This
emanates from the mathematical implication of buying a firm with a lower P/E ratio, but the
increase in EPS will not result in a higher share price. Brealy et al (2003) further argue that in the
short term, an immediate increase in earnings should be offset by lower future earnings growth.
As far as the acquiring company is concerned, notes Copeland et al (2005), the shareholders
seldom enjoy any benefits whereas the shareholders of the target company do. This therefore
implies that there will not be any impact on earnings per share and market price per share of the
acquiring entity. They further posit that a number of alternative theories explain the phenomenon
of such merger failure by postulating that the main motive of the management of a company
when they bid for another company is not maximisation of shareholders‟ wealth, but other
motives have been found to be consistent with empirical evidence. The agency theory suggests
that mergers and takeovers are primarily motivated by the self-interest of the acquirer‟s
management. One of the striking reasons that have been advanced to explain the divergence in
the interests of management and the shareholders of a company include diversification of
management‟s own portfolio, use of free cash flow to increase the size of the firm and acquiring
assets that increase the firm‟s dependence on management.
12.5 The Downside of Mergers and Why Mergers Often Fail
Oglivie (2009) opines that hostile takeovers often lead to costly battles as management of the
target company fight to protect their interests. It is necessary in such situations to ensure that the
defensive tactics that are adopted by the management of the target company do not hurt the
economic interests of the company and other stakeholders. The other potential downside of
mergers is that they reduce the level of competition within an industry, thereby resulting in the
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exploitation of consumers who will end up being charged a price in excess of marginal cost of
resources used to produce the last unit, ie P > MC. Many mergers that appear to make sense
nevertheless fail because managers cannot handle the complex task of integrating two firms with
different production processes, accounting methods, and corporate cultures as well as failure to
manage change. Moreover, the value of most businesses depends on human assets – managers,
skilled workers, scientists and engineers. If these people are not happy in their new roles in the
acquiring firm, the best of them will leave.
Vertical integration to extremes is absurdly inefficient eg before the Polish economy was
restructured, LOT, the Polish state airline, found itself raising pigs to make sure that its
employees had fresh meat on their tables. Vertical integration has been less popular of late.
Many companies are finding it more efficient to outsource the provision of many activities. Gosh
(2001) argues by way of an example that Du Pont seems to have become less convinced of the
benefits of vertical integration, for in 1999 it sold off Conoco. UK Breweries have moved
heavily into the distribution of their product via public houses. However, this attracted the
attention of the Competition Commission which swiftly acted to limit such activity after realising
that the development was against public interest. In Zimbabwe, the Competition and Tariff
Commission is the government-appointed authority that approves mergers and is responsible for
the protection of markets from monopolies and also to ensure that fair competition prevails
among various market players in the economy.
 An acquisition is the purchase of one business or company by another company or

