CIMA’S Official Study System

Strategic Level

Management Accounting – Financial Strategy
John Ogilvie Christine Parkinson

AMSTERDAM BOSTON HEIDELBERG PARIS SAN DIEGO SAN FRANCISCO

LONDON NEW YORK SINGAPORE SYDNEY

OXFORD TOKYO

CIMA Publishing An imprint of Elsevier Linacre House, Jordan Hill, Oxford OX2 8DP 30 Corporate Drive, Burlington, MA 01803 First published 2005 Copyright © 2005, Elsevier Ltd. All rights reserved
No part of this publication may be reproduced in any material form (including photocopying or storing in any medium by electronic means and whether or not transiently or incidentally to some other use of this publication) without the written permission of the copyright holder except in accordance with the provisions of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London, England W1T 4LP. Applications for the copyright holder’s written permission to reproduce any part of this publication should be addressed to the publisher Permissions may be sought directly from Elsevier’s Science and Technology Rights Department in Oxford, UK: phone: ( 44) (0) 1865 843830; fax: ( 44) (0) 1865 853333; e-mail: permissions@elsevier.co.uk. You may also complete your request on-line via the Elsevier homepage (http://www.elsevier.com), by selecting ‘Customer Support’ and then ‘Obtaining Permissions’

British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN 0 7506 6715 X For information on all CIMA publications visit our website at www.cimapublishing.com

Important Note A new edition of the CIMA Official Terminology is due to be published in September 2005. As this is past the publication date of this Study System the page reference numbers for ‘Management Accounting Official Terminology’ contained in this Study System are for the 2000 edition. You should ensure that you are familiar with the 2005 CIMA Official Terminology (ISBN 0 7506 6827 X) once published, available from www.cimapublishing.com Typeset by Newgen Imaging Systems (P) Ltd, Chennai, India Printed in Great Britain

Contents

The CIMA Study System
Acknowledgements How to use your CIMA Study System Study technique Management Accounting – Financial Strategy Syllabus Transitional arrangements

xi xi xi xiii xiv xix 1 1 1 2 3 3 4 5 7 8 10 10 11 12 12 12 13 13 14 16 18 18 19 19 20 20 20 21 22 22 24
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1 Formulation of Financial Strategy
1.1 Introduction 1.2 Objectives of profit-making entities 1.2.1 Financial objectives 1.2.2 Non-financial objectives 1.2.3 Agency theory 1.2.4 Shareholder value analysis 1.3 Objectives of not-for-profit organisations 1.3.1 The three ‘E’s 1.4 Public and private – similarities and differences 1.5 Assessing attainment of financial objectives 1.5.1 Financial performance indicators 1.5.2 Non-financial performance indicators 1.6 The three key decisions of financial management 1.6.1 Investment decisions 1.6.2 Financing decisions 1.6.3 Dividend decisions 1.7 Policies for distribution of earnings 1.7.1 Practical dividend policies 1.7.2 Theory of dividend irrelevance 1.7.3 Scrip dividends 1.7.4 Share repurchases 1.8 The impact of internal and external constraints on financial strategy 1.8.1 Internal constraints 1.8.2 External constraints 1.9 Developing financial strategy in the context of regulatory requirements 1.9.1 Corporate Governance and the Cadbury Report 1.9.2 The Greenbury Report 1.9.3 The Hampel Report 1.9.4 Regulatory bodies 1.9.5 The regulation of takeovers and the competition commission
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1.10 Major economic influences 1.10.1 Interest rates 1.10.2 Term structure of interest rates 1.10.3 Inflation 1.10.4 Exchange rates 1.11 Modelling and forecasting cash flows and financial statements 1.11.1 Forecasting cash flows 1.11.2 Forecasting financial statements 1.11.3 Sensitivity analysis 1.12 Current and emerging issues in financial reporting 1.12.1 IFRS 1 first time adoption of IFRS 1.12.2 IFRS 2 Share-based payment 1.12.3 Reporting environmental issues 1.12.4 Reporting of social issues 1.12.5 Inclusion of forecasts in the annual report 1.12.6 Reporting of human capital 1.13 Summary
Readings Revision Questions Solutions to Revision Questions

26 26 27 30 30 31 31 32 35 36 36 36 38 40 42 42 43 45 51 53 59 59 59 60 60 61 61 62 62 63 64 64 64 65 65 65 65 66 66 66 67 67 67 68

2 Financial Management
2.1 Introduction 2.2 The finance function 2.2.1 Evaluating key success factors in the management of the finance function 2.3 The treasury function 2.3.1 The role of the treasury function 2.3.2 Cost centre or profit centre 2.4 Financial markets 2.4.1 Money market 2.4.2 Capital or securities market 2.4.3 The foreign exchange market 2.4.4 Derivatives markets 2.5 Share price volatility 2.5.1 Technical analysis or chartism 2.5.2 Fundamental analysis 2.5.3 Random Walk Theory 2.6 The efficient market hypothesis 2.6.1 Weak form 2.6.2 Semi-strong form 2.6.3 Strong form 2.6.4 Implications of EMH for financial managers 2.7 Investor ratios 2.7.1 Market price per share 2.7.2 Earnings per share
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2.7.3 The price/earnings ratio 2.7.4 Earnings yield 2.7.5 Dividend-payout rate 2.7.6 Dividend yield 2.7.7 Dividend cover 2.7.8 Book value per share 2.8 Working capital management strategies 2.8.1 The investment decision 2.8.2 The financing decision 2.8.3 Multinational working capital management 2.9 Summary
Readings Revision Questions Solutions to Revision Questions

68 69 69 69 70 71 71 72 72 74 74 75 77 79 85 85 85 85 86 87 87 87 88 89 94 95 95 96 98 99 100 100 100 101 101 104 108 109 110 110 111 113 117 123
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3 Sources of Long-term Finance
3.1 Introduction 3.2 Shareholders’ funds 3.2.1 Ordinary shares 3.2.2 Preferred and deferred ordinary shares 3.2.3 Preference shares 3.2.4 Reserves 3.3 Raising share capital – the stock market 3.3.1 New issues 3.3.2 Rights issues 3.3.3 Share splits and bonus issues 3.4 Debt finance 3.4.1 Debentures 3.4.2 Debt yields 3.4.3 Convertibles 3.4.4 Warrants 3.5 Medium-term financing 3.5.1 Term loans 3.5.2 Mezzanine finance 3.5.3 The lender’s assessment of creditworthiness 3.5.4 Leasing 3.5.5 Lease-or-buy decisions 3.6 Financing of small businesses 3.6.1 Venture capital 3.6.2 Business ‘angels’ 3.6.3 Government assistance 3.7 Summary
Readings Revision Questions Solutions to Revision Questions

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4 Capital Structure and Cost of Capital
4.1 Introduction 4.2 Measuring gearing 4.2.1 Capital gearing 4.2.2 Interest cover 4.2.3 Leverage 4.3 Cost of capital 4.3.1 Cost of equity 4.3.2 Cost of debt 4.3.3 Cost of preference shares 4.4 Weighted average cost of capital 4.4.1 Assumptions in the use of WACC 4.5 Marginal cost of capital 4.6 The traditional theory of gearing 4.7 Modigliani and Miller’s theories of gearing 4.7.1 Limitations of MM theory 4.8 Cost of capital and adjusted cost of capital 4.8.1 Adjusted present value 4.8.2 Adjusted cost of capital – Modigliani and Miller 4.9 Risk and reward 4.10 Portfolio theory 4.10.1 Systematic risk and unsystematic risk 4.11 The capital asset pricing model 4.11.1 Measuring beta values 4.11.2 The security market line 4.12 Using the CAPM as an investment tool 4.13 MM, CAPM and geared betas 4.13.1 Ungearing beta 4.13.2 Geared equity beta 4.14 Use of CAPM in investment appraisal 4.14.1 Limitations of CAP-M 4.15 Arbitrage pricing model 4.16 Summary
Readings Revision Questions Solutions to Revision Questions

133 133 134 134 136 136 137 138 142 144 144 146 146 148 149 154 154 154 156 157 158 161 162 164 165 167 168 168 170 171 172 172 173 175 181 187 197 197 198 198 198 198 198 199

5 Business Valuations
5.1 Introduction 5.2. Asset-based valuations 5.2.1 Choice of valuation base 5.2.2 Merits of asset-based valuations 5.3 Earnings-based valuations 5.3.1 P/E ratio valuation 5.3.2 Earnings yield valuation

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5.4 Dividend-based valuations 5.4.1 Dividend yield 5.4.2 Dividend growth model 5.4.3. Problems of dividend-based valuations 5.4.4 Capital asset pricing model 5.5 Cash-based valuations 5.5.1 Discounted cash flow 5.5.2 Shareholder value analysis 5.6 Business valuations and efficient markets 5.7 Intellectual capital 5.7.1 Forms of intellectual capital 5.7.2 The components of intellectual capital 5.7.3 Valuing intellectual capital 5.7.4 Comparative indicators 5.8 The impact of changing capital structure 5.9 Recognition of the interests of different stakeholder groups in company valuations 5.9.1 Liquidation 5.9.2 Re-financing 5.9.3 Mergers and acquisitions 5.10 Summary References
Readings Revision Questions Solutions to Revision Questions

199 200 200 200 201 201 201 202 202 203 203 205 208 211 213 213 213 214 214 214 214 215 223 227 235 235 235 235 236 236 237 237 238 238 238 239 240 240 240 240 242 242 248

6 Mergers, Acquisitions and Buyouts
6.1 Introduction 6.2 Terminology and types of merger 6.2.1 Terminology 6.2.2 Types of merger 6.3 The reasons for merger or acquisition 6.4 Defences against takeover 6.4.1 Before the bid 6.4.2 After the bid 6.5 Methods of payment for an acquisition 6.5.1 Cash 6.5.2 Share exchange 6.5.3 Other types of finance 6.5.4 Earn-out arrangements 6.6 The post-merger or post-acquisition integration process 6.6.1 Impact on ratios or performance measures 6.6.2 Acquirer’s post-acquisition share price 6.6.3 Example of share valuation, its effects and reasons for acquisition 6.7 Reasons why mergers and acquisitions fail

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6.8 Management buyouts 6.8.1 Financing MBOs 6.8.2 Evaluation by investors and financiers 6.9 Reconstruction 6.9.1 Effect on the share price of a listed company 6.10 Summary
Readings Revision Questions Solutions to Revision Questions

249 249 250 251 252 252 253 257 265 275 275 276 278 279 279 279 280 283 284 285 286 287 288 288 290 291 293 297

7 Investment Appraisal Techniques
7.1 Introduction 7.2 Accounting rate of return 7.3 Payback 7.3.1 Discounted payback 7.4 Discounting techniques 7.4.1 Net present value 7.4.2 Internal rate of return 7.4.3 Modified internal rate of return 7.4.4 Discussion of techniques 7.5 Capital rationing 7.5.1 Single-period capital rationing 7.5.2 Single-period rationing with mutually exclusive projects 7.5.3 Single-period rationing with indivisible projects 7.6 Annual equivalent cost 7.6.1 Asset replacement cycles 7.7 Summary
Revision Questions Solutions to Revision Questions

8 Advanced Investment Appraisal Techniques
8.1 Introduction 8.2 Taxation 8.2.1 Depreciation and capital allowances 8.3 Inflation 8.4 Working capital 8.5 Identification of a project’s relevant costs and benefits 8.6 Linking investment in IS/IT with strategic, operational and control needs 8.6.1 Benefits of a formal strategy 8.6.2 IS, IT and IM strategy 8.6.3 Content of information systems strategy 8.6.4 Cost–benefit analysis 8.6.5 Evaluating system performance
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8.7 Adjusting for risk 8.7.1 Sensitivity analysis 8.7.2 Decision trees 8.7.3 Certainty equivalents 8.7.4 The discount rate 8.7.5 Adjusted discount rate 8.7.6 Capital asset pricing model 8.8 Evaluating and reporting investment opportunities 8.9 Adjusted present value 8.10 Assessing investments as options on future cash flows 8.10.1 The abandonment option 8.10.2 Timing options 8.10.3 Strategic investment options 8.10.4 Valuing options 8.11 Project implementation and control 8.11.1 The investment cycle 8.11.2 Post-completion auditing 8.11.3 Benefits of post-completion auditing 8.11.4 Organisation of PCA 8.11.5 Role of post-appraisal in project abandonment 8.12 Summary
Readings Revision Questions Solutions to Revision Questions

316 316 319 320 320 321 321 322 324 326 326 329 330 330 330 330 332 332 333 334 334 337 343 349

9 Financing and Appraisal of Overseas Operations
9.1 9.2 9.3 9.4 Introduction Financing overseas operations – a global strategy The effect of restrictions on remittances The Euromarkets 9.4.1 Eurocurrency markets 9.4.2 Eurobonds The effect of taxation 9.5.1 Double taxation relief International capital budgeting APV method Summary
Revision Questions Solutions to Revision Questions

9.5 9.6 9.7 9.8

359 359 359 361 361 362 362 362 362 363 366 368 369 373 381 381 381 382 382
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Preparing for the Examination
Revision technique Planning Getting down to work Tips for the final revision phase

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Format of the examination Structure of the paper Types of question Allocation of time Weighting of subjects

382 382 383 383 384 387 419 479 519 611

Case-study Questions
Solutions to Case-study Questions Scenario Questions Solutions to Scenario Questions

Index

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The CIMA Study System

Acknowledgements
Every effort has been made to contact the holders of copyright material, but if any here have been inadvertently overlooked the publishers will be pleased to make the necessary arrangements at the first opportunity.

How to use your CIMA Study System
This Management Accounting – Financial Strategy Study System has been devised as a resource for students attempting to pass their CIMA exams, and provides:
● ● ● ●

A detailed explanation of all syllabus areas; extensive ‘practical’ materials, including readings from relevant journals; generous question practice, together with full solutions an exam preparation section, complete with exam standard questions and solutions

This Study System has been designed with the needs of home-study and distancelearning candidates in mind. Such students require very full coverage of the syllabus topics, and also the facility to undertake extensive question practice. However, the Study System is also ideal for fully taught courses. The main body of the text is divided into a number of chapters, each of which is organised on the following pattern:

Detailed learning outcomes. expected after your studies of the chapter are complete. You should assimilate these before beginning detailed work on the chapter, so that you can appreciate where your studies are leading. Step-by-step topic coverage. This is the heart of each chapter, containing detailed explanatory text supported where appropriate by worked examples and exercises. You should work carefully through this section, ensuring that you understand the material being explained and can tackle the examples and exercises successfully. Remember that in many cases knowledge is cumulative: if you fail to digest earlier material thoroughly, you may struggle to understand later chapters. Readings and activities. Some chapters are illustrated by more practical elements, such as relevant journal articles or other readings, together with comments and questions designed to stimulate discussion.
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Question practice. The test of how well you have learned the material is your ability to tackle exam-standard questions. Make a serious attempt at producing your own answers, but at this stage do not be too concerned about attempting the questions in exam conditions. In particular, it is more important to absorb the material thoroughly by completing a full solution than to observe the time limits that would apply in the actual exam. Solutions. Avoid the temptation merely to ‘audit’ the solutions provided. It is an illusion to think that this provides the same benefits as you would gain from a serious attempt of your own. However, if you are struggling to get started on a question you should read the introductory guidance provided at the beginning of the solution, and then make your own attempt before referring back to the full solution.

Having worked through the chapters you are ready to begin your final preparations for the examination. The final section of this CIMA Study System provides you with the guidance you need. It includes the following features:
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A brief guide to revision technique. A note on the format of the examination. You should know what to expect when you tackle the real exam, and in particular the number of questions to attempt, which questions are compulsory and which optional, and so on. Guidance on how to tackle the examination itself. A table mapping revision questions to the syllabus learning outcomes allowing you to quickly identify questions by subject area. Revision questions. These are of exam standard and should be tackled in exam conditions, especially as regards the time allocation. Solutions to the revision questions. As before, these indicate the length and the quality of solution that would be expected of a well-prepared candidate.

If you work conscientiously through this CIMA Study System according to the guidelines above you will be giving yourself an excellent chance of exam success. Good luck with your studies!

Guide to the Icons used within this Text
Key term or definition Equation to learn Exam tip to topic likely to appear in the exam Exercise Question Solution Comment or Note
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Study technique
Passing exams is partly a matter of intellectual ability, but however accomplished you are in that respect you can improve your chances significantly by the use of appropriate study and revision techniques. In this section, we briefly outline some tips for effective study during the earlier stages of your approach to the exam. Later in the text we mention some techniques that you will find useful at the revision stage.

Planning
To begin with, formal planning is essential to get the best return from the time you spend studying. Estimate how much time in total you are going to need for each subject that you face. Remember that you need to allow time for revision as well as for initial study of the material. The amount of notional study time for any subject is the minimum estimated time that students will need to achieve the specified learning outcomes set out earlier in this chapter. This time includes all appropriate learning activities, for example, face-to-face tuition, private study, directed home study, learning in the workplace, revision time, etc. You may find it helpful to read Better exam results by Sam Malone, CIMA Publishing, ISBN: 075066357X. This book will provide you with proven study techniques. Chapter by chapter it covers the building blocks of successful learning and examination techniques. The notional study time for Strategic level Financial Strategy is 200 hours. Note that the standard amount of notional learning hours attributed to one full-time academic year of approximately 30 weeks is 1,200 hours. By way of example, the notional study time might be made up as follows: Hours Face-to-face study: up to Personal study: up to ‘Other’ study – e.g. learning in the workplace, revision, etc.: up to 60 100 1140 200

Note that all study and learning-time recommendations should be used only as a guideline and are intended as minimum amounts. The amount of time recommended for face-to-face tuition, personal study and/or additional learning will vary according to the type of course undertaken, prior learning of the student, and the pace at which different students learn. Now split your total time requirement over the weeks between now and the assessment. This will give you an idea of how much time you need to devote to study each week. Remember to allow for holidays or other periods during which you will not be able to study (e.g. because of seasonal workloads). With your study material before you, decide which chapters you are going to study in each week, and which weeks you will devote to revision and final question practice. Prepare a written schedule summarising the above – and stick to it! The amount of space allocated to a topic in the study material is not a very good guide as to how long it will take you. For example, ‘Summarising and Analysing Data’ has a weight of 25 per cent in the syllabus and this is the best guide as to how long you should spend on it. It occupies 45 per cent of the main body of the text because it includes many tables and charts.
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It is essential to know your syllabus. As your course progresses you will become more familiar with how long it takes to cover topics in sufficient depth. Your timetable may need to be adapted to allocate enough time for the whole syllabus.

Tips for effective studying
1. Aim to find a quiet and undisturbed location for your study, and plan as far as possible to use the same period of time each day. Getting into a routine helps to avoid wasting time. Make sure that you have all the materials you need before you begin so as to minimise interruptions. 2. Store all your materials in one place, so that you do not waste time searching for items around the house. If you have to pack everything away after each study period, keep them in a box, or even a suitcase, which will not be disturbed until the next time. 3. Limit distractions. To make the most effective use of your study periods you should be able to apply total concentration, so turn off the TV, set your phones to message mode, and put up your ‘do not disturb’ sign. 4. Your timetable will tell you which topic to study. However, before diving in and becoming engrossed in the finer points, make sure you have an overall picture of all the areas that need to be covered by the end of that session. After an hour, allow yourself a short break and move away from your books. With experience, you will learn to assess the pace you need to work at. You should also allow enough time to read relevant articles from newspapers and journals, which will supplement your knowledge and demonstrate a wider perspective. 5. Work carefully through a chapter, making notes as you go. When you have covered a suitable amount of material, vary the pattern by attempting a practice question. Preparing an answer plan is a good habit to get into, while you are both studying and revising, and also in the examination room. It helps to impose a structure on your solutions, and avoids rambling. When you have finished your attempt, make notes of any mistakes you made, or any areas that you failed to cover or covered only skimpily. 6. Make notes as you study, and discover the techniques that work best for you. Your notes may be in the form of lists, bullet points, diagrams, summaries, ‘mind maps’, or the written word, but remember that you will need to refer back to them at a later date, so they must be intelligible. If you are on a taught course, make sure you highlight any issues you would like to follow up with your lecturer. 7. Organise your paperwork. There are now numerous paper storage systems available to ensure that all your notes, calculations and articles can be effectively filed and easily retrieved later.

Management Accounting – Financial Strategy Syllabus
To be first examined in May 2005

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Syllabus outline
The syllabus comprises:
Topic A Formulation of Financial Strategy B Financial Management C Business Valuations and Acquisitions D Investment Decisions and Project Control Study Weighting 20% 30% 25% 25%

Learning aims
Students should be able to:
● ● ●

understand and apply contemporary thinking on strategic financial management, understand and utilise appropriate tools for strategic financial management, evaluate strategic financial management options in light of the needs of management and the policy of the enterprise, characterise and describe the enterprise’s financial strategy and use that characterisation to develop optimal financial strategy for all stages of the life-cycle, and assess and evaluate proposed strategies.

Assessment strategy
There will be a written examination paper of three hours, with the following sections. Section A – 50 marks A maximum of four compulsory questions, totalling 50 marks, all relating to a single scenario. Section B – 50 marks Two questions, from a choice of four, each worth 25 marks. Short scenarios will be given, to which some or all questions relate.