other business entity, while a merger happens when two firms agree to go forward as
a single new company rather than remain separately owned and operated.
 Strictly , if one entity acquires a majority shareholding in another , the second is said
to have been acquired or taken over by the first. If the two entities join together to
submerge their separate identities into a new entity , the process is described as a
merger.
 Types of merger/acquisition
 Horizontal integration
 Vertical integration
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 Diversification
 Horizontal integration results in two entities in the same line of business combine. Bank
and building societies merger. CBZ and Berverly
 Vertical integration results in the entity going to its supplies or to the market , that is
distribution channel. Look at examples of these.
 Diversification results in the entity combining with another not in the same line of
business. Look at examples.
Synergy
It is defined as two or more entities coming together to produce a result not independently
obtainable. For successful business combination we should be looking at a situation where
the market value of the combined entity is greater than the market value of two independent
entities. If this situation occurs we have experienced a synergy , where the whole is worth
more than the sum of two parts. This is often expressed as 2+2=5. It is important to note that
the synergy is automatic. In an efficient stock market A and B will be correctly valued before
the combination and we need to ask how synergy will be achieved, i.e why an increase in
value should occur.
There are a wide variety of reasons why synergies gain arise. These can be broken
down into :
 Operating economies, such as economies of scale and elimination of inefficiency.
 Financial synergy , such as reduced risk caused by diversification
 Other synergies such as market power
 Economies of scale: the combined company can often reduce its fixed costs by removing
duplicate departments or operations, using combined buyer power to reduce purchasing
costs, reducing total spend on marketing and so on
 Access new markets: To support the business expansion (e.g. overseas)
 Purchase products, designs and brands: Quick access to the acquired companies
products and designs, particularly where these are complex, where they are patented or
where there is considerable customer loyalty to brands.
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 Increased revenue or market share: by absorbing a major competitor it increase its
market power (by capturing increased market share) (e.g. reducing supplier power and
increasing buyer power).
 On-selling: The acquired company‟s products can be sold to existing customers (and vice
versa).
 Taxation: A profitable company can buy a loss maker to use the target's loss as their
advantage by reducing their tax liability.
 Vertical integration: Vertical integration occurs when a organisation purchases a
supplier (e.g. to control supply and gain the margin) or a customer (e.g. to control the full
supply chain up to the end customer, and secure custom).
Diversification:
By operating in different products in different markets, risk can be reduced by not depending.
This is designed to smooth the earnings results of a company, which over the long term
smoothens the stock price of a company, giving conservative investors more confidence in
investing in the company. However, this does not always deliver value to shareholders (see
below).
 Staff acquisition: as a method of acquiring skilled and knowledgeable staff. This is
especially common when the target is a small private company or is in the start-up phase
with a specific focus or skill needed by the acquirer.
The reasons to sell the company can include:

 Value to shareholders: who may earn more from the sale than holding shares in the
existing company due to the benefits which can be derived from the companies being
merged.
 Exit strategy for founders or investors (e.g. venture capitalists)
 Release funds for investment: It may be that just part of the business is being sold, and
that money tied up in that part of the business to be sold which can be better invested
elsewhere.
 Strategic change: A part of the business may be sold due to a strategic change e.g.
focusing on other markets
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Forms and Terms of Consideration
Cash
Payment by cash is clear and simple and often preferable to the acquirer as they will have clear
and immediate liquidity as a known price. The acquirer will need to raise the funds, either from
their shareholders or via debt, which may be time consuming and difficult.
Shares
Payment is made in shares of the selling company. The acquired companies shareholders will
then own shares, which they could then either retain, or sell to raise cash, although the exact
value of these will depend on the initial market reaction to the acquisition. This is often less
attractive to the sellers as the exact amount they will receive is not entirely certain, but can be
more attractive to the buyer as there is no need to raise new equity or debt finance themselves.
The terms of the deal may also affect final ownership percentages, and this can be an issue in the
acquirer company if a key shareholder loses control of the business as a result
Convertibles
Convertible debt or preference shares can also be used as part of the consideration in deals. The
conversion to ordinary shares can be after a set period of time or based on certain performance
criteria of the firm being acquired. This is common on purchase of growing companies, as part of
the consideration is in the form of less risky debt finance (ensuring the investor retains
preference in a winding up and more secure interests payments), while also giving the purchaser
the option of converting their debt into equity if the company performs well.
Earn-out arrangements
An earn-out arrangement is where part of the total consideration payment for a business is
deferred. The seller receives a payment on completion of the deal and a further payment after an
agreed period based on future business performance. It is often useful where future earnings in
the acquired company are uncertain, for example when purchasing start up companies by venture
capital firms or angel investors. If the acquired firms management will continue to run the firm
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after acquisition it also serves as an incentive for them to perform well. Earn-out periods are
typically in the range 18 months to 3 years
There are some elements to think about when choosing the form of payment:
 Cash: Availability of cash or ability to raise debt finance to fund the deal, and the impact
on cash and liquidity in the combined company.
 Other bids: What are they offering and in what form and what is competitive?
 Variability of return to seller: e.g. cash is certain, shares less so.
 Gearing in the final combined company: Aiming to optimise the debt/equity ratio and
minimise WACC?
 Tax: The tax impact of the method of payment both to the purchaser and seller
What is a management buy-out?