Learning outcomes and syllabus content A – Formulation of financial strategy – 20%
Learning outcomes On completion of their studies students should be able to: (i) identify an organisation’s objectives in financial terms and evaluate their attainment; (ii) discuss the interrelationships between decisions concerning investment, financing and dividends; (iii) identify and analyse the impact of internal and external constraints on financial strategy (e.g. funding, regulatory bodies, investor relations, strategy, and economic factors); (iv) evaluate current performance, taking account of potential variations in economic and business factors; (v) recommend alternative financial strategies for an organisation. Syllabus content ● The financial and non-financial objectives of different organisations (e.g. value for money, maximising shareholder wealth, providing a surplus).
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The three key decisions of financial management (by which we mean investment, financing, dividend) and their links. Benefits of matching characteristics of investment and financing, for example, in crossborder investment. Identifying the financial objectives of an organisation and the economic forces affecting its financial plans, for example, interest, inflation and exchange rates. Assessing attainment of financial objectives. Developing financial strategy in the context of regulatory requirements (e.g. price and service controls exercised by industry regulators) and international operations. Modelling and forecasting cash flows and financial statements based on expected values for economic variables (e.g. interest rates) and business variables (e.g. volume and margins) over a number of years. Analysis of sensitivity to changes in expected values in the above models and forecasts. Identifying financing requirements ( both in respect of domestic and international operations) and the impacts of different types of finance on the above models and forecasts. Assessing the implications for shareholder value of alternative financial strategies, including dividend policy. Note: Modigliani and Miller’s theory of dividend irrelevancy will be tested in broad terms. The mathematical proof of the model will not be required, but some understanding of the graphical method is expected. Current and emerging issues in financial reporting (e.g. proposals to amend or introduce new accounting standards) and in other forms of external reporting (e.g. environmental accounting).

B – Financial management – 30%
Learning outcomes On completion of their studies students should be able to: (i) identify and describe optimal strategies for the management of working capital and satisfaction of longer term financing requirements; (ii) identify and evaluate key success factors in the management of the finance function and its relationship with other parts of the organisation and, where necessary, with external parties; (iii) discuss the role and management of the treasury function. Syllabus content ● Working capital management strategies. (Note: No detailed testing of cash and stock management models will be set since these are covered at the Managerial level.) ● Types and features of domestic and international long-term finance: share capital (ordinary and preference shares, warrants), long-term debt (bank borrowing and forms of securitised debt, e.g. convertibles) and finance leases, and methods of issuing securities. ● The lender’s assessment of creditworthiness. ● The lease or buy decision (with both operating and finance leases). ● The operation of stock exchanges (e.g. how share prices are determined, what causes share prices to rise or fall, and the efficient market hypothesis). (Note: No detailed knowledge of any specific country’s stock exchange will be tested.) ● The capital asset pricing model (CAPM): calculation of the cost of equity using the dividend growth model (knowledge of methods of calculating and estimating dividend
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● ● ●

growth will be expected), the ability to gear and ungear betas and comparison to the arbitrage pricing model. The ideas of diversifiable risk (unsystematic risk) and systematic risk. (Note: use of the two-asset portfolio formula will not be tested.) The cost of redeemable and irredeemable debt, including the tax shield on debt (numerical questions on the cost of convertible debt will not be tested). The weighted average cost of capital (WACC): calculation, interpretation and uses. Criteria for selecting sources of finance, including finance for international investments. The effect of financing decisions on balance sheet structure and on ratios of interest to investors and other financiers ( gearing, earnings per share, price–earnings ratio, dividend yield, dividend cover gearing, interest cover). Management of the finance function and relationships with professional advisors (accounting, tax and legal), auditors and financial stakeholders (investors and financiers). The role of the treasury function in terms of setting corporate objectives, liquidity management, funding management, currency management. The advantages and disadvantages of establishing treasury departments as profit centres or cost centres, and their control.

C – Business valuations and acquisitions – 25%
Learning outcomes On completion of their studies students should be able to: (i) calculate values of organisations of different types, for example, service, capital intensive; (ii) identify and calculate the value of intangible assets (including intellectual property); (iii) identify and evaluate the financial and strategic implications of proposals for mergers, acquisitions, demergers and divestments; (iv) compare and recommend alternative forms of consideration for, and terms of, acquisitions; (v) calculate post-merger or post-acquisition value of companies; (vi) identify and evaluate post-merger or post-acquisition value enhancement strategies; (vii) discuss and illustrate the impact of regulation on business combinations; (viii) evaluate exit strategies. Syllabus content ● Valuation bases for assets (e.g. historic cost, replacement cost and realisable value), earnings (e.g. price/earnings multiples and earnings yield) and cash flows (e.g. discounted cash flow, dividend yield and the dividend growth model). ● The strengths and weaknesses of each valuation method and when each is most suitable. ● Recognition of the interests of different stakeholder groups in mergers, acquisitions and company valuations. ● Application of the efficient market hypothesis to business valuations. ● Selection of an appropriate cost of capital for use in valuations. ● The impact of changing capital structure on the market value of a company. (Note: An understanding of Modigliani and Miller’s theory of gearing, with and without taxes, will be expected, but proof of their theory will not be examined.) ● Forms of intellectual property and methods of valuation.
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The reasons for merger or acquisitions (e.g. synergistic benefits). Forms of consideration and terms for acquisitions (e.g. cash, shares, convertibles and earn-out arrangements), and their financial effects. The post-merger or post-acquisition integration process (e.g. management transfer and merger of systems). The implications of regulation for business combinations. (Note: Detailed knowledge of the City Code and EU competition rules will not be tested.) The function/role of management buy-outs, venture capitalists. Types of exit strategy and their implications.

D – Investment decisions and project control – 25%
Learning outcomes On completion of their studies students should be able to: (i) analyse relevant costs, benefits and risks of an investment project; (ii) evaluate investment projects (domestic and international) taking account of potential variations in business and economic factors; (iii) recommend methods of funding investments, taking account of basic tax considerations; (iv) evaluate procedures for the implementation and control of investment projects; (v) recommend investment decisions when capital is rationed. Syllabus content Identification of a project’s relevant costs (e.g. infrastructure, marketing and human resource development needs), benefits (including incremental effects on other activities as well as direct cash flows) and risks (i.e. financial and non-financial). ● Linking investments with customer requirements and product/service design. ● Linking investment in IS/IT with strategic, operational and control needs (particularly where risks and benefits are difficult to quantify). ● Calculation of a project’s net present value and internal rate of return, including techniques for dealing with cash flows denominated in a foreign currency and use of the weighted average cost of capital. ● The modified internal rate of return based on a project’s ‘terminal value’ (reflecting an assumed reinvestment rate). ● The effects of taxation (including foreign direct and withholding taxes), potential changes in economic factors (inflation, interest and exchange rates) and potential restrictions on remittances on these calculations. ● Recognising risk using the certainty equivalent method (when given a risk free rate and certainty equivalent values). ● Adjusted present value. (Note: The two-step method may be tested for debt introduced permanently and debt in place for the duration of the project.) ● Capital investment real options (i.e. to make follow-on investment, abandon or wait). ● Project implementation and control in the conceptual stage, the development stage, the construction stage and initial manufacturing/operating stage. ● Post completion audit of investment projects. ● Single period for capital rationing for divisible and non-divisible projects. (Note: Multiperiod rationing will not be tested)

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Transitional arrangements
Students who have passed the Financial Strategy paper under the Beyond 2000 syllabus will be given a credit for the Financial Strategy paper under the new 2005 syllabus. For further details of transitional arrangements, please contact CIMA directly or visit their website at www.cimaglobal.com.

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Mathematical Tables

MANAGEMENT ACCOUNTING – PERFORMANCE EVALUATION THE CIMA STUDY SYSTEM
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Formulae
Valuation models
(i) Irredeemable preference share, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div value: P0 d kpref

(ii) Ordinary (Equity) share, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div value: P0 d ke

(iii) Ordinary (Equity) share, paying an annual dividend, d, growing in perpetuity at a constant rate, g, where P0 is the ex-div value: P0 d1 ke g or P0 d0[1 ke g] g t ), in perpetuity,

(iv) Irredeemable (Undated) debt, paying annual after tax interest, i(1 where P0 is the ex-interest value: i[1 t] kd net or, without tax: P0 i kd (v) Total value of the geared firm, Vg with taxes (based on MM): P0 Vg Vu TB

where TB is the value of tax shield. (vi) Future value of S, of a sum X, invested for n periods, compounded at r % interest: S X[1 r ]n 1 [1

(vii) Present value of £1 payable or receivable in n years, discounted at r % per annum: PV r ]n

(viii) Present value of an annuity of £1 per annum, receivable or payable for n years, commencing in one year, discounted at r % per annum: PV 1 1 r 1 [1 r ]n

(ix) Present value of £1 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r % per annum: PV 1 r

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(x) Present value of £1 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g % per annum, discounted at r % per annum: PV r 1 g

Cost of capital
(i) Cost of irredeemable preference capital, paying an annual dividend d in perpetuity, and having a current ex-div price P0: d kpref P0 (ii) Cost of irredeemable debt capital, paying annual net interest i(1 t ), and having a current ex-interest price P0: i[1 t] Kd net P0 (iii) Cost of ordinary (Equity) share capital, paying an annual dividend d in perpetuity, and having a current ex div price P0: d ke P0 (iv) Cost of ordinary ( Equity) share capital, having a current ex div price, P0, having just paid a dividend, d0, with the dividend growing in perpetuity by a constant g % per annum: d0[1 g] d1 ke g or ke g P0 P0 (v) Cost of ordinary (Equity) share capital, using the CAPM: ke Rf [Rm Rf ] (vi) Cost of ordinary (Equity) share capital in a geared firm, (No tax): V keg k0 [k0 kd] D VE (vii) Cost ordinary (Equity) share capital in a geared firm, (With tax) VD[1 t] VE (viii) Weighted average cost of capital, k0: keg keu [keu kd] k0 keg VE VE VD kd VD VE VD T *L]
u

(ix) Adjusted cost of capital (MM formula) kadj keu[1 tL] or r* r[1

In the following formulae to calculate Beta, used for a geared : (x) u from g , taking d as zero, (No tax): VE
u g

is used for an ungeared , and

g

is

VE

VD

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(xi)

u

from
u

g,

taking
g

d

as zero, ( With tax): VE VD[1 t]

VE

Other formulae
(i) Interest Rate Parity (International Fisher Effect) For indirect quotes Forward rate US$ £ Spot US$ £ 1 1 nominal US interest rate nominal UK interest rate

(ii) Purchasing Power Parity (Law of one price) 1 US inflation rate 1 UK inflation rate (iii) Link between nominal (money) and real interest rates Forward rate US$ £ Spot US$ £ [1 nominal (money) rate] [1 real interest rate][1 inflation rate]

(iv) Equivalent annual cost Equivalent annual cost (v) Theoretical ex-rights price TERP (vi) Value of a right Rights on price Issue price N 1 Theoretical ex rights price Issue price or N Value of a right where N number of rights required to buy one share. 1 N 1 [(N rights on price) Issue price] PV of costs over n years n year annuity factor

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Formulation of Financial Strategy

1

LEARNING OUTCOMES
After completing this chapter you should be able to: identify an organisation’s objectives in financial terms and evaluate their attainment; discuss the interrelationships between decisions concerning investment, financing and dividends; identify and analyse the impact of internal and external constraints on financial strategy; evaluate current performance, taking account of potential variations in economic and business factors; recommend alternative financial strategies for an organisation; discuss and illustrate the impact of regulation on business combinations.

1.1 Introduction
In this chapter we identify the financial and non-financial objectives of different organisations; the three key decisions of financial management and their links; economic forces affecting financial plans; regulatory requirements; modelling and forecasting of cash flows and financial statements; dividend policy, and current and emergency issues in financial reporting.

1.2 Objectives of profit-making entities
Strategy: A course of action, including the specification of resources required, to achieve a specific objective. (Management Accounting: Official Terminology, 2000) Financial strategy is the aspect of strategy which falls within the scope of financial management, which will include decisions on investment, financing and dividends.
1
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Strategic financial management: The identification of the possible strategies capable of maximising an organisation’s net present value, the allocation of scarce capital resources among the competing opportunities and the implementation and monitoring of the chosen strategy so as to achieve stated objectives. (Official Terminology, 2000) The definitions above both indicate that strategy depends on objectives. For a profitmaking entity the main strategic objective is to optimise the wealth of the proprietors, which means achieving the maximum profit possible consistent with balancing the needs of the various stakeholders in the entity, including shareholders, fund lenders, customers, suppliers, employees and government (in terms of taxation and legal constraints on operations). The health of the entity also depends on a proper balance being achieved between long-term projects and short-term opportunities, a major constraint against the latter being that they must not be taken where there is a significant risk that they will damage long-term viability. If all these factors can be effectively balanced the result should be the achievement of the overriding strategic financial management objective of maximising shareholder value.

1.2.1 Financial objectives
For a profit-making entity the main strategic objective is to optimise the wealth of the proprietors. In other words, the objective is assumed to be to maximise shareholder wealth. In practice, this may be interpreted as achieving the maximum profit possible consistent with balancing the needs of the various stakeholders in the entity. Stakeholders Stakeholders: Groups or individuals having a legitimate interest in the activities of an organisation, generally comprising customers, employees, the community, shareholders, suppliers and lenders. The various stakeholder groups may have different interests in the activities of an organisation:
● ● ● ● ●

Shareholders – maximisation of wealth from their investment. Fund lenders – receipt of interest and capital repayments by the due date. Customers – a continuous trading relationship with suppliers. Suppliers – to ensure that they are paid in full by the due date. Employees – to maximise rewards paid to them in salaries and benefits, and continuity of employment. Government – may have the broad objectives of sustained economic growth and maintaining levels of employment.

Economists, and many accountants, believe that cash flow is the main criterion to judge a company’s performance. Cash is a fact, whereas profit can be manipulated by accounting policies. Companies have in fact gone out of business because of a back of funds, even though they were profitable. In reality, shareholder wealth is based on the present value of future cash flows. Managers in practice may have broader objectives – perhaps undertaking any financing, investment, or dividend decision that will achieve satisfactory returns rather than those that
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may optimise returns. Alternatively, objectives may be more related to achievement of a level of: sales, earnings per share, dividend per share, or survival. Shareholder wealth may be measured by the return that shareholders receive from their investment, represented partly by the dividend received each year and partly by the capital gain from the increase in the value of the shares over that period.

1.2.2 Non-financial objectives
A company may also have a number of important non-financial objectives, which may be related to:
● ● ● ●

customer satisfaction; welfare of employees; welfare of management; the environment.

For example, in its annual report for 2004, J. Sainsbury plc, stated the following objectives which recognised in some detail the interests of other stakeholders.
Our objective is to meet our customers’ needs effectively and thereby provide shareholders with good, sustainable financial returns. We aim to ensure all colleagues have opportunities to develop their abilities and are well rewarded for their contribution to the success of their business. Our policy is to work with all of our supplies fairly, recognising the mutual benefit of satisfying customers’ needs. We also aim to fulfil our responsibilities to the communities and environments in which we operate. Contrast this with the all-embracing objective of International Power plc in its annual report for 2002: Our objective is to enhance shareholder values through the viable growth of our business in a socially responsible manner.

The general thrust of this objective features in various sections of the company’s annual report but it is not quantified and it might be useful to consider how its achievement might be measured. In both the examples given above, the lack of quantification of the objectives would make it difficult for shareholders to challenge their achievement in an Annual General Meeting.

1.2.3 Agency theory
A possible conflict can arise when ownership is separated from the day-to-day management of an organisation. In larger companies, the ordinary shares are likely to be diversely held, and so the actions of shareholders are likely to be restricted in practical terms. The responsibility of running the company will be with the board of directors, who may only own a small percentage of the shares in issue. The managers of an organisation are essentially agents for the shareholders, being tasked with running the organisation in the shareholders’ best interests. The shareholders, however, have little opportunity to assess whether the managers are acting in the shareholders’ best interests. Agency theory: Hypothesis that attempts to explain elements of organisational behaviour through an understanding of the relationships between principals (such as
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shareholders) and agents (such as company managers and accountants). A conflict may exist between the actions undertaken by agents in furtherance of their own self-interest, and those required to promote the interests of the principals. (Official Terminology, 2000) Investor relations Where ownership is separated from the day-to-day management of an organisation, managers may be motivated to behave in ways that are not optimal to the shareholders of the organisation:

Shareholders can spread their risk by unresting in a number of companies. Managers have personal and financial capital invested in the company and so may be averase to investing in a risky investment. Shareholders wealth will be maximised by investing in projects with positive net present values. Managers may be more interested in short-term payback than net present value as the investment criterion, in order to help further their own promotion prospects. Managers of companies that are subject to a takeover bid often put up a defence to repel the predator. While arguing this action is in the shareholders best interests, Shareholders of acquired companies often receive large gains in the value of their shares. The managers of the acquired company often lose their jobs or status.

Goal congruence The general term covering the possible conflicts of interest within a company, and the various methods by which attempts are made to overcome such obstacles to goal congruence, is called agency theory. In its broadest sense the term relates to economic models which provide comparisons of information systems. Goal congruence: In a control system, the state which leads individuals or groups to take actions which are in their self-interest and also in the best interest of the entity. (Official Terminology, 2000) It is evident that an important element within companies is the extent to which all members of the management team and their staff work together to achieve the strategic objectives of that company. An aspect of agency theory aims to demonstrate that while various kinds of contract exist, formal and informal (such as job descriptions, departmental responsibilities and office and factory rules), these can only be effective in helping to make a company successful if there is general acceptance of them in practice, and a concerted effort by all concerned to strive in the same direction, that is, to achieve genuine goal congruence.

1.2.4 Shareholder value analysis
Traditionally, managers of limited liability companies have used financial measures such as profit margin and return on assets to assess progress, and have used discounted cash-flow measures to assess the viability of projects or investments. Shareholder value analysis (SVA) is used to bring these three measurement systems into line, and starts from the view that the main objective of the directors of a company is to maximise the wealth of the shareholders. Coca-Cola, Monsanto, Unilever and Tate and Lyle have all used SVA to measure financial performance.
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An assumption of SVA is that the value of a business is the net present value of future cash flows, discounted at an appropriate cost of capital. Financing and investment decisions should be evaluated on their ability to maximise value for the shareholders. The inference is that the decision made will be reflected in the share price. Seven key value drivers have been identified that have the greatest impact on share price:
● ● ● ● ● ● ●

sales growth rate (per cent); profit margin (per cent); cash tax rate (per cent); working capital/sales (per cent); capital expenditure/sales (per cent); cost of capital (per cent); value growth duration period (years).

The ‘value growth duration period’ represents the future period for which the company has a foreseeable competitive advantage. SVA is used to indicate the amount of economic value created in a period. It does so by measuring and managing cash flows of the business that take account of risk and the true value of money. The cash flows used in SVA are the net profits after tax, plus non-cash items, less any investments in working capital and fixed assets. These are known as the ‘free’ cash flows. Free cash flow: Cash flow from operations after deducting interest, tax, dividends and ongoing capital expenditure, but excluding capital expenditure associated with strategic acquisitions and/or disposals. (Official Terminology, 2000) A major difficulty is calculating those future cash flows. This problem can be partly resolved by breaking the value of the business into two constituent parts, such that the value of the business equals the present value of free cash flows during the normal planning horizon, plus a residual value. The residual value represents the present value of free cash flows after the normal planning horizon. Nevertheless, it is still difficult to establish a reliable estimate for the residual value. You will find a comprehensive article on shareholder value analysis in the Readings section of this chapter.

1.3 Objectives of not-for-profit organisations
As a general rule, books on financial management, and modern corporate finance theories, are written in the context of the profit-seeking segment of the private sector. Note that the very survival of such enterprises depends on their being able to identify and satisfy needs and to offer the prospect of an adequate financial return. Those which can hold out such a prospect are able to attract the funds necessary to grow their businesses, while those which cannot must inevitably shrink. Financial management involves not only heeding that discipline but also translating it into a criterion for the allocation of resources within the enterprise. In this context, the expression ‘an adequate return’ describes a situation in which the value of outputs (to customers or, in more upmarket situations, ‘clients’) exceeds the value of inputs of all kinds: not just bought-in goods and services and labour, but also capital. It would be easy to overlook the fact that these profit-seeking enterprises (even if we include privately owned businesses as well as publicly quoted ones) represent only a minority of economic activity. The majority comprises a wide variety of enterprises which are usually
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referred to as ‘not for profit’. In the private sector, you might think of: ● trades unions, trade associations, employers’ organisations and federations thereof (such as the Confederation of British Industry); ● professional bodies, such as the Chartered Institute of Management Accountants; ● housing associations (currently accounting for over 4 per cent of UK housing stock, and building 50,000 units a year), friendly societies, clubs and cooperatives; ● charities; ● religious organisations, such as the Church of England. It is enlightening to ask which of the business imperatives do not apply to such organisations. Can they operate without identifying and satisfying needs? To operate, can they do without adequate investment in resources, and hence the need to attract funds? Is it conceivable that they could do so if the value of their outputs is perceived as being less than the value of inputs? The answers to all these questions must be in the negative. In a way, the expression ‘not-for-profit’ is somewhat misleading: if profit is the legitimate reward for the commitment of funds, why should any organisation which requires long-term funding not seek a profit (albeit under a different name, for example, surplus of income over expenditure, and with an intention that it be ploughed back)? So it is with the public sector, of which central government (currently responsible for over 40 per cent of UK gross domestic product) is the most prominent example. Activities in this sector should not be insulated from the application of financial disciplines. Would it make sense, for example, for:
● ●

the Civil Service College to use a different criterion from CIMA Mastercourses? a National Health trust hospital to use a different criterion from a private hospital?

If the rate of return sought by enterprises in the public sector were to be lower than that sought in the private sector, then the result would inevitably be that the public sector would grow (financed by taxation or borrowing) while the private sector would shrink. In short, the criterion used in resource allocation should be the same across all sectors: the value of outputs should exceed the value of inputs. At this point, however, the distinguishing feature of the ‘not-for-profit’ organisations begins to emerge. It is that their customers are not synonymous with their clients. Accountancy institutes use funds supplied by their members to develop their specialism for the benefit of employers and the public. Charities and religious organisations use the cash from donors to alleviate suffering or promote a belief. The government takes money from those in employment to give it to those out of work, or from the healthy to give to the sick. All of these redistributions are noble in themselves, but they lack the direct link between consumption and price. It is a well-known economic ‘law’ that as the price of a service at the point of delivery tends towards zero, so demand for it tends towards infinity. Consequently, organisations whose income comes from a source other than paying customers are frequently plagued by an excess of demand over supply. There are variations on the customer/client theme, as follows:

Some organisations have elaborate transfer pricing arrangements, which could allow internal customers to relate cost to value, by reference to: – benchmarks derived from prices prevailing in the market economy, for example, the Civil Service College’s charges can be compared with those of a private institution; – the prices quoted by quasi-competitive units within the organisation, as with the National Health Service.

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In some cases, the clients (e.g. the passengers travelling on some railway routes in Britain) will contribute towards the cost but the taxpayer meets the balance in the form of a subsidy. In other cases, the primary function is a regulatory one, and fees are charged to those being regulated, for example, Companies House.

To various degrees, however, managers in such organisations see their role in terms of rationing their limited resources. Specifically, many are uncomfortable with the concept of value, and retreat into choosing between costs. Resources are assumed to be finite, and the task is seen as trading-off within one time-frame, for example the current fiscal year. On a small scale, for example, a church council’s decisions could include choosing between a toilet for the disabled or paying for a missionary to go to a far-off land. On a large scale, the UK government makes a political assessment of what it can raise in taxation and borrowings, and this becomes the total that it can ‘afford’ to spend. Choices have to be made and confrontation (in this case between spending ministries: Health/Education/Defence, etc.) is inevitable. Lower down the scale, departments use the term virement (significantly, a term which is unknown in the private sector) to refer to the need to get permission to offset an overspend on one account against an underspend in another. Managers in the public sector are well aware of the trends, but see considerable obstacles to going with the tide. The stance of national government is to seek stability through rigid planning. The problems with plans is that, in a rapidly changing environment, they are so quickly overtaken by events: flexibility and adaptability are required today. The UK Treasury’s ‘cash limit’ approach to financial management, for example, is tactical and shorttermist, and – in the absence of any countervailing strategic control – inhibits adaptation.

1.3.1 The three ‘E’s
The public sector is usually credited with having drawn attention to the distinctions between:

economy, which is generally thought of in terms of doing things as cheaply as possible, and is therefore associated with the operational level of control; efficiency, which is generally thought of in terms of productivity (the ratio of output to input) and is therefore associated with the tactical level of control; effectiveness, which is generally thought of in terms of doing the right things, and is therefore associated with the strategic level of control.

The first two are much in evidence in public-sector management-control systems. An agency such as the Civil Service College will measure the number of students, the number of courses, the ratio of lecturers to students, and so on. It will also seek its customers’ assessments of the standard of, for example, its lecturing and catering, and compare them with preset targets. In the language of strategic financial management, these are answers to the question ‘How well did we do what we chose to do?’. You should also be aware, by now, of the dangers of concentrating on what can be measured. Note, for example, that it is possible to measure crime detection, but it is not possible to measure crime prevention; it is possible to measure the extent to which the sick are cured, but not the extent to which sickness is prevented. People can be rewarded on the basis of measurables, but it should come as no surprise if they then skimp on the immeasurables: you get what you measure. Measuring performance is but a part of monitoring progress: assessing potential and changes therein are at least as important.
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Disturbingly, the third (and, arguably, the most important) ‘E’ – effectiveness – is the least in evidence. Where the word ‘strategy’ is used, it usually means a 3-year budget. Zero variances (and hence zero feedback) are expected. Health-service purchasers tend to talk, for example, of ‘delivering’ a strategy as though it were a result – a destination rather than the route thereto. This stems, perhaps, from the top-down style which we have seen is still the norm: top management decides what is to be done, middle management has some choice as to how it is done, the vast majority are seen as responsible for doing it. In other words, the emphasis is on tactics, in the form of leadership from behind: ‘Carry on doing what you have been doing but do it cheaper/faster/more accurately, etc.’ Partly, this is cultural, reflecting an antipathy towards uncertainty, risk and surprises. When publicsector investments go awry (e.g. investments in information technology not producing the expected benefits) they tend to be reported in terms of wasting public money. The same outcome in the private sector might be seen as the risk inevitably associated with pushing out the boundaries.

1.4 Public and private – similarities and differences
The public sector is as affected by managerial trends as the private sector. Authority has been delegated, but there is a consequent need for strategic accountability. As in a group of companies, strategy is not just something which exists within one single business, but is also concerned with the relationship between the businesses and the centre. The language of strategy in general, and financial management in particular, is therefore necessary and is developing. Consequently, the decision-support techniques used in the private sector are largely also applicable in the public sector. Take the UK Civil Service College, for example. Given the trend towards generalism, and the reputation of the service for generalism, it might see an opportunity to mount a course for private-sector delegates. But what outlays would be involved, and would they be matched by income? The college is known to research and develop relevant management techniques: again, costs and benefits need to be matched. Its report stresses that its greatest assets are ones – the knowledge and commitment of its staff – not shown on its balance sheet. It is important that such assets are recognised, cost-effectively enhanced, employed to deliver good value for taxpayers’ money, and suitably monitored. In corporate strategy terms, it is possible to quantify the cash flows from the rest of the public sector to the college, obtain its net present value, and then compare with the cost of the nextbest alternative, for example, using a private-sector provider (or, possibly, to compare with the price which could be obtained on disposal). So, subject only to a willingness by those in authority to quantify their judgements, financial management is, on the whole, equally applicable to the not-for-profit sector generally and the public sector in particular. It is worth stressing perhaps, that – in common with the private sector – it is never possible to say whether or not value has been maximised. We do not know what we do not know: specifically, we do not know what opportunities have been missed. This is not a problem for those familiar with devolved authority, as it is the only approach compatible with empowerment: you cannot tell an explorer what to find, or identify what he/she has not found! Some bridge is usually required, from the known to the unknown, for example, to relate the value of a unit to the costs of its tangible assets, and

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to consider what ‘intangibles’ explain the difference. This will often act as a very good attention-directing tool, but recognise it as holding up a mirror: in reality, value is not a function of cost. The health sector provides other examples. Investments in medical equipment represent decisions to trade in purchasing power now in the expectation of benefits later. These benefits may take the form of increased throughput (and hence reduced waiting lists) or the meeting of needs which would otherwise go unsatisfied. These benefits are not measurable, because it is not possible to measure something which has not yet happened; they are judgmental. But this does not mean that they are not quantifiable and hence capable of evaluation. The main obstacle is usually an unwillingness on the part of those in authority (e.g. politicians) to express value judgements, perhaps because they fear such judgements ‘being taken down and used in evidence against them’. For the avoidance of doubt, it is worth stressing that values are equally subjective in the private sector. No one pretends that they can measure the effectiveness of a proposed investment in advertising: they forecast the improvement after assessing the likely reactions of competitors, direct customers and ultimate consumers. The management accountant fulfils a vital role in being able to synthesise these judgements together with others (e.g. the volume–cost relationship and the cost of capital) to identify the optimum level of investment they imply. The forecast outcome is logged, so as to provide a benchmark by which to monitor progress. Of course, there are differing degrees of difficulty – discomfort, even – in making value judgements in the public sector. Currently and foreseeably, the health sector is providing many examples. Thanks to results of research in pharmaceuticals, for example, previously incurable illnesses are being dealt with, and people are living longer. Demand for drugs, etc., is correlated with age, so demand continues to increase. With a progressively smaller proportion of the population in employment, the financial pressures are substantial. How does one make an informed choice as to the transfer of funds between the well and the unwell? What value does one put on curing an illness, or saving a life? These are societal matters, the discomfort being one of the reasons they are placed firmly in the public sector, rather than being left to the ‘survival of the fittest’ philosophy associated with the competitive struggle for existence that we call the market economy. In the UK, this is being addressed by reforms characterised by the creation of the internal market. The main feature is the separation of purchasers (representing a particular geographical area) from the providers (hospitals and other healthcare facilities). The providers are competing among themselves for the purchasers’ funds, the idea being that those offering the best value for money will gain an increasing share of the available funds. In the early days, at least, various ‘rules of the game’ have been laid down, most notably (from a strategic financial management point of view) in the area of pricing. Given that the health service is still one large (but hybrid) business, formula-based transfer pricing is to be expected. The rules are very simple: price must equal cost, and cost must equal total cost, including a target return on capital employed. Those who framed the rules seem to have been thinking in terms of there being one objectively verifiable cost of an activity (which is valid only when looking backwards) but prices have to be established in advance. The demand for sophisticated yet pragmatic costing systems will, consequently, be high for some considerable time to come, as providers seek costs which signal good value for money for the business they seek to attract, and poor value for those they wish to repel.

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1.5 Assessing attainment of financial objectives
Traditionally, managers have focused on financial measures of performance and progress. Increasingly, organisations in both the private and public sectors are using non-financial indicators to assess success across a range of criteria, which need to be chosen to help an organisation meet its objectives. We discuss a number of common financial and non-financial indicators below.

1.5.1 Financial performance indicators

Cash generation. Poor liquidity is a greater threat to the survival of an enterprise than is poor profitability. Unless the organisation is prepared to fund growth with high levels of debt, cash generation is vital to ensure investment in future profitable ventures. In the private sector the alternative to cash via retained earnings is debt. In the public sector this choice has not been available in the past, and all growth has been funded by government. However, in the face of government-imposed cash limits, local authorities and other public-sector institutions are beginning to raise debt on the capital markets, and are therefore beginning to be faced with the same choices as private companies. Value added. This is primarily a measure of performance. It is usually defined as sales value less the cost of purchased materials and services. It represents the value added to a company’s products by its own efforts. A problem here is comparability with other industries – or even with other companies in the same industry. It is less common in the public sector, although the situation is changing and many public-sector organisations – for example, those in the health service – are now publishing information on their own value added. Profitability. Profitability may be defined as the rate at which profits are generated. It is often expressed as profit per unit of input (e.g. investment). However, profitability limits an organisation’s focus to one output measure – profit. It overlooks quality, and this limitation must be kept in mind when using profitability as a measure of success. Profitability as a measure of decision-making has been criticised because: – it fails to provide a systematic explanation as to why one business sector has more favourable prospects than another; – it does not provide enough insight into the dynamics and balance of an enterprise’s individual business units, and the balance between them; – it is remote from the actions that create value, and cannot therefore be managed directly in any but the smallest organisations; – the input to the measure may vary substantially between organisations. Nevertheless, it is a well-known and accepted measure which, once the input has been defined, is readily understood. Provided the input is consistent across organisations and time periods, it also provides a useful comparative measure. Although the concept of profit in its true sense is absent from most of the public sector, profitability may be used to relate inputs to outputs if a different measure of output is used – for example: surplus after all costs, to capital investment. Return on assets (RoA). This is an accounting measure, calculated by dividing annual profits by the average net book value of assets. It is therefore subject to the distortions inevitable when profit, rather than cash flows, is used to determine performance. Distorting factors for interpretation and comparison purposes include depreciation

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policy, stock revaluations, write-off of intangibles such as goodwill, etc. A further defect is that RoA ignores the time value of money, although this may be of minor concern when inflation is very low. RoA may not adequately reflect how efficiently assets were utilised: in a commercial context, taking account of profits but not the assets used in their making, for whatever reason, would overstate a company’s performance. In the public sector, the concept of profit is absent, but it is still not unrealistic to expect organisations to use donated assets with maximum efficiency. If depreciation on such assets were to be charged against income, this would depress the amount of surplus income over expenditure. Other points which may affect interpretation of RoA in the public sector are: – difficulty in determining value; – there may be no resale value; – are for use by community at large; – charge for depreciation may have the effect of ‘double taxation’ on the taxpayer.

1.5.2 Non-financial performance indicators

Market share. A performance indicator that could conceivably be included in the list of financial measures, market share is often seen as an objective for a company in its own right. However, it must be judged in the context of other measures such as profitability and shareholder value. Market share, unlike many other measures, can take quality into account – it must be assumed that if customers do not get the quality they want or expect then the company will lose market share. Gaining market share must be seen as a long-term goal of companies to ensure outlets for their products and services, and to minimise competition. However, market share can be acquired only within limits if a monopoly situation is to be avoided. It is a measure that is becoming increasingly relevant to the public sector – for example universities and the health service. Health providers must now ‘sell’ their services to trusts established to ‘buy’ from them. Those providers which are seen to fail their customers will lose market share as the trusts will buy from elsewhere (within certain limits). Customer satisfaction. This can be linked to market share. If customers are not satisfied they will take their business elsewhere and the company will lose market share and go into liquidation. Measuring customer satisfaction is difficult to do formally, as the inputs and outputs are not readily defined or measurable. Surveys and questionnaires may be used but these methods have known flaws, mainly as a result of respondent bias. It can of course be measured indirectly by the level of sales and increase in market share. The UK Citizen’s Charter was designed to help ‘customers’ of public services gain satisfaction, and provided for redress if they do not – for example, ticket refunds for the late running of trains. Competitive position. The performance of a business must be compared with that of its competitors to establish a strategic perspective. A number of models and frameworks have been suggested by organisational theorists as to how competitive position may be determined and improved. A manager needing to make decisions must know by whom, by how much, and why he is gaining ground or being beaten by competitors. Conventional measures, such as accounting data, are useful but no one measure is sufficient. Instead, an array of measures is needed to establish competitive position. The most difficult problem to overcome in using competitive position as a success factor is in collecting and acquiring data from competitors.
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The public sector is increasingly in competition with other providers of a similar service both in the private and public sectors. For example, hospitals now have to compete for the funds of health trusts. Their advantage is that it is easier to gain access to data from such competitors than it is in the private sector. Risk exposure. Risk can be measured according to finance theory. Some risks – for example, exchange-rate risk and interest-rate risk – can be managed by the use of hedging mechanisms. Shareholders and companies can therefore choose how much risk they wish to be exposed to for a given level of return. However, risk can take many forms, and the theory does not deal with risk exposure to matters such as recruitment of senior personnel or competitor activity. Public-sector organisations tend to be risk-averse because of the political repercussions of failure and the fact that taxpayers, unlike shareholders, do not have the option to invest their money in less (or more) risky ventures.

1.6 The three key decisions of financial management
The practical applications of financial management can be grouped into three main areas of decisions – investment decisions, financing decisions and dividend decisions – which reflect the responibilities of acquiring financial resources and managing those resources.

1.6.1 Investment decisions
Investment decisions are those which determine how scarce resources in terms of funds available are committed to projects, which can range from acquisition of plant to the acquisition of another entity. Investing in fixed assets usually carries the need for supporting investment in working capital, for example, stocks and debtors, less creditors, an aspect often not properly taken into account by management. Investment to enhance internal growth is often called ‘internal investment’ as compared with acquisitions, which represent ‘external investment’. The other side of the investment coin is disinvestment, which means the preparedness to withdraw from unsuccessful projects, and the disposal of parts of an entity which no longer fit with the parent entity’s strategy. Such decisions usually involve one very special element – the right timing for the action to be taken. Disinvestment decisions can also be involved in reconstructions, where an entity has to alter its capital structure, possibly to survive as a result of heavy losses.

1.6.2 Financing decisions
Financing decisions relate to acquiring the optimum finance to meet financial objectives and seeing that fixed and working capital are effectively managed. The financial manager must possess a good knowledge of the sources of available funds and their respective costs, and should ensure that the entity has a sound capital structure, that is, a proper balance between equity capital and debt. Such managers also need to have a very clear understanding of the difference between profit and cash flow, bearing in mind that profit is of little avail unless the entity is adequately supported by cash to pay for assets and sustain the working capital cycle. Financing decisions also call for a good knowledge of evaluation of risk: excessive
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debt carries high risk for an entity’s equity because of the priority rights of the lenders. A major area for risk-related decisions is in overseas trading, where an entity is vulnerable to currency fluctuations, and the manager must be well aware of the various protective procedures – such as hedging – which are available. The opportunity cost of finance In making financial decisions, the manager must always be aware of the opportunity cost aspect involved. Thus, if a company wishes to raise money by means of an issue of ordinary shares, the terms must be made attractive enough to make it worth while for the investor to forgo the opportunity cost of investing in the next-best investment project. Also if a company wishes to maintain or improve its share price, it must pay satisfactory dividends and show good long-term growth prospects, otherwise it will lose out because its investors will find it more satisfactory to sell out and not forgo the opportunity cost of alternative equities. In setting a price for anything – whether it be for a company’s product or services, or the rate of interest to be paid for borrowings or to receive on loans, or the cost of equity capital – it is important to be fully aware of what the market requires and what the market will bear.

1.6.3 Dividend decisions
Dividend decisions relate to the determination of how much and how frequently cash can be paid out of the profits of an entity as income for its proprietors. The owner of any profit-making organisation looks for reward for his or her investment in two ways: the growth of the capital invested and the cash paid out as income. For a sole trader this income would be termed drawings and for a limited liability company the term is dividends. The dividend decision thus has two elements: the amount to be paid out and the amount to be retained to support the growth of the entity, the latter being also a financing decision; the level and regular growth of dividends represent a significant factor in determining a profitmaking company’s market value, that is, the value placed on its shares by the stock market. The three types of decision are interrelated, the first two pertaining to any kind of entity, while the third relates only to profit-making organisations. Thus it can be seen that financial management is of vital importance at every level of business activity, from the sole trader to the largest multinational corporation. It is instructive to think this point through by taking the case of the sole trader. He (she) has to invest capital in a shop, fittings and equipment and in the purchase of stock and sustaining debtors (working capital); he has to have sources of capital to finance his investment such as his own capital and bank borrowings; and he has to make dividend decisions to determine how much can be reasonably withdrawn from the business to ensure that it will remain sufficiently liquid and, if desired, capable of growth.

1.7 Policies for distribution of earnings
Dividend policy is one of a company’s financing decisions. How should a company divide its earnings between payments to shareholders and retention for future investments if the aim is to increase the market value of the firm? Using internally generated funds is often thought to be a ‘free’ form of finance. This is of course not the case, and it is important to remember that these funds do have a cost, that is, an opportunity cost, normally taken as the weighted average cost of capital.
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In deciding a company’s dividend policy the following factors should be considered:

● ●

Liquidity. In order to pay dividends, a company will require access to cash. Even very profitable companies might sometimes have difficulty paying dividends if resources are tied up in other forms of asset, especially if bank overdraft facilities are not available. Repayment of debt. Dividend payout may be made difficult if debt is scheduled for repayment and this is not financed by a further issue of funds. Restrictive covenants. The Articles of Association may contain agreed restrictions on dividends. In addition, some forms of debt may have restrictive covenants limiting the amount of dividend payments or the rate of growth which applies to them. Rate of expansion. The funds may be needed to avoid overtrading. Stability of profits. Other things being equal, a company with stable profits is more likely to be able to pay out a higher percentage of earnings than a company with fluctuating profits. Control. The use of retained earnings to finance new projects preserves the company’s ownership and control. This can be advantageous in firms where the present disposition of shareholdings is of importance. Policy of competitors. Dividend policies of competitors may influence corporate dividend policy. It may be difficult, for example, to reduce a dividend for the sake of further investment, when competitors follow a policy of higher distributions. Signalling effect. This is the information content of dividends. Dividends are seen as signals from the company to the financial markets and shareholders. Investors perceive dividend announcements as signals of future prospects for the company. This aspect of dividend policy is assuming increasing importance, and there have been numerous instances reported in the press where companies have paid an increased dividend when financial prudence suggests that they should be paying no dividend at all.

Having taken into account the above factors, companies will formulate standard dividend policies, three of which are discussed below.