 A management buyout (MBO) is a form of acquisition where a company's existing
managers acquire a large part or all of the company.
 Management buyouts are similar in all major legal aspects to any other acquisition of a
company. The particular nature of the MBO lies in the position of the buyers as managers
of the company, and the practical consequences that follow from that.
 In particular, the due diligence process is likely to be limited as the buyers already have
full knowledge of the company available to them.
 Purpose
 The purpose of such a buyout from the managers' point of view may be to save their jobs,
either if the business has been scheduled for closure or if an outside purchaser would
bring in its own management team.
 They may also want to maximise the financial benefits they receive from the success they
bring to the company by taking the profits for themselves. This is often a way to ward off
aggressive buyers.
 Financing
 Debt financing
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 The management of a company will not usually have the money available to buy the
company outright themselves. They would first seek to borrow from a bank, provided the
bank was willing to accept the risk.
 Management buyouts are frequently seen as too risky for a bank to finance the purchase
through a loan. Management teams are typically asked to invest an amount of capital that
is significant to them personally, depending on the funding source/banks determination of
the personal wealth of the management team. The bank then loans the company the
remaining portion of the amount paid to the owner.
 Pvt Equity/venture capital funding If a bank is unwilling to lend, the management will
commonly look to private equity investors or venture capitalists to fund the majority of
buyout. A high proportion of management buyouts are financed in this way.
 They generally aim to maximise their return and make an exit after 3–5 years while
minimising risk to themselves, whereas the management rarely look beyond their
careers at the company and will take a long-term view.
 As a condition of their investment, the backers will also impose numerous terms on the
management concerning the way that the company is run. The purpose is to ensure that
the management run the company in a way that will maximise the returns during the term
of the backers' investment,
 In certain circumstances, it may be possible for the management and the original owner
of the company to agree a deal whereby the seller finances the buyout.
 The price paid at the time of sale will be nominal, with the real price being paid over the
following years out of the profits of the company. The timescale for the payment is
typically 3–7 years.
 A “friendly” takeover is where the companies cooperate in negotiations. in the case of a
hostile deal , the board and/or management of the target is unwilling to be bought or the
target's board has no prior knowledge of the offer
 The management may resist the deal by advising shareholders not to sell, selling off
valuable assets or demerging part of the business. Hostile acquisitions can become
"friendly", as the purchaser secures endorsement of the transaction from the board of the
seller through negotiation.
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Defences
 Any listed company needs to be aware that a bid might be received at any time.
 The directors of a company subject to a hostile takeover bid should act in the best
interest of their shareholders.
 However in practice they will consider the views of other stakeholders.
 If the board of the target company decides to fight a bid that appears to be financially
attractive to their shareholders , then they should consider the following defences.
Pre bid defences

 Communicate effectively with shareholders
 Revalue non-current assets
 Poison pill
 Change the articles of association
Post bid defences

 Appeal to their shareholders
 Attack the bidder
 White knight
 Counter bid (pacman)
 Refer bid to the competition authorities
 Communicate effectively with shareholders
 This include having a public relations officer specialising in financial matters liaising
constantly with the entity stockbrokers, keeping analysts fully informed and speaking to
journalists.
 Revalue the non current assets
 Non current assets are revalued to the current value to the current value to ensure that the
shareholders are aware of the true assets value per share.
 Poison pill strategy.
 Here the target company takes steps before a bid has been made to make itself less
attractive to a potential bidder. The most common method is for existing shareholders to
be given rights to buy future bonds or preference shares.
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 Super majority
 The articles of association are altered to require that a higher percentage , say 80% of
shareholders have to vote for a takeover.
 Post-bid Defence Appeal to their shareholders
 For example by declaring that the value placed on the target company „s shares is too
low in relation to the real value and earning power of the company‟s assets, or
alternatively that the market price of the bidder‟s shares is unjustifiable high and is
not sustainable
 Attack the bidder
 Typically concentrating on the bidder‟s management style , overall strategy , methods of
increasing earnings per share, dubious accounting policies and lack of capital investment
 White Knight Strategy
This is where the directors of the target company offer themselves to a more friendly
outside interest. This tactic should be adopted in the last resort as it means that the
company will loose its independence.
 Pacman defence
Where the bidding company is itself the subject of a takeover bid by the target company.
 Competition authorities
The target entity could seek government intervention by bringing in competition
authorities.
Summary on Mergers and Acquisitions
The foregoing analysis reveals that mergers create synergies, enhance tax and operational
efficiencies, boost economies of scale, increase market share, deploy surplus funds, combine
complementary resources, improve earnings per share and ultimately boost market price per
share. It has been shown through both theory and empirical evidence that such key benefits are
reaped only if synergies, better management, or other changes make the two firms worth more
together than apart. In the event that a merger does not make sense, the acquirer‟s earnings per
share may rise but with no corresponding increase in its market price per share. If mergers result
in reduced competition and attract the ire of the competition authorities in any given country,
such authorities will intervene to safeguard consumer interests. Effective communication is a
151 | P a g e
crucial qualitative factor to be seriously adhered to in order to avoid post-merger pitfalls. New
reporting systems and procedures should only be introduced after proper consultation and staff
training in which management need to make clear their objectives and ensure that changes will
not cause disruption of operations.
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TYPICAL EXAMINATION
QUESTIONS
QUESTION 1
You are a student on attachment at Kundai Holdings. The company would like to raise $5
million in the next 50 months. It currently has $600,000 that it intends to deposit in a special
account with a local financial institution which pays 42% interest per annum, compounded
monthly. Your immediate supervisor is busy and has delegated an assignment to you to compute
the monthly instalment that needs to be paid at the end of every month. Calculate that instalment
and also re-compute it if the instalment is paid at the beginning of every month instead. Clearly
indicating the steps you would follow, verify your answer using an appropriate Microsoft Excel
Spreadsheet Function to convince your immediate supervisor that your manual calculations are
accurate. [10]
QUESTION 2
(i) A savings account pays 36% interest per annum compounded continuously. How much must
be invested now in order to accumulate to $100,000 at the end of 8 years? [3]
(ii) Explain the significance of the exponential constant [2.718281828] in the field of finance.[5]
QUESTION 3
Cecilia is contemplating either to borrow $50,000 at 36% per annum repayable at the end of evry
month for 18 months or to borrow $25,000 at 48% per annum repayable over 12 months. She
understands that you are an expert in financial mathematics. Demonstrate your financial
mathematical prowess by calculating the monthly instalment in each case and also by generating
the two respective loan amortisation schedules. Cecilia also asks for assistance in how a
spreadsheet can help in answering his queries. Explain to her accordingly. [10]
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QUESTION 4
A trust fund is set up to pay for the university education of a 2-year old boy. With the
arrangement, $120,000 will be paid to the student at the end of every quarter of 5 years starting
when he turns 18 years old. The fund earns 7.5% interest per annum compounded quarterly.
Calculate the sum that must be deposited now to kick-start the trust fund. [10]
QUESTION 5
A home-seeker would like to know how much would be the monthly payment for a 10-year
mortgage of $750,000 towards a house that he intends to buy if interest rate on the mortgage is
36% per annum compounded monthly. He realises that it is a Sunday and banks are closed. He
heard that you are a University student pursuing Corporate Finance/Financial Management as
one of your core courses. He then decides to approach you for a loan amortisation schedule for
the 120 months involved. Prepare the schedule for him. [10]
QUESTION 6
Using two timelines, two future value formulae and two present value formulae to illustrate your
answer, explain fully the difference between an ordinary annuity and an annuity due.
[5]
QUESTION 7
A home-seeker would like to know how much would be the monthly payment for a 25-year
mortgage of $955,000 towards a house that he intends to buy if interest rate on the mortgage is
30% per annum compounded monthly. Calculate the monthly instalment and generate the loan
amortisation schedule for the first year. How does the $955,000 principal sum differ with the
present value of that instalment if it were a perpetuity. [5]
QUESTION 8
Prepare a loan amortization schedule for a $3,000 loan at 45% per annum compounded weekly,
repayable at the end of every week for 25 weeks. In addition, demonstrate your financial
mathematical prowess by calculating the weekly instalment using MS Excel and clearly show all
the steps involved. [10]
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QUESTION9
A trust fund is set up to pay for the university education of a 10-year old boy. Under the
arrangement, $10,000 will be paid to the student at the end of every month for two years starting
when he turns 21 years old. The fund earns 15% interest per annum compounded monthly.
Calculate the sum that must be deposited now to launch the trust fund. [10]
QUESTION 10
A self-employed investor who has just turned 35 years og age wants to save for his retirement
with a savings account. He plans to retire at his 65th birthday and wants a monthly income of
$2000 until he dies. He has budgeted conservatively assuming he will die at 95. Assume that
until he reaches 65, the savings account earns 8% interest per annum compounded annually. At
the age of 65, assume that the interest accumulated in the savings account pays a lumpsum tax of
30%. Thereafter, assume that the investor is in a zero % bracket and that the interest on his
account earns 7% interest per annum compounded monthly. How much should the investor
deposit annually in his savings account beginning on his 35th birthday and ending on his 64th
birthday to finance his retirement? [25]
QUESTION 11
(a) For each of the four $1000 bond instruments tabulated below, calculate, amortise and
interpret the value of each bond using the following formula:
VB = [ ∑ ]+[ ] in each of the following two circumstances:

( ) ( )
(i) if the interest is compounded on an annual basis. [10]
(ii) if the interest is compounded on a semi-annual basis. [10]
155 | P a g e
Bond Coupon Rate Per Yield to Maturity Time to Maturity
Annum
A 12.8% 9.7% 6 years
B 9.6% 9.6% 5 years
C 0% 12% 7 years
D 8.5% 11.4% 8 years
(b) Explain how each of your answers above can be verified using both an Excel Spreadsheet
and the Financial Calculator. [5]
QUESTION 12
(a) Derive Gordon‟s Constant Dividend Growth Model of share valuation. [5]
(b) Using an appropriate curve-fitting software, show that the dividend on an ordinary share for a
certain listed entity from Year 0 [Do] of $2 that grows by a constant growth rate of 6% per
annum will give rise to an exponential function rather than a linear function. Show that the curve
will be as follows:
4
3.5 y = 2e0.0583x
3
2.5
2
1.5
1
0.5
0
0 2 4 6 8 10 12
[5]
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(c.) Critically evaluate the weaknesses of the dividend growth behaviour depicted in the graph
above. [5]
(d). Explain the relationship between the two alternative functions Dn = Do(1+g)n and
Dx = 2e0.0583x , clearly showing how the former can be transformed into the latter. Explain
how each one of these two functions can be used to predict the 16th year‟s dividend per share.
[5]
(e) Discuss the usefulness of the Capital Asset Pricing Model (CAPM). [5]
QUESTION 13
A‟s directors have decided to embark on major capital expenditure, which will be financed by a
major issue of funds. The estimated project cost is $6 million, part of which will be financed by
equity, and the rest of which will be financed by bonds. As a result of undertaking the project,
the cost of equity (existing and new shares) will rise from 10% to 13%. The cost of preference
shares and the after-tax cost of existing bonds will remain the same, while the after-tax cost of
the new bonds will be 10%.
BEFORE :
Source of Capital After-Tax Cost Market Value