1.7.1 Practical dividend policies
Constant payout ratio There are important links between dividends and profits. In company law, for instance, the prohibition of paying dividends other than out of profits is seen as an important protection for creditors (including lenders, who may well specify a maximum proportion of profits which can be declared as dividends while their loans remain in force). This is reinforced by the accounting concept which defines profit as what you could afford to distribute, and still be as well off as you were. Such links encourage a backward-looking approach to dividend policy, with some boards of directors publishing an objective to maintain a certain dividend cover, that is, to declare dividends which represent a constant percentage of profits after tax. In a stable state, one would expect some symmetry in the figures, for example, a company whose profits after tax represented a 10 per cent per annum return might choose to plough half back into the business, and look forward to a 5 per cent per annum growth in its profits (and earnings per share) and hence dividends. This forms the basis of the idea that the value of a company is a multiple of its past profits. The reality, however, is not one of a stable state. One very specific shock to the system has been the instability of the unit of measure (money). Should dividends be related to the profits calculated under the historical cost convention, or after making an adjustment to exclude the inflationary element? Ought they to be
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influenced by translation gains and losses (usually taken direct to the reserves figure on the balance sheet)? Bear in mind that ‘well-offness’ is measured by reference to the cost of unconsumed tangible assets. No allowance is made for the intangible assets (such as quality, reputation and pace of innovation) which are so crucial to survival in a rapidly changing environment. Intriguingly, what the accountant calls an asset, for example, an old-fashioned piece of plant, can actually be a strategic liability. Stable policy – signalling Some boards of directors think not in terms of maintaining dividend cover, but in terms of maintaining a trend in the absolute level of payout. Their starting point for deciding this year’s dividend is what was paid last year, what rate of increase it represented on the previous year, and whether they feel that this rate can be repeated, taking into account considerations of liquidity. Rightly or wrongly, the dividend decision is seen as a powerful signal to the market of the directors’ confidence in the future of the enterprise, and this does appear to be supported by evidence that unexpected dividend cuts have been followed by a reduction in share prices. The danger, of course, is that this can become a game, in which directors seek to give the signal they think will have the most favourable effect on the share price. Some even argue that the aim must not be to surprise the market, which leads to the suggestion that the dividend should be what the analysts are predicting. In pure economic terms, companies should pay zero dividends when they have sufficient positive net present value projects to utilise all their after tax profits and pay out 100 per cent of after tax profits when they have no such investment possibilities. Whatever the theoretical rationale, boards – in the UK at least – would not countenance such potentially huge variation in dividends payouts that such a policy would imply. In the UK, the practice of maintaining a particular rate (sometimes real, sometimes nominal) of growth of dividends has been very popular, and seemed to work well as long as things were stable, cyclical or at least predictable. As the rate of change has speeded up, however, its limitations have become more obvious and more serious. In particular, the unexpectedly severe downturn in the UK in the early 1990s presented boards with a dilemma: given sharply reduced profits, what should be preserved – dividend growth or dividend cover? Some fund managers made it clear that they preferred dividends to retentions. Some boards responded, to the point of declaring dividends in excess of their profits after tax. One chairman talked about the need to ‘reward shareholders for their loyalty’. As a general rule, however, financial journalists took the opposite view, based on their perception of dividends as just another outlay, like wages or advertising or plant and machinery. Companies in financial difficulties, they argued, should cut dividends and increase investment. Such comments give the impression that their authors mistakenly see financial management as being about trade-offs within one time-frame (i.e. the short term). The reality is that it is about trade-offs between different time-frame. Residual dividend policy Strategic financial management does focus on the creation of value and, as we have seen, is principally concerned with forecast cash flows. The question is what cash is needed, not for some irrelevant aim of maintaining a quantum of assets evaluated at unconsumed historical cost, but for the strategies which are in place. Those strategies will have been evaluated by discounting the said cash flows at the cost of capital, and the dividend decision should, logically, be subject to the same discipline.
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To the extent, that is, that the company has opportunities to invest for a return in excess of the cost of capital, it should retain funds within the business. If, on the other hand, it has funds in excess of its identifiable viable investment opportunities, it should return them to its shareholders for investment elsewhere. This would mean much more volatile levels of dividend, of course, but that was what equity capital was originally meant to be about. The idea of a share being more like a bond, i.e. carrying an entitlement to a steady, or steadily increasing, stream of dividends, is relatively new. It may be coincidence, but it has come to prominence as the proportion of shares owned by institutions has grown. In the 1950s, two-thirds of UK listed company shares were owned by individuals; by 1990, two-thirds were owned by institutions. At this stage, it is worth noting that, rather than transferring wealth from the company to the shareholders in the form of dividends, it is possible to return capital to them by ‘buying back shares’, i.e. the company makes an offer to all members, or goes out into the market to buy its own shares. This does not happen very often but does allow shareholders to choose: they can take the cash, or have a larger interest in the company. The effect on the entity is the same as paying a dividend, but the tax situation may make it possible to benefit (at least some) shareholders at the expense of the tax authorities.

1.7.2 Theory of dividend irrelevance
To appreciate the theory advanced by Modigliani and Miller (MM) in 1961 regarding dividend policy and the hypothesis of dividend irrelevance, we need to understand MM’s fundamental principle of valuation: ‘that the price of each share must be such that the rate of return (dividends plus capital gains per dollar invested) on every share will be the same throughout the market over any given interval of time.’ This principle is supported by three basic assumptions: 1. In ‘perfect’ capital markets no buyer, seller or issuer of securities is large enough for their transactions to significantly affect the current ruling price. Information regarding the ruling price is available to all without cost, and no brokerage fees, transfer taxes or other transaction costs are incurred in the trading of securities. In addition, no tax differentials exist either between dividends or retentions of profit or between dividends and capital gains. 2. All investors will behave ‘rationally’ in that they will prefer more wealth to less, and they are indifferent as to whether any given increment of their wealth is in the form of cash payments (dividends) or an increase in the market value of their holdings (capital gains). 3. ‘Perfect certainty’ carries the implication of complete assurance on the part of every investor as to the future investment programme and future profits of every company. With this assurance there is, among other things, no need to distinguish between stocks and bonds as sources of funds for this analysis, which is itself based on an analytical framework set up to examine the effects of differences in dividend policy on the current price of shares in an ideal economy, characterised by the three assumptions of perfect capital markets, rational behaviour and perfect certainty. Important aspects of this theory arising from the above assumptions, or developed from them, include the following:

In a tax-free world, shareholders will not differentiate between dividends or capital gains, the value of a company and therefore the price of its shares being based only on the earnings capacity of its assets and investments, that is, on the worth of the projects in which the company has invested its funds.

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The so-called ‘clientele effect’ shows that a company with a particular pattern and stability of dividend profile will attract stockholders having a similar preference for that type of profile. Thus, since shareholders’ expectations are being met, the price of shares will be unaffected by changes in dividend policy. If retentions are insufficient to allow a company to take up all its worthwhile investments, the shortfall caused by a dividend can be offset by obtaining further funds from other external sources. MM argue that although there will be a loss in value of existing shares as a result of using external finance instead of retentions, such loss will be exactly offset by the amount of the dividend paid; as a result a company should be indifferent as to whether it pays a dividend and obtains external funding or retains more of its profits. Thus, the effect of dividends on share price is exactly compensated for by other sources of financing. MM recognise that dividends can in some way affect share prices, but suggest that the positive effects of dividend increases on such prices relate not to the dividend itself but to the ‘informational content’ of dividends in regard to future earnings. This information leads to shareholders pushing up the share price on the basis of their expectations as to future earnings. From these arguments it seems reasonable to assume that if a company does not have sufficient worthwhile projects to use up retentions, it should distribute these surplus funds to its shareholders, who will then be able to invest in other companies which do have satisfactory investments to which these extra funds can be applied.

Within the considerable limitations of the assumptions made, which are discussed below, MM do present some interesting, if contentious, arguments as to why dividends are irrelevant to the value of any particular company. Has MM’s theory any practical relevance today? Arguably we can answer positively in that:

it sets out a number of issues which provide useful background in developing an approach to dividend policy, for example, concerning ‘informational content’ of dividends; since legalisation of share buy-backs in the UK, a number of companies have shown interest in, and a few have acted upon, the concept of returning surplus funds to shareholders, signifying that this may prove to be the better way of ensuring their more profitable use.

In a perfect world, which in the interests of clarity MM explicitly assumed, their theory would seem unexceptional. In the real world, however, we need to recognise some imperfections:

Use of the accounting model for purposes beyond its design specification. As mentioned above, retention of profits is likely to result in the company reporting earnings per share growth. Paying dividends and raising capital would not. If that earnings per share figure is seen as a measure of performance, or is used for determining rewards, this could have considerable significance. Transaction costs. It costs money to pay a dividend, and it costs money to raise capital. To eliminate one transaction by reducing the size of the other would clearly avoid wasteful administration costs. Taxation is never neutral, and the declaration of a dividend can affect the attribution of value as between shareholders and the tax-gatherers. Whether companies need be concerned about the tax ultimately borne by their shareholders – in respect of dividends and/or the buying and selling of shares – is a moot point. Some are adopting policies which appeal to a particular clientele, that is, category of investor; others are passively
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watching the steady decline of the individual shareholder, and the growth of the tax-exempt fund. Barring a change of policy, the UK market is polarising: individuals are being encouraged to invest in National Savings and tax-exempt individual savings accounts (ISAs); share ownership increasingly appeals only to pension funds and the like. The inefficiency of the market. A dividend is certain, being tangible cash-in-hand and discretionary income, whereas the market price is subject to all sorts of extraneous influences and therefore more uncertain. Note, accordingly, how increasing the dividend is a predictable response to a threat of a takeover, the presumption being that it will have the effect of increasing the share price. Supporters of the efficient market hypothesis would like to think that prices equate with the net present value of projected cash flows and are therefore fair as between buyers and sellers, but it would be perverse to argue that directors have a responsibility for the bargains struck between consenting shareholders, that is, for ensuring that reality fits the hypothesis! It would be more rational to argue that they should concentrate on creating wealth, and recognise that the question of its distribution as between stakeholders is far from being within their control.

1.7.3 Scrip dividends
Companies sometimes offer shareholders a choice between a cash dividend and additional shares worth the same, or approximately the same amount. The dividend paid in shares is referred to as a scrip dividend and is often offered when the directors feel they must pay a dividend but would prefer to retain cash funds within the business. The presumption is that the retained funds will be invested in projects which can reasonably be expected to earn an adequate return. As with bonus or scrip issues directors rarely highlight the fact that once the reserves are capitalised in this way, they become undistributable. To see how scrip dividends work, imagine a company with 100 million shares in issue, the directors of which decided to declare a dividend of 12p per share. In the ‘normal’ course of events this would mear a cash outflow of £12 million to the shareholders. Assuming, for the sake of illustration, that the company’s shares had been trading at around 360p ex div., the board might offer an alternative of one new share for every 30 held. There would be rules as to fractional entitlements, of course, but in simple terms someone who held, say, 3,000 shares could receive a divident of £360, or 100 shares’ worth – at the contemporary share price – £360. From the point of view of the individual shareholder:

if he (or she) had been thinking of buying some more shares, and felt that the price was unlikely to fall below 360p in the near future, he would welcome the opportunity of obtaining some without having to pay the usual commissions, etc.; if he had no wish to increase his holding, he could simply take the dividend as originally declared; if he had no firm views, he could take part dividend and part shares.

1.7.4 Share repurchases
The decline in scrip dividend offers in recent years has coincided with an increase in the number of companies returning capital to investors through share repurchase schemes, or in some cases by making a special dividend payment.
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The repurchase of a company’s shares may be carried out for a number of reasons:
● ● ● ● ●

return of surplus cash to investors; to reduce the company’s cost of capital; to enhance earnings per share in the hope of also increasing market price per share; to prevent, or reduce the likelihood of, unwelcome takeover bids; to adjust the gearing of the company to a higher level, closer to the company’s optimal capital structure; to reduce the amount of cash needed to pay future dividends.

The ability of UK companies to repurchase shares was introduced in the Companies Act 1981. The process requires approval of the shareholders, and any shares repurchased must be cancelled. There are also further rules imposed by the Stock Exchange and the Takeover Code, which control the use of share repurchases. The majority of recent share repurchases, and special dividends, have been as a result of companies having surplus cash in excess of their operational requirements. Shares may be repurchased by:
● ● ●

purchase on the open market; individual arrangement with institutional investors; a tender offer to all shareholders.

An individual arrangement with institutional investors tends to be the most popular approach as it is the quickest, most efficient means of returning surplus cash. Often therefore, only a small group of shareholders will participate in a share repurchase, whereas all shareholders will participate in a special dividend. A further consideration in the return of surplus cash concerns the possible tax implications for investors. A share repurchase may lead to a capital gains tax liability for participating investors, while a special dividend would normally attract an income tax liability. A share repurchase may suggest a failure of management to identify projects that will generate returns above the company’s cost of capital. Returning capital to shareholders gives the shareholders the opportunity to generate higher returns for themselves by investing elsewhere. It can also be difficult to determine a price for the share repurchase that is fair to all parties.

1.8 The impact of internal and external constraints on financial strategy
1.8.1 Internal constraints
Two of the main internal constraints on financial strategy are funding and gearing. Traditionalists claim that capital structure can be planned and managed to maximise the value of the firm. Modigliani and Miller claim that the value of an ungeared company cannot be more than the value of a geared company except for the present value of the tax shield and the costs of financial distress. These issues are dealt with in Chapter 4. The main argument in favour of gearing, that is, introducing debt into the capital structure is that the interest payments attract tax relief. The argument against debt is that it introduces financial risk into the company. Financial managers have to formulate a policy that balances the effect of these opposing features, such as the state of the economy, government
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economic policy, and sources of finance and their cost cannot be ignored when determining capital structure policy.

1.8.2 External constraints
Major external constraints include:
● ● ● ●

Government regulation (this is discussed in Section 1.9). Regulatory bodies (Regulation is discussed in Sections 1.9.4 and 1.9.5). Major economic influences (these are discussed in Section 1.10). Accounting concepts: Detailed knowledge of accounting procedures will not be examined in this volume. However, discussion may be required on current and emerging issues in financial reporting (relevant topics are discussed in Section 1.12). Sources of finance and their cost when determining capital structure policy (these are discussed in Chapters 3 and 4).

1.9 Developing financial strategy in the context of regulatory requirements
The financial manager must have a proper understanding of those aspects of legislation which impact upon entities. Such legislation will include the Companies Acts, health and safety regulations, laws relating to consumer protection and consumer rights, laws relating to contract and agency, employment law and laws relating to protection of the environment. You should be aware of the meaning of tax havens, which are used by large organisations – usually multinational corporations – to defer payment of tax on funds earned prior to them being remitted to the parent company’s host country or used for investment purposes. Such havens will be expected to impose only low rates of tax on income earned by resident subsidiaries or low withholding taxes on dividends remitted, to have satisfactory financial services able to provide adequate support facilities and to possess political and currency stability. Understanding the implications of regulation on takeover and merger activities is required although you will not need detailed knowledge of the City Code on takeovers and mergers.

1.9.1 Corporate Governance and the Cadbury Report
Statutory control of corporate governance has been with us for a long time, and has increased over time, but has generally lagged behind the demonstrable need for it. It is impossible to legislate against crime, for example, fraud, but there is a case for spelling out the ‘rules of the game’. The theory which underpins current UK legislation is based on the idea that a board of directors represents the interests of the shareholders, but in practice it is often dominated by executive managers. The trends towards share options and pay schemes related to high profits have opened up a risk that courses of action which are good for the directors can have an adverse effect on the long-term health of the enterprise. Among the issues of particular concern at the moment are:

creative accounting designed to circumvent limits on directors’ powers as defined in Articles of Association (e.g. the inclusion of brands on the balance sheet, avoiding the need for prior approval of acquisitions);

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the inability of shareholders to stop directors investing in uneconomic projects (often funded by rights issues, the arithmetic of the process meaning that the best they can do is sell their rights in the market); the question of where the loyalties of auditors lie. The practice of valuing intangibles and then auditing them has now been outlawed by the Institute of Chartered Accountants, but many auditors are helping to devise schemes of off balance sheet finance, so as to avoid limitations on directors in listing agreements and banking covenants – suggesting they are servants of the management rather than shareholders, bankers and creditors.

The philosophical question is whether legislation and regulation should spell out the broad principles and trust directors and auditors to follow its spirit, or provide a detailed set of rules which should be followed to the letter. What we have at present is claimed to be the former, but there are many who say it is not working satisfactorily. The chairman of the Accounting Standards Board has urged directors and auditors to follow the spirit, otherwise there would be detailed regulation. The implicit message is that this would result in more bureaucracy and political intervention. The central recommendation of the Cadbury Committee’s report in 1991 was that the boards of all listed companies should comply with the ‘Code of Best Practice’ set out in its report, and this is to be underpinned by a Stock Exchange listing requirement for a ‘statement of compliance’. Objectively verifiable items should be reviewed by the auditors. Among the items covered in the code are:
● ● ● ● ●

● ● ●

regularity and comprehensiveness of board meetings; separation of powers at the top of the organisation; availability of advice to all directors; inclusion of ‘independent’ non-executive directors; limit of 3 years for executive directors’ contracts (unless overridden by general meeting), disclosure of total emoluments, and control via a remuneration committee; appointment of an audit committee; report on the effectiveness of internal controls; assertion of ‘going concern’ status, with supporting assumptions as necessary.

Detailed knowledge of corporate governance issues is not required for the Financial Strategy syllabus. Students are expected to have a general understanding of the key principles. Overseas candidates will be able to comment on regulation in their own country as an alternative to the UK examples given in this Study System.

1.9.2 The Greenbury Report
There have been further developments since the Cadbury Report. The main recommendations of the Greenbury Committee’s report have become requirements for Stock Exchange listing:

The remuneration committee should consist entirely of non-executive directors with no personal interest other than as shareholders in the matter to be decided. An annual report should be provided for shareholders, approved by the shareholders at the annual general meeting. Full details of the directors’ remuneration should be disclosed.
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A number of non-mandatory recommendations were also made, which included:
● ●

bonuses should partly comprise shares or options; directors’ contracts should be for terms of one year or less, in order to avoid large pay-offs.

1.9.3 The Hampel Report
The Hampel Committee was set up to develop issues raised in the Cadbury and Greenbury reports. The report, issued in 1998, proposed combining the best practices, principles and codes of all three reports into a single code. The Stock Exchange subsequently issued a combined code on corporate governance, and amended the listing rules to make compliance with the code obligatory for listed companies. Among the key recommendations of the Hampel Report are:
● ●

● ● ●

● ●

The primary duty of the directors is to enhance the shareholders’ investment. Non-executive directors should comprise at least one-third of the membership of the board. The roles of chairman and chief executive should generally be separate. All directors should submit themselves for re-election at least once every 3 years. A remuneration committee should be established, composed of independent, nonexecutive directors. A business presentation is recommended at the annual general meeting, with a questionand-answer session. A resolution should be proposed at the annual general meeting relating to the annual report and accounts. An audit committee should be established, composed of at least three non-executive directors, at least two of these being independent. Directors should report on internal control. The accounts should contain a statement describing how corporate governance principles are applied.

1.9.4 Regulatory bodies
Where a market is not competitive, or is in the early stages of becoming so – as is the case with privatised utilities in the UK – there is a need for regulators whose role is to try to balance the interests of the various stakeholders. Customers need to be protected by limiting the extent to which entities can use a monopoly position to create excessively high added value for the benefit of shareholders, employees, and, through taxation, the state. Even so, the regulator still needs to ensure that prices will provide sufficient margins to allow for necessary investment. Similar situations can exist overseas, especially where countries are at an early stage of competition development. Here the state will often control the rate of development by licensing ‘private’ entities, while delegating to regulators a number of powers relating to business operations. Important issues for regulating in the UK and overseas are the prevention of ‘cross-subsidy’, that is, the transferring or offloading of portions of overhead costs from lower- to higher-margin products, the limitation of non-price barriers affecting the entry of new competitors, and assuring reasonable quality of product in relation to price. Non-price barriers could include trade restrictions, or restricted access to supplies or distribution channels.
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Regulators and their relationship to the regulated is a tricky area. Regulators rarely have statutory rights to enforce decisions and can usually only advise government. Their responsibilities may also only extend to the regulated portion of a company’s business; if the company has interests in a deregulated area the regulator has to take steps to ensure the correct allocation of costs. In the UK, examples of institutions covered by this section of the syllabus are the regulators of privatised industries. Examples include Oftel (telecommunications), Ofgas (gas) and Ofwat (water), plus organisations such as the Competition Commission (which is not strictly a regulator, rather a watchdog). Understanding the purpose of these organisations, and the influence they may have on government and company decisions, is necessary. Detailed knowledge of the procedures of the various organisations will not be expected in your examination. In an international environment, financial managers need to know about issues in other countries. However, examination questions will usually allow overseas candidates to comment on institutions in their own country as an alternative to the UK examples which may be given in the question.

Exercise 1.1
Explain the objectives and main activities of a regulatory authority.

Solution
The starting point for establishing a regulatory regime is a clear set of government objectives. The regulatory rules should then be designed so that they both meet government objectives and can readily be understood by both regulator and the regulated industry. These objectives may be classified under three headings:
● ● ●

the protection of customers from monopoly power; the promotion of social and macroeconomic objectives; the promotion of competition.

Where participants in a regulated market are judged to possess significant market power, and where there is no other protection for customers, methods for protecting customers in a specific sector by controls on prices and on quality of service will need to be considered. A particular focus here will be on price or tariff controls. Social objectives cover a variety of possible government objectives, including the availability and affordability of services in particular areas and to particular groups such as the disabled or customers in rural areas. It is often difficult to achieve these objectives (which may be specific) from wider government macroeconomic objectives. These can include policy on employment, pricing (and inflation) and investment, and may be particularly important in developing countries. The first step in designing effective regulations to promote competition is to identify where potential barriers to entry might exist, and their relative importance. Once the market segments in which there is scope for competition have been identified, steps will be needed to assist its development.
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Other regulatory options may also be considered, including:

Prohibiting cross-subsidy. To enforce this it will be necessary to require the company to make available to the regulator separate accounts for separate businesses. Removal of the right to compete in defined activities. An alternative to requiring separation or prohibiting cross-subsidy is to prohibit the regulated company from competing in the activity in which competition is to be promoted. Creation of a regulation prohibiting discrimination. The established company can prevent the loss of its most valuable customers to a new competitor by offering special terms of service. A rule to prevent this may therefore be appropriate. Regulation may be enforced by a number of means: legislation, licences, industry codes of practice, government department versus independent regulator.

The need for these, and the effectiveness of current controls, will depend very much on the technical characteristics of the particular service offered.

1.9.5 The regulation of takeovers and the competition commission
The syllabus does not require detailed knowledge of the regulation of takeovers or the operations of the UK Competition Commission. However, some understanding of the implications of regulation is useful, as often companies use a reference to the competition authorities as a defence against takeover. UK takeovers are regulated in three ways, two of them formal and the third informal. UK mergers are considered by the competition authorities under the Enterprise Act 2002. Any UK mergers which do not fall under the EC Merger Regulation (ECMR), and which meet the jurisdictional tests in the Enterprise Act 2002, fall to the UK authorities: Office of Fair Trading (OFT), Competition Commission (CC) and, in the case of public interest considerations and, for the time being, mergers between water and sewerage companies, the Secretary of State for Trade and Industry (SoS). The public interest considerations relate to national security and media mergers. The latter covers newspapers, broadcasting and cross-media mergers. Generally, mergers can only be considered by the UK competition authorities if the turnover in the UK of the enterprise being taken over exceeds £70m or the merger creates or increases a 25 per cent share in a market for goods or services in the UK or a substantial part of it. There is no general requirement to notify mergers to the UK competition authorities. The OFT investigates all mergers in the first instance and, with the exception of public interest cases, decides whether or not they should be referred to the CC for further investigation. The test is whether the OFT believes a merger has resulted or may be expected to result in a substantial lessening of competition. At this stage there are three ways in which a merger may be treated:
● ● ●

it may be referred to the CC for further investigation; it may be cleared; or undertakings may be sought in lieu of a reference to the CC.