Equity 10% $11 million
Preference share capital 10% $ 3 million
Bonds 8.5% $ 9 million
AFTER :
Source of Capital After-Tax Cost Market Value
Equity 13% $14 million
Preference share capital 10% $ 3 million
Existing Bonds 8.5% $ 9 million
New Bonds 10% $ 3 million
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REQUIRED
[i] Calculate the Current WACC [7]
[ii] Calculate the Revised WACC [8]
[iii] Calculate the Marginal WACC [7]
[iv] Explain the three circumstances under which MWACC is appropriate as opposed to WACC
in evaluating a new proposed project. [3]
QUESTION 14
Construct your own PV of Cash Flow and PV of Ordinary Annuity Financial Tables in MS
Excel (use one worksheet only) using 20 rows from Period 1 to Period 20 as well as 20 columns
from 1% to 20%. Use of 5 decimal places is required.
Marks will be allocated towards:

• MS Excel Formulae
• Originality
• A footnote below each Financial Table briefly explaining what the Financial Table
seeks to achieve.
QUESTION 15
PQR Ltd, whose cost of capital is 10%, operates a machine which cost $25,000 and has a useful
life of 4 years. The details of the machine‟s running costs for each year, which are all cash except
for depreciation on a straight line basis, and the resale value at the end of each year are as
follows:
Year 1 Year 2 Year 3 Year 4
Running costs $13,750 $17,250 $18,750 $21,250
End-of-year resale value $15,000 $10,000 $ 7,500 $ 2,500
Please note that in your depreciation computation, you are advised to ignore scrap value.
158 | P a g e
REQUIRED
Determine the optimal replacement cycle of the machine. In your capacity as the Finance
Director of PQR Ltd, write a report to the Board of Directors highlighting your findings and the
basis of your calculations. Also prepare a short presentation in the form of 8 to 10 slides for
presentation in the special meeting of the Board. [25 marks]
QUESTION 16
[a] Explain the Efficient Market Hypothesis‟ three forms [9]
[b] Discuss the implications of efficient capital markets for a corporate finance manager who
wishes to maximise shareholder wealth [10]
[c] Outline how empirical research has generally been undertaken to test the validity of the
Efficient Market Hypothesis [6]
QUESTION 17
ABC plc specialises in the manufacture of sportswear. Sales in the current year have been $5.2
million. The terms of sale are 2% discount 14 days, net 28 days, although those customers not
taking the discount actually take longer than 28 days to pay on average. The current level of
debtors is $500,000, included in which are the one half of ABC's customers who take advantage
of the cash discount. 1% of credit sales become bad debts. The net operating margin (excluding
bad debts and discounts) for ABC is 25% of sales.
The company is considering a change in its credit policy to 4% discount 14 days, net 28 days. It
anticipates the following effects of this change:
Sales to increase by 10% pa
75% of customers to take advantage of the discount
The period of time before payment for customers not taking the discount to increase by one
week
Bad debts to fall to 0.5% of sales
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ABC's cost of finance is 12%.
Required:
(a)Calculate the financial implications of this change in credit policy and give your advice on the
proposed change.
(b)Debtors and credit control are, of course, only one aspect of working capital management.
What policies may produce savings in other items of working capital?
(c )Discuss some of the potential difficulties attached to the management of working capital.
QUESTION 18
(a).The following probability distribution has been established in respect of Project X:
Probability 10% 40% 30% 20%

NPV $75,000 $90,000 $150,000 $200,000
Calculate the project‟s Expected Net Present Value (ENPV), Variance, Standard Deviation and
Coefficient of Variation.
(b).The following financial information has been collected by a firm for its investment
considerations:
Security E(R.) σ Correlation with

Market
A 18% 60% 75%
B 14.5% 75% 80%
C 14% 80% 85%
D 25% 70% 90%
E 15% 50% 95%
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Given that the standard deviation of the market is 40%,
(i) Calculate the variance of each security and the market
(ii) Calculate the beta of each security.
(iii) Given that Rf = 7% and Rm = 12%, calculate the required rate of return
of each security
(iv) Identify the over, under and correctly valued securities.
QUESTION 19
Menang Bhd, which has a cost of capital of 12%, is considering the investment of $7 Million in
an improved conveyor belt system with a life of five years. Straight line depreciation applies
with zero salvage value. The output produced will sell at $8.00 each and variable cost is
expected to be $4.00 and cash fixed cost will be $200,000. It is expected that 800,000 units will
be sold each year. The company‟s tax rate is 25%.
Assume that the managers are fairly confident of their estimates of all the project‟s cash flow
variables except price and unit sales. Further, they regard a drop in unit sales below 700,000 or a
rise above 900,000 units as being extremely unlikely and they expect the selling price to fall
within the range of $ 6.00 to $ 9.00. Thus, 700,000 units @ $6.00 defines the lower bound or the
worst-case scenario, while 900,000 units @ $9.00 defined the upper bound, or the best-case
scenario. The base case or most likely values are 800,000 units @ $ 8.00.
Probability
Worst case 0.25
Most likely case/Base case 0.50
Best case 0.25
The company will only accept projects with coefficient of variation less than 2.50.
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FORMULA SHEET
BUSINESS MATHEMATICS
 nt
(1+r) R[ 1 (1 i ) ] ( )
Present Value of an Annuity Due: P = i or PVOA = PMT(1+r)[ ]
R[ (1i i) 1 ] or FVOA =
nt
(1+r) ( )
Future Value of an Annuity Due: A = PMT(1+r)[
COST OF CAPITAL & VALUATION OF SECURITIES
Weighted Average Cost of Capital : [WACC] = Ke + Kd(1-T)
Capital Asset Pricing Model : E(r.) = Rf + βi(E(rm) – Rf)
Dividend Valuation Model : Po = +( +( + ….. =

) )
( )
Dividend Growth Model (Perpetuity) : Po = =
Value of Preference Shares: Po = +( +( + ….. =

) )
Value of Redeemable Debt : Po = +( +( + ….. + (

) ) )
( )
Value of an Ungeared Company : Vu =
( )
Value of a Geared Company : Vg = +
Cost of Equity of a Geared Company: (Without Taxes) : Keg = Keu + (Keu – Kd)
Cost of Equity of a Geared Company : (With Taxes) : Keg = Keu + (Keu – Kd)(1-T)
EARNINGS-BASED VALUATION BASES
Earnings Yield =
Price Earnings (P/E) Ratio =
( )
Market Value of a Company (Earnings with growth) =
END OF FORMULA SHEET
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FINANCIAL TABLES
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PRESENT VALUE OF $1 to be receivable or payable at the end of n periods
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149
Period 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065
16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054
17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045
18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038
164 | P a g e
19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031
20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026
Present Value of an Annuity of $1, receivable or payable at the end of each of n periods
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.678 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.351 14.877 13.590 12.462 11.470 10.594 9.818 9.129 8.514
Period 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
165 | P a g e
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843
20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870
166 | P a g e
REFERENCES
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Brealy, R.A. and Myers, S.C. (2013) : “Principles of Corporate Finance”; McGraw Hill, New
York
Brealy, R.A. and Myers, S.C. and Marcus (2003) : “Fundamentals of Corporate Finance”;
McGraw Hill, New York
Coase, R. H. (1937) :„The Nature of the Firm‟; Economica , Vol 4, pp 386-405
Copeland, T.E.; Weston, J.F.; Shastri, K (2005): “Financial Theory and Corporate Policy”; 4th
Ed; Pearson/Addison Wesley, New York
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Review, Vol 14 pp 57-74
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Acquisitions?”, Journal of Corporate Finance pp151-178
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Studies, Vol 29, pp 134-154
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for US Firms”, British Journal of Management Vol 9; pp91-114
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Jensen, M. and Ruback, R.S. (1983) :„The market for corporate control : The scientific
evidence‟; Journal of Financial Economics, Vol 11 PP 5-50
Kumara, M and Satyanarayana, N.V. (2013) : “An Analysis of the Impact of Merger and
Acquisition of Corus by Tata Steel” IOSR Journal of Business and Management Vol 11 pp41-47
Ogilvie, J (2009) : “F3 - Financial Strategy”, CIMA Official Learning System, CIMA
Publishing, Elsevier, UK.
Olokoyo, F.O. (2013) : Capital Structure and Corporate Performance of Nigerian Quoted Firms :
A Panel Data Approach, African Developmnt Review, Vol 25(3).
Pawaskar, V (2001) : “Effect of Merger on Corporate Performance in India”, Vikalpa, Vol 26
Phuong, L.T.V. and Nguyet, P.T.B. (2017) : Capital Structure and Firm Performance : Empirical
Evidence from a Small Transition Country”, Research in International Business and Finance, Vol
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Salim, M and Yadav, R (2012) : Capital Structure and Financial Performance : Evidence from
Malaysian Listed Companies”, Procedia – Social and Behavioural Sciences, Vol 65, pp 156-166.
Van Horne, J.C. and Wachowicz Jr, J.M. (2001) : “Fundamentals of Financial Management”;
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169 | P a g e