Where a merger is referred to the CC, they are required to determine whether it has resulted or may be expected to result in a substantial lessening of competition and to take the action it considers reasonable and practicable to address any adverse effects of the merger that they have identified.
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All CC reports are published. Companies can also obtain confidential guidance or informal advice from the OFT on whether or not a potential merger would be likely to be referred. For public interest cases, the SoS will decide whether to clear a merger, refer it to the CC, or seek undertakings in lieu of a reference following receipt of advice from the OFT and, in the case of media mergers, from OFCOM. The SoS will also decide whether to make an adverse public interest finding following receipt of the CC’s report. In making these decisions, the SoS must accept the views of OFT and CC as to jurisdiction and whether there is an anti-competitive outcome. For a merger situation raising defined public interest issues, but which falls below the turnover and share of supply tests, the SoS may issue a special intervention notice allowing the competition authorities to consider those issues. As with other public interest cases, the SoS will make any decision on reference to the CC and on an adverse public interest finding. The public interest considerations relating to media mergers came into force on 29 December 2003 when they were inserted into the Enterprise Act by the Communications Act 2003. A special regime exists for mergers between water and sewerage companies. These are currently considered under the Water Industry Act 1991, with changes to be made through the Enterprise Act and the Water Act. A key change will be that the OFT and the CC will replace the SoS as relevant authorities in water mergers. Those mergers completed, notified to the OFT by means of the statutory merger notice, or referred to the CC before 20 June 2003, are considered under the Fair Trading Act as follows:
● ●

final decisions on mergers taken by the SoS rather than the OFT and the CC; mergers considered against a broader public interest test rather than the new test of whether they result in a substantial lessening of competition; a worldwide assets-based criteria for determining whether a merger is subject to merger control procedures rather than a UK-based turnover test.

Section 58 of the Fair Trading Act 1973 requires proprietors of newspapers circulating in the UK to obtain the Secretary of State’s (Department of Trade & Industry) prior written consent to acquire a controlling interest in another newspaper or newspaper assets if the total sales (i.e. paid-for circulation) of all the newspapers concerned (the proprietor’s existing titles plus those to be acquired) is 500,000 or more copies per day of publication. The second mode of regulation is under the competition policy of the European Union, set out in Articles 81 (formerly Article 85) and 82 (formerly 86) of the Treaty of Rome. Article 82 prohibits the abuse of a dominant firm position insofar as it may affect trade between member states. The ECMR provides that a merger that creates a dominant position, as a result of which competition would be significantly impeded, shall be declared incompatible with the common market. The Regulation applies to all mergers with a ‘Community Dimension’, defined in terms of turnover levels. The ECMR was designed to provide ‘one-stop’ merger control to avoid the risk of mergers being investigated under two or more jurisdictions. National authorities may not normally apply their own competition laws to mergers falling within the ECMR. The third control on takeovers is operated by the Takeover Panel, formed in 1968 to counter the perceived inadequacy of the statutory mechanisms for regulating the conduct of both parties in the takeover process. The Panel consists of representatives from City and other leading business institutions, such as the CBI, the Stock Exchange and the ICAEW accounting body, thus representing the main associations whose members are involved in takeovers, whether as advisers, shareholders or regulators. The Panel promulgates and
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administers the Takeover Code, a set or rules with no force of law, but which reflects what those most closely involved with takeovers regard as best practice. It does, however, have some sanctions to enforce its authority, such as public reprimands, which damage the reputation of violators of the Code, perhaps leading to the collapse of the bid and, for financial advisers, to long-term loss of business. The Panel’s ultimate sanction is to request its members to withdraw the facilities of the City from offenders, although this is extremely rare. Source: Department of Trade and Industry. (www.dti.gov.uk/cp/ukmergerguide.htm)

1.10 Major economic influences
In this section we review some of the major economic forces affecting an organisation’s financial plans, such as interest rates, inflation and exchange rates.

1.10.1 Interest rates
In the UK, short-term interest rates are set by the Bank of England’s Monetary Policy Committee. A rate of interest is the price of money which is lent/borrowed. It is expressed as a percentage of the sum, calculated on an annual basis. For example, if someone buys a gilt, and thus lends money to the government, they will receive interest. In this case it is calculated on the purchase price. Thus there is an inverse relationship between the price of gilts and the rate of interest. Let us assume that a £100 stock pays £10 annually to the holder as interest. If someone bought the stock and held it until maturity, after (say) a year they are effectively receiving 10 per cent interest. However, if the £100 nominal value stock is bought for less than its face value at, say, £97, the purchaser is really receiving 10.31 per cent, that is, £10 on an outlay of £97. Furthermore, if the government needs to sell more stock in order to finance its publicsector borrowing requirement, the price might fall to £95. However, this effectively means that a higher rate of interest is paid by the borrower (and received by the buyer). It is 10.52 per cent, that is (£10 £95). Generally, the longer the time period of a loan, the higher the rate of interest given/charged because of the greater risk and uncertainty involved. However, because some borrowers are safer than others, two loans for the same length of time might carry different interest rates. For example, normally a bank loan to a low-risk, blue-chip plc would receive a lower rate of interest than a loan to a high-risk sole trader. A central rate of interest It is clear that there is no such thing as the rate of interest because there are many rates of interest, which reflect varying risk. However, there has always been a central rate around which the others vary and to which governments have paid great attention. This has usually been the rate at which the Bank of England would lend to the money market, based on Treasury bill rates. In the post-war period until 1971 this key central rate was called bank rate and was fixed 1 by the Bank of England. It was replaced by minimum lending rate which was set at _ per cent 2 above the weekly Treasury bill lender rate, so that it reflected market conditions. However, in 1981 this rate was abolished and so there is no ‘official rate’. Nevertheless, the bank base rate has become a key indicator. It moves to reflect changes in the money market which are
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triggered by the Bank of England’s behaviour in that market. For example, if the Bank of England wants higher rates of interest and sells more bills, thereby pushing prices down, this will have a ripple affect and base rates will rise too (causing further ripples).

1.10.2 Term structure of interest rates
One of the primary considerations in evaluating debt is the likely movement in interest rates. This will affect the relative costs of long- and short-term debt, as well as increasing or decreasing the preference for fixed interest rates. In practice, long-term rates will normally be higher than short-term rates, owing to the additional risk borne by the lender. Hence an interest premium is required to attract investors to longer-term securities. This effect may be magnified or reversed by investors’ expectations of future rates, an anticipated rate rise producing higher longer-term rates. This difference between long- and short-term rates is known as term structure. The term structure of interest rates is shown by the yield curve. Figure 1.1 shows an upward-sloping, or normal, yield curve showing long-term rates to be higher than those available in the short term. The yield curve will normally be upwardsloping in order to compensate investors for tying up their money for longer periods of time. In extreme cases, this may justify a company borrowing, using short-dated stock which is replaced regularly – although the level of transaction costs makes this unlikely. Sometimes the yield curve will be downward, or inverse, with short-term interest rates higher than long-term rates, as shown in Figure 1.2. In the UK, the Bank of England

Figure 1.1

Term structure of interest rates

Figure 1.2

Inverse yield curve
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Monetary Policy Committee meets monthly to set interest rates. Their influence is directed primarily towards short-term interest rates, as a means of managing inflation in the economy. Short-term interest rates might be increased to combat inflation. If, however, interest rates are expected to fall in the future once the risk of inflation has been countered, long-term interest rates may be lower than short-term rates, and the yield curve would therefore be downward sloping. Factors that influence term structure In general terms, an increasing term structure results from two factors:
● ●

increased risk of longer debt; anticipated general interest-rate rises.

More detailed analysis is required, however. Below are listed formal theories as to why interest rates increase with time. Expectations theory This states that the forward interest rate is due solely to expectations of interest-rate movements. If an individual wishes to borrow for two years, two obvious possibilities present themselves: (a) borrow for 2 years at an agreed rate; (b) borrow for 1 year and refinance for the second year (i.e. pay off the first loan by taking out a second). In option (a), the interest paid on the loan will be based on the current interest rate and the forward rate for one year. In option (b), the individual will consider the current interest rate and the expected interest rate for year two. Thus, the choice between the options hinges on whether the forward rate for year two is higher or lower than the expected rate. From the lender’s point of view, if the expected rate was higher they would only lend short, preferring to renegotiate at the end of 1 year and take advantage of the anticipated rate rise. A similar argument could be made if the expected rate was lower than the forward rate. Thus, for long- and short-dated debt to coexist, expected future rates and forward rates must be equal. Thus, the term structure of interest rates arises purely from investor expectations. Liquidity preference theory The problem with the expectations theory is that it ignores risk. If the expected rate for year two is the same as the forward rate, then an individual needing to borrow for 2 years would choose a 2-year loan since this eliminates the uncertainty of the actual interest rate to be paid in year two. Thus, borrowers will aim to borrow for the period for which they need funds. If lenders wish to lend for only one year there will be a shortage of long funds and an excess of short funds. This will lead to a premium on forward rates – that is, lenders will get a bonus for lending for two years and borrowers will have to pay extra if they insist on a 2-year loan. In this case the term structure of interest rates would again be upward-sloping but now this would be because of the liquidity preference of lenders and borrowers. Market segmentation It has been argued that demand for capital funds in practice can be segmented, particularly on a time basis. Thus, for example, companies tend to finance
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stocks with short-term funds and equipment with long-term funds. This leads to different factors affecting long- and short-term rates and a lack of a clear trend in the yield curve, characterised by irregularities such as humps and dips. Real interest rates The real interest rate puts interest rates in the context of inflation. When the rate of interest is higher than the rate of inflation, as in 1992–93, there is a positive real rate. This means that borrowers are losing in real terms but savers are gaining. Conversely, when the rate of inflation is higher than the rate of interest (e.g. 1980), the real rate of interest will be negative. In such a case borrowers gain and savers lose. The relationship between real and nominal rates of interest is given by the formula originally considered by Fisher: (1 nominal rate) (1 real rate) (1 inflation rate)

If the nominal rate of interest is 7 per cent and the rate of inflation is 2 per cent, the real rate of interest is calculated as: 1 + real rate = 1 + nominal rate = 1.07 = 1.049 1 + inflation rate 1.02 Thus, the real rate is 4.9 per cent. The effects of interest rate changes Changes in interest rates affect the economy in many ways. The following consequences are the main effects of an increase in interest rates:

Spending falls – expenditure by consumers, both individual and business, will be reduced. This occurs because the higher interest rates raise the cost of credit and deter spending. If we take incomes as fairly stable in the short term, higher interest payments on credit cards/mortgages, etc., leave less income for spending on consumer goods and services. This fall in spending means less aggregate demand in the economy and thus unemployment results. Asset values fall – the market value of financial assets will drop, because of the inverse relationship (between bonds and the rate of interest) explained earlier. This, in turn, will reduce many people’s wealth. It is likely that they will react to maintain the value of their total wealth and so may save, thereby further reducing expenditure in the economy. This phenomenon seems to fit the recession of the early 1990s when the house-price slump deepened the economic gloom. For many consumers today a house, rather than bonds, is their main asset. Foreign funds are attracted into Britain – a rise in interest rates will encourage overseas financial speculators to deposit money in Britain’s banking institutions because the rate of return has increased relative to that in other countries. Such funds could be made available as loans to British firms by the banking sector. The exchange rate rises – the inflow of foreign funds raises demand for sterling and so pushes up the exchange rate. This has the benefit of lowering import prices and thereby bearing down on domestic inflation. However, it makes exports more expensive and possibly harder to sell. The longer-term effect on the balance of payments could be beneficial or harmful depending on the elasticity of demand and supply for traded goods. This is discussed in detail in a later chapter.
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Inflation falls – higher interest rates affect the rate of inflation in three ways. First, less demand in the economy may encourage producers to lower prices in order to sell. This could be achieved by squeezing profit margins and/or wage levels. Second, new borrowing is deferred by the high interest rates and so demand will fall. Third, the higher exchange rate will raise export prices and thereby threaten sales which in turn pressurises producers to cut costs, particularly wages. If workers are laid off then again total demand is reduced and inflation is likely to fall.

1.10.3 Inflation
Inflation is defined simply as ‘rising prices’ and shows the cost of living in general terms. The effects of inflation If the rate of inflation is low, then the effects may be beneficial to an economy. Businessmen are encouraged by fairly stable prices and the prospect of higher profits. However, there is some argument about whether getting inflation below 3 per cent to, say, zero, is worth the economic pain (of, say, higher unemployment). There is agreement, though, that inflation above 5 per cent is harmful – worse still if it is accelerating. The main arguments are that such inflation:

distorts consumer behaviour – people may bring forward purchases because they fear higher prices later. This can cause hoarding and so destabilise markets, creating unnecessary shortages. redistributes income – people on fixed incomes or those lacking bargaining power will become relatively worse off, as their purchasing power falls. This is unfair. affects wage bargainers – trades unionists on behalf of labour may submit higher claims at times of high inflation, particularly if previously they had underestimated the future rise in prices. If employers accept such claims this may precipitate a wage–price spiral which exacerbates the inflation problem. undermines business confidence – wide fluctuations in the inflation rate make it difficult for entrepreneurs to predict the economic future and accurately calculate prices and investment returns. This uncertainty handicaps planning and production. weakens Britain’s competitive position – if Britain’s inflation exceeds her competitors’, then it makes exports less attractive (assuming unchanged exchange rates) and imports more competitive. This could mean fewer sales of British goods at home and abroad and thus a bigger trade deficit. For example, the decline of Britain’s manufacturing industry can be partly attributed to the growth of cheap imports when they were experiencing high inflation in the period 1978-83. redistributes wealth – if the rate of interest is below the rate of inflation, then borrowers are gaining at the expense of lenders. The real value of savings is being eroded. This wealth is being redistributed from savers to borrowers and from creditors to debtors. As the government is the largest borrower, via the national debt, it gains most during inflationary times.

1.10.4 Exchange rates
The exchange rate of a currency is a price. It is the external value of a currency expressed in another currency, for example £1 $1.60. A more complex measure expresses the value in terms of a weighted average of exchange rates as an index number. These are currencies
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of a nation’s main trading partners in manufactured goods and are collected in a representative basket. This is known as the effective exchange rate and shows the relative importance of the country as a competitor in export markets. A fall in the index shows a depreciation of a currency relative to the total basket of currencies on which the index is based. However, it is possible that that currency may be appreciating against some currencies in the basket whilst depreciating against others. A fall in the index simply shows that there is an overall depreciation, whereas a rise in the index would show an overall appreciation. The exchange of currencies is vital for trade in goods and services. British firms selling abroad will require foreign buyers to exchange their currency into sterling to facilitate payment. Similarly, British importers will need to pay out in foreign currencies. Also, when funds are transferred between people in different countries, foreign exchange is required. Today, the sale and purchase of currencies for trading purposes is dwarfed by the lending and borrowing of funds. The internal and external values of a currency are different. The former refers to the purchasing power of a currency at home. Inflation lowers the internal value. The external value is not affected by domestic inflation directly, but it changes with variations in other nations’ exchange rates. These variations reflected the demand for and supply of currencies on foreign exchange markets. In turn these tend to reflect trade performance. The foreign exchange market This market enables companies, fund managers, banks and others to buy and sell foreign currencies. Capital flows arising from trade, investment, loans and speculative dealing create a large demand for foreign currency, particularly sterling, US dollars and Euros. Typical deals are in Euros, and £300 billion is traded daily in London, the world’s largest foreign exchange centre. London benefits from its geographical location, favourable time intervals (with USA and the Far East in particular) and the variety of business generated there – insurance, commodities, banking, Eurobonds, etc. Foreign exchange trading may be spot or forward. Spot transactions are undertaken almost immediately and settled within two days. However, forward buying involves a future delivery date from three months onward. Banks and brokers, on behalf of their clients, operate in the forward market to protect the anticipated flows of foreign currency from exchange rate volatility. The forward price of a currency is normally higher (at a premium) or lower (at a discount) than the spot rate. Such premiums (or discounts) reflect interest rate differentials between currencies and expectations of currency depreciations and appreciations. As the foreign exchange market has grown, so other instruments such as futures and options have been developed to protect foreign exchange commitments. Currency futures involve the trading of forward transactions other than for currencies themselves, while currency options enable buyers (at a premium paid to the writer of the option, usually a bank) to guarantee a buying (or selling) price for a currency at a future specified date.

1.11 Modelling and forecasting cash flows and financial statements
1.11.1 Forecasting cash flows
Cash flow forecasts are vital to the management of cash. They show, over periods varying between a single day, a week, a month, a year or even longer, the expected inflows and outflows of cash through the company. They help to show cash surpluses and cash shortages.
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Management can therefore use cash budgets to plan ahead to meet those eventualities; arranging borrowing when a deficit is forecast, or buying short-term securities during times of excess cash. Remember that there will be differences between the cash flow forecast for a period and the forecast income statement for that period. This is because the cash budget is concerned with cash payments and cash receipts, while the income statement is concerned with income earned and expenses consumed in a period. Areas where the two statements may show different amounts include:

the cash budget will record budgeted cash receipts from customers, while the income statement will show forecast revenue for the period; the cash budget will record budgeted cash payments to suppliers, while the income statement will show forecast cost of sales, which will reflect opening stock, plus purchases, less closing stock; the cash budget shows the budgeted cash payments for expenses such as wages, electricity and rates. The income statement will record the expenditure expected to be consumed in the period, reflecting any accounts or prepayments; the cash budget will reflect the cost of purchasing a fixed asset at the expected date of purchase and the proceeds at the date of sale. The income statement will record a depreciation charge for the consumption of the asset and a profit or loss on disposal.

1.11.2 Forecasting financial statements
In an examination you may be required to model annual cash-flow forecasts and other financial statements using expected changes in values, based on data for a base year. The example below demonstrates such an approach.
Example 1.A
Lavinia Products plc manufactures toys and other goods for children. It has been trading for 3 years. The shares in the company are owned by five people, all of them employed full time in the business. The company is doing well and now needs additional capital to expand operations. Assume that you are a consultant working for Lavinia Products plc. You have been assigned to the company to advise on its objectives and financial situation. As well as being provided with financial statements for the year to 31 December 2006, the company’s accountant gives you the following information: 1. Sales and costs of sales are expected to increase by 10 per cent in each of the financial years ending 31 December 2007, 2008 and 2009. Operating expenses are expected to increase by 5 per cent each year. 2. The company expects to continue to be liable for tax at the marginal rate of 33 per cent. Assume tax is paid or refunded twelve months after the year end. 3. The ratios of debtors to sales and creditors to cost of sales will remain the same for the next three years. 4. The fixed assets are land and buildings which are not depreciated in the company’s books. Capital allowances on the buildings may be ignored. All other assets used by the company (machinery, cars, etc.) are rented. 5. Dividends will grow at 25 per cent in each of the financial years 2007, 2008 and 2009, as per the company’s objectives. 6. The company intends to purchase new machinery to the value of £500,000 during 2007 although an investment appraisal exercise has not been carried out. It will be depreciated straight line over 10 years. The company charges a full year’s depreciation in the first year of purchase of its assets. Capital allowances are available at 25 per cent reducing balance on this expenditure. 7. Additional stock was purchased for £35,000 at the beginning of 2007. The value of stock after this purchase is likely to remain at £361,000 for the foreseeable future. 8. No decision has been made on the type of finance to be used for the expansion programme. However, the company’s directors think they can raise new medium-term secured debt if necessary. 9. The average P/E ratio of listed companies in the same industry as Lavinia Products plc is 15.
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The company’s objectives include the following:
● ● ●

33 FORMULATION OF FINANCIAL STRATEGY

to earn a pre-tax return on the closing book value of shareholders’ funds of 35 per cent per year; to increase dividends per share by 25 per cent per year; to obtain a quotation on a recognised stock exchange within the next 3 years.

A summary of the financial statements for the year to 31 December 2006 is shown below. LAVINIA PRODUCTS PLC Summarised income statement for the year to 31 December 2006 Revenue Cost of sales Gross profit Operating expenses Interest Tax liability Net profit Dividends declared £000 (1,560 1,(950) (1,610 1,(325) 1,0(30) 1,0(84) 1,0171 1,5068

Summarised balance sheet at 31 December 2006 Non-current assets (net book value) Current assets: Inventory Receivables Cash and bank £000 £750 326 192 1,350 1,318 £000 Capital and reserves Ordinary share capital (ordinary shares of £1) Retained profits to 31 December 2005 Retentions for the year to 31 December 2006 Total financing Non-current liabilities 10% debenture redeemable 2020 Current liabilities Trade creditors Other creditors (including tax and dividends) 500 128 103 731 300 135 1,0 152 1,318

Requirements
Using the information in the case: (a) prepare forecast income statements for the years 2007, 2008 and 2009, and calculate whether the company is likely to meet its stated financial objective (return on shareholders’ funds) for these 3 years; (b) prepare cash-flow forecasts for the years 2007, 2008 and 2009, and estimate the amount of funds which will need to be raised by the company to finance its expansion. Notes: 1. You should ignore interest or returns on surplus funds invested during the 3-year period of review. 2. This is not an investment appraisal exercise; you may ignore the timing of cash flows within each year and you should not discount the cash flows. 3. Ignore inflation.

Solution
(a) Income statements for the year to 31 December .2006 .£000 1,560 (2007 ((£000 (1,716 (2008 ( £000 (1,888 (2009 ( £000 (2,076
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Cost of sales Gross profit Operating expenses Depreciation Interest on debt Profit before tax Tax Profit after interest and tax (,(950) (1610 (.(325) (1,(30) (1255 (1,(84) 1,171 (1,045) 00671 0 0(341) 00;(50) (1,,(30) 00250 (1,, (58) (1,192 (1,150) 00738 0( (358) (1,,(50) (1 ,(30) 00300 (1, (85) (1,215) (1,264) 00812 0( (376) (1,,(50) (1 ,(30) 00356 (1, (111) (1,245)

Notes: 1. Revenue and direct costs are increased by 10 per cent and operating expenses by 5 per cent per annum from 2006 onwards. 2. Tax is calculated as: Profit before tax Add depreciation Capital allowances Taxable profit Tax at 33% Other relevant information 2006 Dividends Dividends payable (£000) DPS (%) Percentage increase Percentage payout Earnings Profit retained (£000) EPS (pence) Percentage increase Value of equity (£000) 500,000 shares at PE of 15 Shareholders’ funds Ordinary share capital Retained earnings Shareholders’ funds Profit before tax ROSF (%) ROCE (%) (b) Cash-flow forecasts for Inflows Cash from sales Outflows Payments for purchases Operating expenses Working capital Machinery Tax payments Dividends paid Interest Total outflows Net cash flow Opening balance Cumulative cash balance
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£000 255 125) ,255 ,284

£000 250 50 (125) ,175. ,158.

£000 300 50 (((94) ,256) .285.

£000 356 50 ( (70) )336) )111)

2007 85 17.0 25 44 107 38.4 12.4 2,880 £000 500 2,338 2,838 250 29.8 27.0

2008 106 21.2 25 49 109 43.1 12.1 3,232 £000 500 2,447 3,947 300 31.7 29.0 2008 £000 1,867 1,135 358

2009 133 26.6 25 54 112 49.0 13.8 3,675 £000 500 2,559 1,059 356 33.6 31.0 2009 £000 2,053 1,248 377

68 13.6 49 103 34.2

2,565 £000 500 2,231 2,731 255 34.9 31.0 2007 £000 1,697 1,031 341 35 500 84 68 1,030 2,089 (392) (3350 ---(342)

58 85 1,130 1,666 201 (((342) ---(141)

85 106 1,230 1,846 207 (((141) ---(166

MANAGEMENT ACCOUNTING – FINANCIAL STRATEGY
The company will need to raise a minimum of £342,000 plus interest payments – which at 12 per cent would be £41,000 in the first year. A total of approximately £400,000 will therefore need to be raised. Calculation of cash from sales and payments for purchases Assuming, as per the question, that the ratio of debtors to sales and creditors to cost of sales remains the same (12.3 and 14.2 per cent respectively) the calculations are as follows: 2007 £000 1,716 192 3(211) 1,697 1,045 135 3(149) 1,031 2008 £000 1,888 211 3(232) 1,867 1,150 149 3(164) 1,867 2009 £000 2,076 232 3(255) 2,053 1,264 164 3(180) 2,053

35 FORMULATION OF FINANCIAL STRATEGY

Sales Opening debtors Less closing debtors (12.3% of sales) Cash received Purchases Opening creditors Less closing creditors (14.2% of CoS) An IAS 7 format is also acceptable.

Net cash inflow from operating activities Interest paid Dividends paid Net cash inflow Tax paid Investing activities: fixed assets Net cash outflow Net cash flow before financing Net cash inflow from operating activities for 2007

2007 £000 290 (30) (((68) 192 (84) (500) (584) (392)

2008 £000 374 (30) (((85) 259 (58) ((((–(((( ( (((58) 201)

2009 £000 428 (30) (106) (292 (85) ((((–(((( (((85) 207)

Gross profit (before depreciation) Less operating expenses Increase in debtors Increase in creditors Increase in stocks

£000 671 (341) (19) 14 (((35) (290(

1.11.3 Sensitivity analysis
Sensitivity analysis tests the effect of varying the projected value of important variables. When forecasting cash-flows and financial statements, it is essential that uncertainties in estimates of costs and benefits are taken into account by, at the very least, undertaking a sensitivity analysis. Significant variables may include:
● ● ● ●

sales volumes levels of productivity costs of materials labour costs.

Sensitivity tests should be well designed; it is not sufficient to show the implications of an arbitrary variation around a particular cost or benefit. Some indication of the likely range of variation is needed.

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1.12 Current and emerging issues in financial reporting
In July 2001 the Inernational Accounting Standards Board (IASB) announced its technical agenda which can be summarised as follows: Four key high-priority projects ● Accounting for share-based payments ● Business combinations ● Performance reporting ● Accounting for insurance contracts Applying international accounting standards ● New guidance on first-time application of International Financial Reporting Standards (IFRS) ● Disclosure and presentation of financial institutions’ activities Improvements projects ● Amendments to IAS 39 Financial Instruments: Recognition and Measurement ● Improvements (e.g. eliminating inconsistencies and reducing elements of choice). The four high-priority projects are all controversial to some degree. A major issue in business combinations accounting is the future of the pooling of interests/merger method of accounting, permitted by both IAS and UK accounting standards, but which has been recently abolished in the US. Performance reporting has been, and continues to be, a major problem in both practical and conceptual terms for reasons which include the following:
● ● ●

Problems of definition of gains, revenue, income, losses. Tension between economic and accounting definitions of income. Decision-usefulness and fair-value accounting: dealing with the consequences in the income statement. Complexity of income statements which cover operational and financial gains and losses, and recognised but not realised gains and losses on operational and financial assets and liabilities. Establishing a bottom line.

1.12.1 IFRS 1 first time adoption of IFRS
This standard applies to all entities adopting IFRSs as the basis of their reporting. The objective of the IFRS is:

to ensure that an entity’s first IFRS financial statements, and its interim financial reports for part of the period covered by those financial statements, contain high quality information that: (a) Is transparent for users and comparable over all periods presented: (b) provides a suitable starting point for accounting under International Financial Reporting Standards; and (c) can be generated at a cost that does not exceed the benefits to users.

1.12.2 IFRS 2 Share-based payment
Share-based payment is an issue that has concerned standard-setters around the world for at least a decade. It was debated at length during the 1990s in the USA where the problem is
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particularly pressing due to the large number of company executives who are paid in the form of shares or share options. The Financial Accounting Standards Board in the US was only partially successful in addressing the problem; a standard was issued but compliance was voluntary. In 2000, the G4 1 group of standard setters issued a discussion paper whose proposals would require companies to account fully for the costs of share-based payment. The IASB announced during 2001 that it would be undertaking a project to produce a standard on the subject. In February 2004 it issued IFRS 2 Share-based payment. What is the issue? Share option schemes are frequently used as a means of rewarding employees. They may also be used as a means of buying-in goods or services from parties outside the company. Such schemes can become very complicated, especially if the options are dependent in some way on company or employee performance. In some cases, share schemes of various types are used as a means of replacing substantial parts of remuneration in the form of regular salary, or indeed as a complete substitute for remuneration. In the case of risky business start-ups (particularly in high-tech industries) employees may agree to work for little or nothing, being rewarded instead either by shares in the company at start-up (at which point the shares are likely to be worth little or nothing) or by options to purchase shares at a minimal price at some future date. Employees in such cases voluntarily take on a risk, in the hope of material reward in future. The advantage to the start-up company is obvious: it obtains the advantages of highly skilled labour without having to pay for it. If the business fails, the value of the stock or options will never materialise and the employees bear the opportunity cost of their services which, in the event, have been supplied for no return. If the business prospers the shares gain in value, the options are exercised, and, in some cases, the employees gain huge rewards for the risk they have run. A simple example, set in the context of an established business, will illustrate the issue.
Example 1.B
Company A, a listed company, rewards its senior employees from time to time by granting share options. On 1 January 20X3 it grants each member of a group of senior employees an option on 10,000 shares, at an exercise price of the market value of the shares on 1 January 20X3 ($3.50), the option to be exercised no earlier than 1 January 20X6. Three years later, on 1 January 20X6 the market value of one share is $4.50. Senior employee B decides to exercise the option. He pays A $35,000 (10,000 shares @ $3.50) and receives 10,000 shares in exchange. Employee B has thus gained a benefit with a current value at 1 January 20X6 of $10,000 (current value of shares $4.50 10,000 $45,000 less the $35.000 just paid). Whether or not B chooses to realise his gain immediately by selling the shares at $4.50 each is entirely up to him; hence-forth, for as long as he owns the shares, he bears all of the risks and rewards of ownership, just like any other equity shareholder in a listed company. Accounting for this transaction appears straightforward: $10,000 to be credited to share capital, being the nominal value of shares issued; $25,000 to share premium account; a debit of $35,000 to cash for the amount received from the employee. However, beyond these simple entries there is the question of the $10,000 benefit to the employee, which can be viewed as representing delayed remuneration for his services over the 3-year period. Applying the accruals concept, remuneration should be matched against the revenue which the services of the employee have helped to create. So, in this case, should there not be an additional debit of $10,000 to the income statement over the 3 years in order to reflect the cost of these services? The arguments for and against its inclusion are as follows. For ● The $10,000 represents remuneration and so should be properly reflected as an expense; the means by which the remuneration is paid is irrelevant. ● If the company does not fully reflect remuneration for services to employees the performance statement will be incomplete, and users will neither be able to properly assess the stewardship of management nor to make fully informed economic decisions.
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If costs of employment are fully reflected in some companies (because they are paid via regular salaries) and not in others (because rewards are wholly or partly in shares or share options) then the performance statements between companies will not be comparable. (Remember: comparability is one of the four key qualitative characteristics of financial statements identified by the IASC in its Framework).

Against The $10,000 does not represent an outflow of economic benefits from the company. The gain arises because of the company’s share price performance, and is receivable by the employee independently of any action by the company. ● The $10,000 does not represent an expense within the terms employed by the conceptual framework. Losses (which include expenses) ‘are decreases in ownership interest not resulting from distributions to owners’. The $10,000 is not a decrease in ownership interest. ● If $10,000 is debited to the company’s performance statement, what should happen to the related credit? It is doubtful whether it fulfils the characteristics of either a liability or ownership interest.

Up till now there has been limited guidance on accounting for share-based payment. There is a standard in the US but, because of adverse responses from interested parties, its adoption for share-based payments is voluntary.

IFRS 2’s response to the problem The IFRS should be applied to all share-based payment transactions, and it identifies three principal types: 1. Equity-settled share-based payment transactions. This category would include the transaction in Example 1B above. 2. Cash-settled share-based payment transactions. This is where the provider of services or goods (i.e. in most cases the employee) is rewarded in cash, but the cash value is based upon the price of the company’s shares or other equity instruments. 3. Transactions where one of the parties involved can choose whether the provider of services or goods is rewarded in cash (value based on equity prices) or in shares. The underlying assumption of the IFRS is that the issue of share options and grants of shares to employees and others creates a financial instrument which must be accounted for. Recognition. Where payment for goods and services is in the form of shares or share options the transaction should be recognised in the financial statements. There should be a charge to profit and loss account when the goods or services are consumed. Where the payment is equity-settled (type 1 above) the corresponding credit should be to equity. Where the payment is cash-settled (type 2 above) the corresponding credit should be to liabilities. Measurement. The transaction should be measured at the fair value of the shares or options issued. Measurement can be direct, that is, at the fair value of the goods or services received, or indirect, that is, by reference to the fair value of the equity instruments granted. In this latter case, fair value should be measured at the date of grant.

1.12.3 Reporting environmental issues
Protecting the environment is a key issue affecting everyone. Pressures are placed on businesses to ensure that the environment suffers minimum damage as a result of their products, processes or services. Businesses are using recyclable materials, monitoring pollution levels and taking other environmentally sound measures to comply with customer demand for ‘green’ products. Indeed, as writers suggest, the work of the accountant is changing so as to encompass environmental issues.
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This will include:

● ● ● ●

Dealing with environmental taxes. France, for example, charges businesses for air and water pollution and reinvests those taxes in pollution control. Investment appraisal will have to take environmental factors into account. Costing new pollution controls. Reporting on the feasibility of replacing materials for environmental purposes. Estimating the impact of ‘green’ consumer preference.

This general trend is extending to the annual financial report; companies are reporting information about their actions with regard to maintaining the environment. Such disclosures include:
● ● ●

level of toxic waste, energy usage and noise; policies regarding environmental care; comment on actions the company has taken, for example in choice of raw materials or product policies.

The annual report is traditionally a vehicle for financial information about the company. However, the users of the annual report represent a wide audience which extends beyond the shareholders and investors. Companies therefore view the annual report as a public relations document and report much voluntary information regarding their products, policies and so on and this now includes information about their actions towards preserving the environment. Indeed some companies are almost obliged to report on environmental issues. Generally, the trend in environmental reporting by companies has been slow and on an ad hoc basis. Some companies make a company policy statement only, others may make a company policy statement and a statement of what action has been taken to implement the policy, not necessarily quantified. Finally, some companies may report physically audited measurements, such as water pollution, emissions or depletion of non-renewable resources, plus reporting on indirect effects such as the environmental impact of suppliers and the impact resulting from the disposal of a product, and consideration of stakeholders from an environmental point of view. A powerful force in the demand for environmental information from companies arises from the ethical investment movement and the Green Alliance. Furthermore, the green movement headed by groups such as Greenpeace and Friends of the Earth is making the public aware of environmental issues and forcing companies to care. The situation is inconsistent. International bodies such as the United Nations, as well as the UK’s Confederation of British Industries, have addressed the main issues. However their proposals have been complex and impractical for implementation by industry and standard-setting bodies. Environmental issues are major concerns, and regulations issued by governments and international bodies are helping to ensure that environmental care is increasing. At present there are no mandatory requirements to publish results of environmental audits but some environmental bodies require that companies publish a summary of figures on pollution emissions, waste production, consumption of raw materials, energy and water, noise and a presentation of the company’s environmental policy. EC proposals set standards for environmental issues, such as emission levels for pollution. It is also seeking a requirement for publication of these levels and targets.
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As environmental regulations increase and demands from the public, consumers and investors become more onerous, companies will suffer the cost of these actions. Contingent liabilities relating to the results of environmental audits, other clean-up measures, environmental disasters and other litigation due to noise or waste policies need to be disclosed in the financial statements. The current situation is not wholly satisfactory and there is much ground to cover:

Not all companies currently report environmental information; some companies may report environmental issues one year and none at all in another year. As disclosures are of a voluntary nature there is a danger that the information may be incomplete and therefore unreliable. The importance of disclosure of information varies according to particular industries. Chemical, oil, steel and other high-polluting industries are seen as being more responsible for reporting on environmental issues. The use of environmental issues appears to be more of a public relations exercise rather than an obligation.

However, adequate disclosure is of limited reliability unless it is adequately audited. There is at present no obligation to carry out an environmental audit. If such audits are carried out they are confidential, are not carried out to agreed standards, and the audit reports do not have to be published.

1.12.4 Reporting of social issues
The present nature of environmental reporting is a product of lobby groups, government and international pressures on companies and individuals to be aware of, and take care of, the environment. However, this is not a new concept. Accounting theorists have always questioned the role of financial reports. Currently, they communicate financial information resulting from historic transactions entered into by the company. This relates primarily to the exchange of goods and services and excludes movements in human capital, the effects on the social environment and details of future financial position and performance. The theory of socio-economic accounting is the process of ordering, measuring and disclosing the impact of exchanges between a firm and its social environment. This involves looking at social resources and the exchanges between a company and society. Society is seen as a number of subsystems with which the company will interact. Interaction with the economic system is currently reported in the financial reports. Social accounting seems to extend the reporting function beyond this system to include:

The physical environment. The company will utilise physical resources such as coal, gas and agricultural products but the social cost of this use is currently not reported. The meteorological and biological environment. In its use of energy and the production of goods the firm will cause changes in the surrounding atmosphere and natural environment. The sociological environment. The way in which a firm attracts human resources, and uses those resources, will affect local society.

The activities of a company may lead to an increase in social resources. For example, the provision of employment in an area may result in a social benefit.
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On the other hand, if the activities of a company lead to the depletion of social resources this is termed a social cost. Social costs include:
● ● ● ●

pollution: air, water, noise; depletion and destruction of animal resources; soil erosion and deforestation; unemployment and idle resources.

Social reporting would include a social income statement, recording social costs and benefits to different areas of society, and a social balance sheet disclosing staff assets, organisational assets, the use of public goods, financial and physical assets. One of the most important papers to be produced on the subject was The Corporate Report (UK), published in 1975. It reviewed the objectives and role of the financial statements as the IASB has done in its Framework. The Corporate Report went further in advocating the publication of supplementary reports to meet the needs of other users. These were:

Statement of corporate objectives. The statement could take many forms but would include all stakeholders’ objectives The employment report, intended to give information on the number and details of employees, wage rates, the type of work and training. Statement of future prospects. The Corporate Report acknowledged that it was difficult to report on issues in this area. Yet it would provide vital information to all users. Value-added reports, showing the development of resources throughout the organisation and the interdependency of all parties (employees, government, capital providers, not just profit for shareholders). A typical value-added statement shows the split of turnover between the interested parties:
ABC Group: value-added statement for the year ended 31 December 20X1 $ Revenue X Less: bought-in materials and services (X) Value added X Applied to Employees Wages, pensions and other benefits X Government Corporation tax X Providers of capital Interest on loans X Dividends X Retained by the company for future growth and capital expenditure Depreciation X Retained earnings ‘ X‘ Total allocated funds ‘X ‘

The provision of such information would be costly. There would be a need for independent review or audit, further adding to the cost. The incorporation of this additional information in the annual report would become truly widespread only if encapsulated in regulation.
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1.12.5 Inclusion of forecasts in the annual report
Why not require enterprises to include forecasts in their annual report? There has been discussion within the accounting profession on the issue of including forecast information in the annual report. A suggestion is that the primary statements should include an additional column for forecast budgets. This information is available within the management information system. However, the implications for companies including this information are profound. If the company included an optimistic forecast and those forecasts were not met then the market’s perceptions would be that management was incompetent, with resultant effects on the company’s share price. If, on the other hand, the forecast was too pessimistic then again this would have adverse effects on the company’s share price and would result in undervaluation of the company. Furthermore, if the company outperformed the forecast, perceptions may be that this was due to luck rather than management efforts. Some authors have stated, however, that these potential effects would force budgets to be realistic. Annual reports would include management’s analysis of the forecasts and so produce a new type of reporting. It would also force management to consider the effects of decisions. The analysis of the financial report and information for decision-making would be more relevant from a user’s point of view. Those who do not wish to include forecasts cite commercial reasons. Forecasts would have to include commercial plans and so provide valuable information to competitors. However, if this was a mandatory obligation, competitors would of course have to provide that information as well. Provision of additional information would be costly. Costs include not only the financial costs of obtaining the information but also costs to the firm from action taken on the information by investors, customers and suppliers.

1.12.6 Reporting of human capital
The difference between the market value of an entity and shareholders’ funds in the balance sheet can be due to factors such as staff with good management skills, the existence of certain technical skills within the company and know-how. These human resource factors are not quantified in the financial statements at present but are, all the same, recognised by the markets involving a company. An asset is defined by the IASC Framework as ‘… a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise’. Certainly the skills and talents of employees and management will contribute to the generation of future benefits to the company. The problem arises as to how to value the human resource factors. The wages and salaries paid to management and employees for their skills are expensed in the year. However, if the view was taken that human resources were an ‘asset’ of the business, the costs would be capitalised in the balance sheet and depreciated or charged to the income statement in line with the income they generate. Valuation of the ‘asset’ would be in line with other methods used in the balance sheet: historical cost, replacement cost, economic value. The historical cost method would involve capitalising all costs associated with recruiting, selecting, employing, training and developing an employee and then amortising these costs over the expected useful life of the asset. Problems arise with this method. The value of the asset’s ability to generate benefits to the firm does not necessarily correspond to the historical cost and amortisation. Furthermore,
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different companies will incur differing costs for training and development, for example, therefore hampering comparisons. The replacement cost method estimates the cost of replacing the existing human resources, that is, what costs would be incurred to bring new staff to the level of competence of existing staff. Again, however, this value does not equate with the value of future benefits the asset will generate. Also, as with other physical assets there may not be an equivalent replacement for a given human asset. Finally, estimating the replacement costs would be very subjective. An economic value for a human asset could be obtained using an adjusted discounted future wages method. Discounted future wages are adjusted by an efficiency factor to measure the effectiveness of human capital of a company. There are many other non-monetary methods of valuing human resources of a company and these would involve much subjectivity.

1.13 Summary
This chapter has aimed to provide an overview of financial strategy. We discuss the main groups into which financial management decisions can be classified: investment, financing and dividends. We explain how financial strategy is applicable to, and equally important in, organisations which do not seek distributable profits, emphasising that the key factor is the assessment of the value of the output of an entity and especially the excess of that value over the cost of inputs, whether it be in the private or the public sector. Dividend payments have been shown to be irrelevant to shareholder wealth in perfect capital markets. When market imperfections – such as taxes, transaction costs and imperfect information – are considered, the situation is less clear. Companies tend to adopt stable and consistent dividend policies, in order to attract a clientele of investors whose personal taxation position suits that particular policy. Unexpected fluctuations in the dividend payment tend to be avoided because of the informational content of the dividend which is being signalled to the market. We discuss the impact of economic and regulatory constraints on financial strategy. We have illustrated in detail an approach to modelling and forecasting cash flows and financial statements and identified some current and emerging issues in financial reporting.