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THE CATHOLIC UNIVERSITY OF

Faculty of Commerce, Innovation and

[2] Bachelor of Business Management Finance Honours Degree

[3] Bachelor of Accounting Honours Degree

Contacts : +263 786 935 295 / +263 772 676 275

Lecturer: Forward Kufakunesu

1.0 Course Name: CORPORATE FINANCE 1B

3.0 Course Overview

4.0 Course Aims

At the end of the course, students are expected to:

1. Understand advanced financial mathematics and demonstrate formula derivation.

6.0 Learning and Teaching Activities (Course Delivery)

6.1 Attendance at Lectures and Tutorials

7.0 Schedule of Teaching Activities

 Present Value of a single cashflow

(6) Self-directed learning

3 5(2) Advanced Investment Appraisal Techniques

(6) Self-directed learning

(6) Self-directed learning

(6) Self-directed learning

7 Working Capital Management

(8) Self-directed learning

7.1 Summary of Student Workload and Total Study Time (TST)

Activity Time Commitment (hours)

Activity Time Commitment (hours)

7.1.3 Assessment Time (AT)

Activity Time Commitment (hours)

8.2 Formative Assessment

8.3 Student Feedback

8.4 Summative Assessment

SCENARIO 1 – PV followed by FV, with no instalments (PMTs) in-between

Scenario 1 is described by the following relationship between PV and FV as mapped by r and n:

Compounding involves finding FV given PV, r and n: FV = PV(𝟏 + 𝐫)

Discounting involves finding PV given FV, r and n: PV = (𝟏 𝐫)

FURTHER ASPECTS OF FINANCIAL MATHEMATICS

Derivation of Continuous Compounding Formula

Recall that Compounding‟s formula: FV = PV(𝟏 + 𝐫)

Also recall that Discounting‟s formula: PV = (𝟏 𝐫)

PRESENT VALUE (PV)

INTEREST RATE PER PERIOD (RATE)

PV of $1 Cashflow at the end of Period n

Study the timeline below:

PMT PMT PMT PMT PMT ……………………………………………….. PMT

PMT PMT PMT PMT PMT PMT .... .... PMT

Multiply both sides by ( )

Subtract Equation [2] from Equation [1]

LOAN AMORTISATION SCHEDULE

1.3 SCENARIO 3 – PV followed by a series of PMTs forever

1.4 SCENARIO 4 – A series of PMTs followed by FV

Method 2 – Manual Formula $28,967.22

Method 3 – Financial Calculator $28,967.22

Method 3 – MS Excel FV Function $28,967.22

Derivation of the Formula approximated by Rule of 72

10% n = Log2/Log1.1 = 7.27 years n = 72/10 = 7.2 years

(b) Geometric Mean = √( + )( + )( + ) ( + )] - 1

= 5.809% per year

To demonstrate that your answer is correct, to perform the following exercise:

How to Use the Financial Calculator

Class Exercise Without Answers

How to Use Microsoft Excel

Geared and Ungeared Beta

The Relationship Between Risk and Return

[1] Sharpe‟s Ratio =