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Readings

1

The article by Paul Nichols compares the concepts of cash-flow return on investment, economic value added and cash value added. He revisits the ‘profit is an opinion; cash is a fact’ argument of a couple of decades ago, and concludes that management will have to relearn how to manage the fact of cash, and that the ability to manage and manipulate profit is no longer sufficient. The second article considers the trend towards corporate social responsibility reporting.

Unlocking shareholder value
Paul Nichols, Management Accounting, October 1998. Reproduced with permission.
I get paid to make the owners of the company increasingly wealthy with each passing day. Everything else is just fluff. Former Coca-Cola CEO, Roberto Giozueta Our traditional mindset has always somehow perceived business as buying cheap and selling dear. The new approach defines a business as the organisation that adds value and creates wealth. Peter Drucker, Harvard Business Review, February 1995

Since the start of limited liability companies, corporate accountants have been measuring the success of their organisations by using traditional measurements – profit margin, return on assets, return on equity etc. At the same time, when judging the viability of individual projects or investments, they have used discounted cash flow measurements – NPV, IRR etc. And while they were adopting this dual approach the investor was using yet a third set of measurements – EPS, P/E etc. It was surely only a matter of time before something happened to bring the three different measurement systems into line: for both management and investors to judge the success of a company by the same criteria that they judged investments. That catalyst was the publication in 1986 of Alfred Rappaport’s Creating Shareholder Value. This book started a major change in the way both management and shareholders view performance. At the same time it was the starting point for an acceleration in the activity of consultants, each developing their own version of the best way of judging performance in this new world. All the consultants follow a similar thought process: 1. Profit has become to some extent a discredited measure – to quote Price Waterhouse’s Profit is an opinion; cash is a fact. Arguably, decades ago there was little difference between cash flow and profit. However, as the world has become more complex and accounting
45
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rules and practices have had to match this complexity, so a gulf has developed between the two. Inevitably (?) this has led to many accounting entries being made on the basis of management judgement. Acquisitions, goodwill adjustments, pension funding, depreciation policies, deferred-tax accounting etc. have taken us down the judgement route. No longer is profit judged by the auditor to be correct. It is now only true and fair. 2. If profit cannot be trusted then cash, the fact rather than the opinion, needs to be measured. Rappaport argued (and all the consultants agree) that there are five drivers of cash: ● turnover growth rate; ● operating profit margin; ● the percentage of incremental revenue spent on fixed capital net of depreciation; ● the similar percentage for working capital; ● the percentage tax rate – paid rather than the accounted charge. These drivers need to be measured over the future period for which the company has perceived competitive advantage – what Rappaport calls ‘the value growth potential period’. 3. The traditional cost of capital reflected in the profit and loss account – interest – is inadequate. When assessing the validity of a project or an investment a company will use a composite capital cost rate that contains not just the cost of loan interest but also some proxy for the cost of shareholders’ funds. The same concept of a composite rate is needed in the evaluation of the total enterprise. Normally a company will use the traditional weighted average cost of capital, which takes both the cost of debt and of equity and weights them according to the book, or projected book, gearing. 4. What needs to be measured is how well the company is performing to the benefit of its owners, the shareholders. There is a view strongly held by many that companies are only there to generate value for their shareholders. The shareholder knows after the event how much he has made by measures such as total shareholder return (the increase in the value of his portfolio assuming reinvestment of all dividends). What is needed is a tool to help management deliver it. Although all consultancies follow these four basic logical steps they all have their own individual models, which can broadly be grouped under three main types.
Cash-flow return on investment (CFROI)

There are many variants of this approach, which is perhaps the most popular in the UK, but all follow the original Rappaport thinking. Future cash flows are compared with the weighted average cost of capital either as an absolute sum of money surplus or future cash flows are stated as an internal rate of return (IRR) which in turn is compared with the WACC. Each consultancy will have its own version of how the result is to be computed. Each will have its own way of handling inflation, of valuing assets and of portraying the final result. It is general practice to make a distinction between replacement capital and growth capital, treating the former as negative cash flow like normal expenses and only the latter as genuine investment. Some will want to evaluate past performance on the basis of actual data and some will want to forecast future CFROI on the basis of projected results. Essentially, it seeks to value company performance using similar techniques to those traditionally used in evaluating individual items of investment. Consistent with the use of CFROI is the use of the Q ratio, originally a macro-economic measure in which the market value of a company (plus debt) is compared with the inflationadjusted value of its assets. The Q ratio indicates whether a company’s managers have generated value for their shareholders with the assets they control.
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Economic value added (EVA)™

Developed by consultants Stern Stewart, this methodology has received considerable publicity and has a growing acceptance among companies, particularly in the USA. The Stern Stewart method is to start with profit rather than cash flow. In recognition of the potential distortions caused by traditional accounting methodologies, however, they make changes to the reported profit from a shopping list of some 160 different adjustments. The guiding principles of EVA adjustments are:

Investment decisions taken by the company should result in assets regardless of how they are treated in the accounts. Thus some training expense, perhaps some marketing expense, will be capitalised. Most notably, goodwill expense that has been written off will normally be reinstated as an asset. Assets once created cannot be eliminated by accounting action. For example, where a company has capitalised goodwill and subsequently, for perfectly prudent accounting reasons, decides to write down the value of the goodwill, the write-down (in the USA called asset impairment) is written back in the EVA calculation. It is therefore perfectly possible to report an after-tax loss and yet still report a positive EVA.

Despite the complexity of these adjustments, the basic concept of EVA is not difficult to understand. Consider Figure 1. By all traditional measures company B is the better company: it is double the size, has a higher after-tax profit margin and a higher return on capital employed. Yet when the cost of equity is deducted it has a negative Economic Value Added compared with the positive result in company A. Essentially (apart from the accounting adjustments), the only difference between the traditional P&L and the EVA result is the cost of equity. As such, it is not a difficult concept to grasp and a growing number of companies are quoting an annual EVA value in their annual report. Stern Stewart supplements EVA with MVA (market value added) which reflects the spread between the capital invested in a company and the market value of a business.
Company A 400 200 100 600 50/50 10% 15% 100 30 70 45 225 25 12% 17.5% 19% 23.75% 35 10 190 Company B 800 400 200 1000 10/90 10% 25% 200

Revenue Operating profit Tax* Capital Debt/equity ratio Interest rate Cost of equity Operating profit after tax Cost of interest: 10% 3 300 10% 3 100 Traditional profit after tax Cost of equity: 15% 3 300 25% 3 900 Economic value added ROCE (70 600) (190 1000) PROFIT %

* Includes tax effect of interest (EVA and Economic Value Added are registered trademarks of Stern Stewart & Co.)

Figure 1
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Year 1 180 273 (123) 0.66
1.03

Operating cash flow OCFD Cash value added CVA Index

Year 2 270 287 (17) 0.94

Year 3 350 301 19 1.16

Year 4 390 316 74 1.23

Year 5 430 332 98 1.34

Average discounted CVA Index

Figure 2

Cash value added (CVA)™

This concept, developed by Swedish consultants FWC AB, takes cash flow as the starting point, making a similar distinction as with CFROI between strategic investments and book assets. To calculate CVA, first calculate what FWC call the operating cash-flow demand (OCFD). This represents the annual cash-flow amounts, growing by the assumed rate of inflation that will yield an IRR equal to the WACC on the original investment. Thus in Figure 2, the OCFD line shows the annual amounts, growing at an assumed inflation rate of 5 per cent which give a NPV of zero over the five-year period with a discount rate (WACC) of 15 per cent and an original investment of 1,000. Annual cash flows in some years are insufficient to meet this requirement, the extent being measured by the CVA index. Over the full five years the average index (the PV of the operating cash flow divided by the PV of the OCFD) being greater than 1, the business is generating value.
So what?

Does this amount to more than merely the latest way in which consultancies can make money? Perhaps only time will tell, but there are a number of pointers that suggest that something radical has changed in the way companies will be managed:

An increasing number of stockbrokers and analysts are using the new methodologies to assist in forming the opinions they give their clients as to which shares to buy. To the extent that a company convinces the analysts that it will add value so the analyst will recommend it and so the share price will rise. A self-fulfilling prophecy. With wider share ownership and the sophistication of markets, shareholders are demanding a healthy return. No longer is it sufficient for a company continually to deliver decent profits. Now the shareholder understands measures like Total Shareholder Return and wants to invest in companies that deliver it. Management now understand that they are employed ultimately by the shareholders and to keep their jobs they must deliver shareholder value. These new models help them to manage their companies in ways that will do so. No longer is the management and manipulation of profit, the opinion, sufficient. Management must re-learn the skills of managing the fact, cash. Controlling the cash drivers that Rappaport defined presents a new way of managing a business. What else could be more important?

Green signals ‘go’
Danka Starovic, Financial Management, October 2002. Reproduced with permission.

Sustainable development has crept up the corporate agenda in the past few years. An issue that was still a marginal concern when the Body Shop became a public company in 1985, it
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now claims a place in boardrooms around the country. This surge of interest is less connected to mounting evidence of manmade environmental and social disasters than to intense pressure from protesters. The firms that were targeted in anti-capitalist riots and media campaigns in the past few years are often the ones putting corporate social responsibility (CSR) on the map – Shell after publicity about Nigeria and Brent Spar, Monsanto after GM crops, Nike after the NoLogo campaign and the Seattle riots. They are recognising that the activists cannot be ignored. Managing reputational risk has become a serious corporate governance concern. This is hardly surprising considering that brands can be a company’s most significant intangible asset. In addition, the internet has made it much easier for people to disseminate information and voice their dissatisfaction. Many firms’ first line of defence is to produce a CSR report. Voluntary reporting guidelines are emerging all the time, as are independent social and environmental auditing standards. This is a positive development. The more we know about what companies are doing, the more we can make informed investment choices. But, if such reporting fails to translate into a mechanism for improving performance, it cannot reduce a company’s environmental impact or promote social equity. Indeed, there is a danger that, in a rush to appear good, the purpose of reporting is being forgotten. In June, British American Tobacco issued its first social report. Although it was designed to meet standard AA1000 and was audited by an independent verifier, it failed to convince BAT’s key stakeholders (many of whom had refused to participate in its production). The company was accused of hypocrisy. BAT’s arguments that no industry is wholly good or bad, and that risky businesses are in particular need of this type of report, may be valid – up to a point. The problem is that no amount of stakeholder engagement will make cigarettes safe. An attempt to build trust by increased disclosure inevitably seems misplaced. Real sustainability involves structural changes, either to your value chains or to your entire business model. This may seem drastic, but we have to tackle the paradox that, while capitalism has created more wealth than any previous economic system, it has done so at a price. Environmental rating agency Trucost recently said that no UK company would be profitable if the cost of its impact on the environment was reflected in its bottom line. It is debatable whether any of the most respected companies of the past 100 years have ever made an environmentally sustainable profit. If BAT is at one end of the scale, the Co-operative Bank is at the other. Last year, it refused £2.5 million of business on ethical grounds. Around 98 percent of the bank’s electricity comes from renewable sources, its water consumption has been cut by 9.1 per cent and it saves £3.5 million a year primarily from reduced paper usage. It also reports that its ethical stance has contributed £20 million to its pre-tax profits of £107.5 million. In the Co-operative Bank’s case, sustainability is about adjusting what it does, not simply making it transparent. Reporting should be the visible part of the structure. It should be supported by a robust internal architecture for measuring performance and a decision-making capability that reflects a wider range of concerns. Of course, more firms should still be encouraged to produce audited CSR reports. Companies such as the Co-operative Bank show the benefits to be gained from stakeholder engagement. If nothing else, it helps firms to stay ahead of the regulators. Compliance may still be the biggest driver for sustainable development. Those who trust that industry interest will prevail over government intervention should remember not only the mandatory Operating and Financial Review (part of the Company
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Law Review), but a spate of EU legislation such as the end-of-life vehicle and end-of-life electronic and electric equipment directives. This autumn Linda Perham MP is reintroducing to the Commons the corporate responsibility bill, which seeks to put social reporting on a par with mandatory financial reporting. It may not go through, but it has been signed by more than 200 MPs and reflects a change of mood on this issue. It is unrealistic to expect companies to drop profit-making operations to save the planet We should focus instead on findings such as those of the Business in the Environment survey that FTSE-100 firms are gaining competitive advantage by being ahead of the law in this area. Change should be incremental, not accompanied by a big regulatory stick. Enforced regulation will at best produce grudging compliance. For markets to operate with sustainable development principles firmly embedded as a basis for decision-making, this is not enough. There has to be a programme of education that should engender a gradual shift in views. Firms whose reputations were damaged by protesters should be at the forefront. It is far better to be judged on controlled performance indicators, developed in consultation with stakeholders, than to be considered guilty because of rumours.

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Revision Questions

1

Question 1
The objective of a health authority (a public-sector organisation) is stated in its most recent annual report as:
To serve the people of the region by providing high-quality healthcare within expected waiting times.

The ‘mission statement’ of a large plc in a manufacturing industry is shown in its annual report as:
‘In everything the company does, it is committed to creating wealth, always with integrity, for its shareholders, employees, customers and suppliers and the community in which it operates.’

Requirements (a) Discuss the main differences between the public and private sectors which have to be addressed when determining corporate objectives, or missions. (8 marks) (b) (i) Describe three performance measures which could be used to assess whether or not the health authority is meeting its current objective. (6 marks) (ii) Explain the difficulties which public-sector organisations face in using such measures to influence decision-making. (6 marks) Note: Candidates may draw on their knowledge and experience of the public sector in their own country when answering this question. (Total marks 20)

Question 2
Assume that you are a financial analyst attending a shareholders’ meeting at PDQ plc on behalf of your employers, a large pension fund. Your company is one of the few institutional investors in PDQ plc, which is a medium-sized listed company. The majority of the shareholders are small, private investors. At the shareholders’ meeting you overhear a group of shareholders discussing the company’s dividend policy. Some of the comments you hear are as follows:

‘I think the company should increase its dividend payout to the maximum it can afford without having to borrow. That way our returns are less risky.’ ‘I don’t agree. I think the company should reduce the dividend and retain even more of its earnings for future investment.’
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‘I would prefer no cash dividend at all and receive annual bonus shares. The value of my shareholding would then immediately increase.’ ‘I read somewhere that dividend policy has no effect at all on the value of the company’s shares.’

Requirements (a) Discuss the validity or otherwise of the shareholders’ comments. (15 marks) (b) The expectations and requirements of institutional investors in respect of a company’s dividend policy may be different in a number of respects from those of private, individual shareholders. Explain these differences and comment on the problems PDQ plc might face in trying to reconcile the requirements of the two groups of shareholders. (10 marks) (Total marks 25)

Question 3
When determining the financial objectives of a company, it is necessary to take three types of policy decision into account – investment policy, financing policy and dividend policy. Requirements (a) Discuss the nature of these three types of policy decision, commenting on how they are interrelated and how they might affect the value of the firm (i.e. the present value of projected cash flows.) (10 Marks) (b) Describe the different function of treasury and financial control departments of an organisation and comment on the relative contributions of these two departments to policy determination and the achievement of financial objectives. (10 marks) (Total marks 20)

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Solutions to Revision Questions

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Solution 1
(a) Among the differences between the public and private sectors of the economy, as far as objectives and missions are concerned, are the following: ● Those of the public-sector bodies are likely to have been spelled out in a statute or vesting document. As such, managers would have difficulty in adapting them as conditions change. On the other hand, the directors of a private-sector enterprise are able to determine its objectives and mission themselves, and to change them as conditions dictate. ● The value of the output of a private-sector organisation is determined by paying customers, and can be incorporated in its objectives, missions and decision criteria. One of the main arguments for retaining an endeavour in the public sector is that it cannot be left to the market to determine its income. Unfortunately, however, top managers in the public sector are generally reticent about quantifying the value of such endeavours. ● In the private sector, failure to meet the aspirations of the various stakeholders (e.g. as listed in the plc mission statement) brings penalties, and may trigger the demise of the enterprise. In the public sector, disbelief can be suspended for long periods, with the result that some stakeholders’ aspirations are ignored. Objectives often boil down simply to the aim to achieve the results spelled out in a plan imposed from above. ● The public sector is constrained by tactical controls in the shape of short-term cash limits. This often ushers in rationing, which amounts to a conflict between stakeholders. Private-sector companies can look far enough ahead to see how the interests can be harmonised – though not all avail themselves of this facility! ● Private-sector organisations are acutely aware of the need to earn a satisfactory return on investment (typically around 15 per cent per annum in terms of operational cash flows in the UK). The public sector is only slowly moving away from the concept of capital being free at the point of delivery (a recipe for demand in excess of supply) and has not yet embraced the idea that it is a commodity which is freely available at a price. (b) (i) Unfortunately, ‘high-quality healthcare’ and ‘within expected waiting times’ are rather vague. It would be useful to quantify them in some way. Assuming that is done, among the measurements which might be useful are: ● waiting time for accident/emergency admissions, or arrival of ambulance, compared with expectation (or failing that, a regional or national average);
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length of waiting lists for important elective surgery, again compared with expectation (or failing that, a regional or national average); ● patients’ view as to quality of service, against declared aim. (ii) Some of the difficulties of the public sector are just beneath the surface of the question. Health authorities are responsible for the purchasing of healthcare from providers (typically NHS trusts). However, they are constrained by rigid budgets allocated by the NHS Executive. lf an authority fails to live up to objectives along the lines of those quoted, or to achieve expected results, it could simply be because it does not have the funds. Letting waiting lists lengthen is the easiest way to keep within an inadequate budget. That is not a reason for not measuring performance of course, but it does affect the interpretation of the measurements. Some performance measurements in the public sector can run counter to what constituents want and, in many cases, to common sense. Judging police forces on the basis of costs per crime recorded, for example, discourages crime prevention. If surgeons were influenced by the measurement of how quickly they discharge their patients, they would not meet the patients’ aspirations. The more important things in life cannot be measured, because they have not happened – e.g. crimes and illnesses which have been prevented, or opportunities created. The way forward is to be honest about constraints, e.g. to phrase the health authority’s objective in terms of obtaining the maximum value in healthcare terms for a given budget.

Solution 2
(a) The fact that different shareholders have different views as to what the company should do is hardly surprising, but some of the remarks could be based on misunderstandings. Dealing with each in turn: ● The idea that the company should increase its pay-out to the amount it can afford has considerable merit in corporate governance terms in the sense that, to the extent that it acquired funds for expansion, it would have to make the case to its shareholders’ general meeting. We do not know what the company’s borrowings are, so we do not know what impact there would be of establishing zero borrowings as the criterion. The shareholder should be dissuaded from thinking, however, that the net result such a policy would be to reduce the risk associated with the returns to shareholders. The uncertainty associated with returns achieved by the company depends on the projects in which it chooses to invest, and the individual shareholder is also subject to the risk that, when he comes to sell the shares, the price will be at a cyclical low. ● To the extent that funds are retained in the business, rather than paid as a dividend, the important question is whether the investments are viable, that is, enhance the net present value of the equity. From an individual shareholder’s point of view, there is a secondary question as to whether this enhancement will be reflected in the share price at the time he comes to sell his holding. ● Paying no dividend at all is an extreme case of the situation described in the previous paragraph. The viability of the investments the retentions would fund is what affects the value of the business (as an entity and therefore, indirectly, to its shareholders). There is no necessity to capitalise the retentions in the form of a bonus issue – indeed, the effect of doing so is to make them undistributable for ever more, thereby weakening shareholder power vis-à-vis the directors. ● The net cash flow attributable to shareholders is a function of the investment and borrowing decisions made by the board of the company concerned. In other
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words, the difference between distributions (e.g. dividends) and financing (e.g. rights issues) is predetermined. Directors can ‘mix and match’ these two components as they see fit, and there is a spectrum of possibilities, from paying high dividends and having frequent rights issues, to retaining a high proportion of profits and occasionally buying back some of their shares. There may well be some tax benefits – for some shareholders at least – in adopting a particular policy. This will be identified by a treasury function which has the aim of maximising the proportion of entity value which is attributable to the equity. Whether this value is reflected in the share price at any particular point in time is, of course, a different question again. If the speakers accept these comments, they might well ask what dividend policy does make economic sense. The answer is to see the dividend as being a return to shareholders of those funds which cannot be invested for a return in excess of the cost of capital. This would make dividends as volatile as the rest of the environment, but is consistent with a rational investment policy (i.e. projects are supported if they show positive net present value) and recognises that the share price is part of a zero-sum game: for every buyer there is a seller. Over and above those considerations, it should be recognised that there are a number of factors, given current regulations and practices, which prompt many people to see short-run share prices as important in themselves. If enough people believe that share prices are a function of current dividends then they will be, and this will influence directors’ decisions – especially if they have some share options about to mature. Setting out to maximise the short-term share price will rarely maximise the long-term financial health of the entity. (b) One theory of dividend policy is that a company attracts particular types of shareholder because of its policies, including its dividend policy. This is known as the ‘clientele’ effect. This effect might influence the attitudes of the two types of shareholder mentioned in the question. Other considerations are as follows: ● Financial institutions are largely non-taxpaying because they can reclaim the advance corporation tax that they pay on dividends. This means that they will be mostly unconcerned about dividends or capital gains as far as taxation is concerned. However, there are two main considerations: cash flow and transaction costs. ● It is likely that institutions would press for a higher payout, as they did in 1991–92, when companies were reporting lower profits. ● Small private investors are less easy to categorise. If they are wealthy they may prefer capital gains because they are tax-efficient (even when tax rates are the same there is an annual tax-free allowance, and capital gains tax is not paid until it is assessed. Dividends are taxed at source). If they are not particularly wealthy they may prefer a high, stable dividend which guarantees them a regular income. In fairness, these individuals are most likely to prefer investment in gilt-edged securities, high-quality corporate debt, or National Savings. How the company deals with these possible conflicts depends on a number of factors:

whether it is happy with the mix of individual and institutional shareholders it has at present, or whether it wished to attract more institutions; market image – if it is to satisfy institutions it may need to raise dividends even when it cannot afford to (as noted above) or when it does not wish to; its belief in the importance of dividend policy.
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Solution 3
Aim of question. This question dealt with the determination of financial objectives and the role of treasurer and financial controller. The question aimed to test candidates’ abilities to examine, evaluate and assess the policy decisions and organisation structure of an organisation. Tips/guidance/common errors ● Most candidates made a satisfactory to good effort at Part (a). ● Not many candidates managed to discuss the interrelationships of the three policies and how they affected the value of the firm. ● Many candidates spent far too long discussing dividend policy to the detriment of the answer as a whole. ● Answers to Part (b) of the question were varied. ● Most candidates recognised the major functions of the two departments but these were often provided as a list with no discussion of the relative contributions to the achievement of financial objectives. This question examines the following syllabus area: (i) The finance function.
● ●

The three key decisions of financial management: The role of the treasury function; The benefits and shortcomings of establishing treasury departments as profit centres and cost centres; The financial objectives of different organisations.

(a) Investment decisions involve the analysis and appraisal of capital expenditure projects, acquisitions, mergers and disinvestments, together with the related committal of funds; also decisions relating to working capital and trade investments, with the aim of maintaining satisfactory returns for the organisation. Financial controllers will assess the likely cash flows of the various alternatives and identify the one with the maximum net present value. Financing decisions relate to obtaining suitable and adequate funds with which to operate the business, and to the desired level of gearing represented by the most appropriate combination of short-, medium- and long-term debt, together with equity, including internally generated funds. If capital needs to be raised the company will seek that mix of sources that minimises the weighted average cost of capital. Dividend decisions are based in part on making payments to shareholders that will currently satisfy their desired long-term rate of return and thereby help to maintain the company’s share price. They are also based in part on retaining sufficient profits to sustain and advance the level of operations to secure shareholders’ aspirations for the future. The key decision is whether shareholders would be better off having money now or allowing it to be reinvested in the business to produce a higher level of cash flow in future. The three kinds of decision are subsets of comprehensive financial management and are linked by the twin foundations thereof: cash flow and the cost of capital. Financial management is about heeding the discipline of the market economy (that only enterprises that can offer the prospect of an adequate return will be able to raise the money required to fund their growth) and translating it into a criterion for the deployment of funds (to business opportunities that offer the prospect of an adequate return, that is,
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in excess of the cost of capital). On this (dynamic) basis, dividends reflect the amount of cash not required for investment or reducing borrowings. (b) In summary, a treasurer handles the acquisition and custody of funds, whereas the controller has responsibility for accounting, reporting and control. The CIMA Official Terminology describes treasury management as the function concerned with the provision and use of finance. The main functions of such a department include: – establishment of corporate financial objectives; – managing the firm’s liquid assets – cash, marketable securities, etc.; – managing the company’s funding – determination of policies, identifying sources and types of funds; – corporate finance and related issues, such as taxation, pension fund investment, etc. (although these functions are sometimes performed by the controller); – (in a multinational) dealing with currency management – dealing in foreign currencies, hedging currency risks, etc. The financial control function is concerned mainly with the recording and reporting of financial information such as: – preparation of budgets and budgetary control; – preparation of periodic financial statements such as monthly accounts and annual accounts; – management and administration of activities such as payroll and internal audit (which in some cases may be a separate department responsible directly to the finance director). From the above it appears that treasury has the main responsibility for setting corporate objectives and policy, and financial control has the responsibility for implementing policy and ensuring the achievement of corporate objectives. This distinction is probably far too simplistic: in reality, both departments will make contributions to both determination and achievement of objectives. There is a circular relationship, in that treasurers quantify the cost of capital, which controllers use as the criterion for the deployment of funds; and controllers quantify projected cash flows, which in turn trigger treasurers’ decisions to employ capital. In smaller firms the functions of treasury and financial control may be combined, and even in larger firms the two roles often include related activities – for example, management of cash. Although the controller has the main reporting responsibilities, the treasurer will typically report on cash flows and cash management. In some cases, ownership of responsibility for certain activities is not clear-cut. For example, credit control, taxation, insurance and pensions are sometimes handled by the treasury department, sometimes by the controller’s department.

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Financial Management

2

LEARNING OUTCOMES
After completing this chapter you should be able to: identify and evaluate optimal strategies for the management of working capital; identify and evaluate key success factors in the management of the finance function; discuss the role and management of the treasury function.

2.1 Introduction
Financial management is defined in CIMA’s (Management Accounting: Official Terminology) as follows: ‘The management of all the processes associated with the efficient acquisition and deployment of both short- and long-term financial resources’. We begin this chapter with a discussion of the finance function, which in larger organisations is likely to be split into financial control and treasury. This is followed by a discussion of the efficiency of capital markets. We consider key success factors by which stock market analysts measure performance and conclude with an evaluation of the strategies for the management of working capital.

2.2 The finance function
In a large company the finance function may be split between treasury and financial control, with both functions reporting to the chief financial officer. The financial control function will be concerned primarily with the allocation and effective use of resources, and will have responsibility for investment decisions. The treasury function is usually responsible for obtaining finance and managing relations with the financial stakeholders of the organisation who will include shareholders, fund lenders, and taxation authorities.
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The relationship between financial control and treasury is often blurred, but two examples of the relationship may be: 1. The treasurer is best able to assess the cost of capital and quantify the organisation’s aversion to risk, while the financial controller relates these factors to group strategy. 2. The financial controller identifies the organisation’s currency risks, while the treasurer advises on the best means to hedge the risk.

2.2.1 Evaluating key success factors in the management of the finance function
There are many methods of measuring the success of the finance function; two are identified here. Balanced Scorecard This is an approach that emphasises the need to provide information that addresses all relevant areas of performance in an objective and unbiased fashion. The information provided may include both financial and non-financial elements, and cover areas such as customer satisfaction, internal efficiency, and innovation. Benchmarking The relative performance of the finance function could be measured by benchmarking against finance functions is other organisations. Alternately, in a large organization, the finance functions in subsidiary companies could be benchmarked against each other.

2.3 The treasury function
The establishment of a specialist treasury function within the finance department can be traced back to the late 1960s. Developments in technology, the breakdown of exchange controls, increasing volatility in interest rates and exchange rates, combined with the increasing globalisation of business have all contributed to greater opportunities and risks for businesses. To survive in today’s complex financial environment, businesses need to be able to actively manage both their ability to undertake these opportunities, and their exposure to risks. A separate treasury function is more likely to develop the appropriate skills, and it should also be easier to achieve economies of scale; for instance, in achieving lower borrowing rates, or netting-off balances. In larger companies and groups, treasury will usually be centralised at head office, providing a service to all the various units of the entity and thereby achieving economies of scale, for example, by obtaining better borrowing rates, whereas financial control is now frequently delegated to individual units, where it can more closely impact on customers and suppliers and relate more specifically to the competition that those units have to face. As a result, treasury and financial control may often tend to be separated by location as well as by responsibilities.
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2.3.1 The role of the treasury function
The key responsibilities of the treasury function are:

Banking. The treasurer will be responsible for managing relationships with the banks. In this book we view this function as an integral part of the three other functions identified below, and it is considered within the chapters covering those specific functions. Liquidity management. This will involve working capital and money management. The treasurer will need to ensure that the business has the liquid funds it needs, and invests surplus funds. Funding management. Funding management is concerned with identifying suitable sources of funds, which requires knowledge of the sources available, the cost of those sources, whether any security is required, and management of interest rate risks. Currency management. The treasurer would be responsible for providing the business with forecasts of exchange rate movements, which in turn will determine the procedures adopted to manage exchange rate risks. Dealing in the foreign exchange markets and dayto-day management of foreign exchange risks becomes a key function for the treasurer.

The treasurer’s responsibilities can also be categorised according to the three levels of management:

strategic, for example, matters concerning the capital structure of the business and distribution/retention policies, the actual raising of capital, including share issues, the assessment of the likely return from each source and the appropriate proportions of funds from each source, the decision as to the level of dividends, and consideration of alternative forms of finance; tactical, for example, the management of cash/investments and decisions as to the hedging of currency or interest rate risk; operational, for example, the transmission of cash, placing of ‘surplus’ cash and other dealings with banks.

Treasurers require specialist skills to be able to handle effectively an ever growing range of capital instruments, for example convertible preference shares issued in the name of an offshore subsidiary, and to determine the most suitable way to protect their company from foreign exchange risk, which demands a good knowledge of forward markets and an ability to select the most appropriate methods of hedging and foreign exchange cover. They also need a knowledge of taxation in all areas in which the group operates and, deriving from that, the ability to advise effectively on policies such as transfer pricing in permissible ways to minimise overall tax liability, and to be able to liaise competently with the group taxation department. The capacity to make large gains or losses is enormous: a treasurer can wipe out, in a few hours, all the profit made from making and selling things over several months. It is important, therefore, that authority and responsibility associated with the treasury function are carefully defined and monitored. This becomes even more important as the range of derivatives increases. Senior managers need to be aware of which risks are being carried, which laid off, and, where appropriate, taken on. There is also growing pressure for companies to disclose, in their annual reports, more information about their treasury policies, and their ‘positions’ as at the balance sheet date.

2.3.2 Cost centre or profit centre
An area for debate is whether the treasury activities should be accounted for simply as a cost centre, or as a business in its own right, seeking to make a profit out of its activities – for
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example, by charging other businesses in the enterprise for its services (and giving those businesses the choice of whether they use it or a bank). The main advantages of operating treasury as a profit centre rather than as a cost centre are as follows:

Individual business units of the entity can be charged a market rate for the service provided, thereby making their operating costs more realistic. The treasurer is motivated to provide services as effectively and economically as possible to ensure that a profit is made at the market rate, for example, in managing hedging activities for a subsidiary, thereby benefiting the group as a whole. The main disadvantages are as follows: The profit concept is a temptation to speculate, for example, by swapping funds from currencies expected to depreciate into ones expected to appreciate. Management time is unduly spent in arguments with business units over charges for services, even though market rates may have been impartially checked (say by internal audit department). Additional administrative costs may be excessive.

The decision as to whether to operate treasury as a profit centre may well depend on the particular ‘style’ of the company and the extent of centralisation or decentralisation of its activities.
Example: Treasury management at J Sainsbury
The annual report of J Sainsbury for 2004 states: Treasury policies are reviewed and approved by the Board. The Chief Executive and Finance Director have joint delegated authority from the Board to approve finance transactions up to £300m and responsibility for monitoring treasury activity and performance. The group’s central treasury function operates as a cost centre with responsibility for funding, interest rate and currency risk management and cash management. Group policy permits the use of derivative instruments but only for reducing exposures arising from underlying business activity and not for speculative purposes.

2.4 Financial markets
Financial assets and claims on financial assets are traded in financial markets. Nowadays there may be no physical marketplace, transactions taking place by telecommunications. The major financial centres throughout the world will, typically, have three (or possibly four) financial markets. These are as follows.

2.4.1 Money market
The money market is the market for trading in relatively short-dated funds, usually for less than one year. These markets are dominated by the major banks and other financial institutions. Large companies will also borrow and lend on the money market. The term ‘money market’ encompasses the markets for trading in:
● ●

Short-term inter-bank loans. Terms may range from overnight to 12 months or more. Short-term inter-company loans. Large companies will be able to lend and borrow directly with banks on the inter-bank market.

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Short-term local authority debt instruments. Local authorities have a requirement for short-term cash, with terms ranging from overnight to twelve months or more. Interest would be payable on these instruments. Bills of exchange. Bills of exchange enable suppliers to receive the benefit of payment will before the customer actually pays. Certificates of deposit. Certificates of deposit (CDs) are issued by banks at a fixed interest rate for a fixed term, usually between 3 and 5 years. Commercial paper. Large companies may issue unsecured short-term loan notes, referred to as commercial paper. These loan notes will generally mature within nine months, typically between a week and three months. The notes can be sold on the discount market at any time before their maturity date. Eurocurrency. Banks lend and borrow in foreign currencies.

2.4.2 Capital or securities market
Capital or securities markets trade in longer-dated securities (usually over twelve months) such as shares and loan stocks. Examples of capital markets would be the Stock Exchange, the bond market and the Eurobond market. Capital markets have two main functions: 1. They provide a primary market for raising new capital for business, usually in the form of equity (shares) to new shareholders or existing shareholders (via rights issues). 2. They also allow trading in existing securities – the secondary market. This is an important function as it provides investors with a means of selling their investments should they wish to. In the UK, the London Stock Exchange is the principal trading market for long-dated securities. It controls and regulates two markets: 1. the Official List or Main Market, which deals in the securities of larger, more established companies; 2. the Alternative Investment Market (AIM), which deals in the securities of smaller, less wellestablished companies. The compliance rules and costs of this market are less onerous than for the Official List. The London Stock Exchange is also the market for government securities (gilts). Flotation Flotation is the process of making shares available to investors by obtaining a quotation on the Stock Exchange.

Exercise 2.1
Before reading the solution see if you can list the main advantages and disadvantages of flotation for a company.

Solution
There are a number of advantages and disadvantages of a flotation on the Stock Exchange.
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Advantages of flotation

● ●

● ●

Once listed, the market will provide a more accurate valuation of the company than had been previously possible. Realisation of paper profits. Raise profile of company, which may have an impact on sales, credibility with suppliers and long-term providers of finance. Raise capital for future investment. Makes employee share schemes more accessible.

Disadvantages of flotation
● ●

● ● ●

Costly for a small company (flotation, underwriting costs, etc.). Investors perceive small companies to be riskier and therefore may require higher returns if they are to be attracted at all. Making enough shares available to allow a market. Reporting requirements are more onerous. Stock Exchange rules for obtaining a quotation on the full market are quite stringent.

A private company seeking a stock market quotation may obtain a listing on the Alternative Investment Market initially, with the intention of progressing to the Official List at a later date.

2.4.3 The foreign exchange market
The foreign exchange market is a market for trading in currencies. Deals here may be for immediate delivery (spot deals) or for future delivery (forward deals).

2.4.4 Derivatives markets
An example of a fourth type of market is the London International Financial Futures and Options Exchange (LIFFE) where derivatives are traded. Derivatives is a generic term for a range of traded financial instruments that have developed from securities, commodity and currency trading. Examples of derivatives are options and swaps. These can be used as hedging devices, to reduce risks, or simply for speculation.

2.5 Share price volatility
An example of the volatility of today’s business environment, of particular interest to financial managers, is that displayed by the prices at which the shares of publicly quoted companies change hands. The return from such an investment is the reward required by investors and equates to the dividend plus the capital gain. The required reward will reflect the level of risk undertaken by the investor. In terms of this return on investment, the dividend is dwarfed by the potential for capital gains (or losses). In recent years, for example, the dividend yield on UK shares has been around 4 per cent per annum, but it has not been unusual for the price of a share in a particular company to rise or fall by 50 per cent in a year. Anyone able to predict such movements would become very wealthy indeed!
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There are people who claim to be able to do so, their techniques ranging from interpretation of zodiac horoscopes though to more sophisticated computer based techniques.

2.5.1 Technical analysis or chartism
Technical analysts or chartists believe future prices can be charted and a pattern identified that can be used to predict future prices. Technical analysis: The analysis of past movements in the prices of financial instruments, currencies, commodities etc, with a view to, by applying analytical techniques, predicting future price movements. (Official Terminology, 2000).

2.5.2 Fundamental analysis
The fundamental theory of share valuation states that the value of a share will be equal to the discounted present value of the future expected dividends from the share, discounted at the shareholders’ cost of capital. Fundamental analysis: Analysis of external and internal influences upon the operations of a company with a view to assisting in investment decisions. Information accessed might include fiscal/monetary policy, financial statements, industry trends, competitor analysis etc. (Official Terminology, 2000) Fundamental analysts will assess whether a share is undervalued or overvalued and recommend buying or selling accordingly.

2.5.3 Random Walk Theory
Despite the considerable efforts made in this area, however, it is significant that the majority of funds underperform the index of the equity market as a whole. This has led many practitioners (e.g. pension fund trustees) to choose passive management, i.e. buying and holding a selection of shares representative of the market as a whole. There has also been a significant increase in the number of ‘tracker’ funds in recent years. These are funds that provide a return in line with the stock market as a whole. They do this by investing in all the companies in the stock market, or investing in a representative sample of those companies. On the available evidence, it is not surprising that theorists have developed the idea that the progress of a particular share price is a ‘random walk’, rendering the achievement of consistently superior returns an impossibility. In other words, tomorrow’s share price is independent of today’s share price.

2.6 The efficient market hypothesis
The purpose of a stock market is to bring together those people who have funds to invest with those who need funds to undertake investments. Companies seeking to raise equity are asking investors for a permanent investment as equity shares have no redemption date. Investors may not be encouraged to invest on these terms unless they can be convinced that they will be able to realise their investment at a fair price at any time in the future.
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For this to happen, stock markets must price shares efficiently. Efficient pricing means incorporating into the share price all information that could possibly affect it. In an efficient market investors can buy and sell shares at a fair price and companies can raise funds at a cost that reflects the risk of the investments they are seeking to undertake. A considerable body of finance theory has been built on the hypothesis that, in an efficient market, prices fully and instantaneously reflect all available information. The efficient market hypothesis (EMH) is therefore concerned with information and pricing efficiency. Three levels or forms of efficiency have been defined: these are dependent on the amount of information available to the participants in the market.

2.6.1 Weak form
The EMH in its weak form says that the current share price reflects all the information that could be gleaned from a study of past share prices. If this holds, then no investor can earn above-average returns by developing trading rules based on historical price or return information. This form of the hypothesis can be related to the activities of chartists using technical analysis. The EMH in its weak form questions the value of technical analysis, as share prices will move randomly if the market shows weak form efficiency. The weak form of the efficient market hypothesis has been tested by subjecting series of share prices or indices to statistical tests to determine whether there is any correlation between past and present prices. Evidence suggests that it is not possible to predict future prices by looking at a series of past prices. Another series of tests has been to establish whether trading rules enable above-average returns to be earned. These tests attempt to determine if it is possible to earn above-average returns by following standardised trading rules.

2.6.2 Semi-strong form
The semi-strong form of the EMH says that the current share price will not only reflect all historical information, but will also reflect all other published information. If this holds, then no investor can be expected to earn above-average returns from trading rules based on any publicly available information. This form of the hypothesis can be related to fundamental analysis. Fundamental analysis attempts to identify over- or undervalued companies through studying publicly available information. The EMH in the semi-strong form suggests that any publicly available information will already be captured in the current share price. Studies have shown that it is not possible to benefit from always buying shares when good news is published. This is explained by the fact that the speed at which the market reacts to public information is so rapid that individual investors cannot adopt a policy that will consistently result in exceptional profits from a quick reaction to good news.

2.6.3 Strong form
The strong form of the EMH says that the current share price incorporates all information, including non-published information. This would include insider information and views held by the directors of the company. If this holds, then no investor can earn aboveaverage returns using any information whether publicly available or not. It is difficult to test this proposition as with ‘insider information’ it should be possible to gain some advantage. A member of staff involved in a takeover bid could predict the likely
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movement in the share price of the companies concerned. It would then be possible to buy or sell shares in the companies before the details of the takeover bid were published. As ‘insider trading’ is illegal, it is difficult to test this form of the EMH.

2.6.4 Implications of EMH for financial managers
If capital markets are efficient, the main implications for financial managers are:

● ●

the timing of issues of debt or equity is not critical, as the prices quoted in the market are ‘fair’; a company cannot mislead the markets by adopting ‘creative accounting’ techniques; the company’s share price will reflect the net present value of the company’s future cash flows, so managers must only ensure that all investments are expected to exceed the company’s cost of capital. A summary of the hypothesis is as follows:

● ●

the weak form of efficiency is where share prices reflect all historical information; the semi-strong form of efficiency is where share prices reflect all publicly available information; the strong form of efficiency is where share prices reflect all information (public and internal) and is the perfect information environment.

The more efficient the market is, the less the opportunity to make a speculative profit. If the market displays strong-form efficiency, it becomes impossible to consistently outperform the market. Research has suggested that the UK capital markets are efficient in the semi-strong form. Abnormal gains may be made from what is called insider dealing, where an investor obtains internal information about the company and purchases or sells shares based on that information. Insider dealing is an offence in the UK in order to protect the stability of the capital markets. In some countries (e.g. Japan), however, insider dealing is not illegal and is considered to be a useful contributor to an informationally efficient market. Although there are some dissidents, the majority of observers would appear to be satisfied that the random pattern of share price movements is consistent with the semi-strong form, that is, that shares reflect all published information. Given that insider dealing is illegal, they say, that is good enough: the market can be presumed to be efficient.

2.7 Investor ratios
Investors will wish to assess the performance of the shares they have invested in: over time, against competing companies in the same sector, and against the market as a whole. There are a number of ratios which will be of specific interest to investors. The use of the market price of equity is an important component of this type of analysis.

2.7.1 Market price per share
The market price (MPS) used throughout Management Accounting: Financial Strategy is the exdividend market price. Ex-dividend means that in buying a share today, the investor will not
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participate in the forthcoming dividend payment. Sometimes in an examination, the market price may be quoted cum-dividend which means with dividend rights attached. Here the investor will participate in the forthcoming dividend if purchasing the share today. Arguably the investor will be willing to pay a higher price for the share, knowing that a dividend payment is forthcoming in the near future. The relationship between the cum-dividend price and the ex-dividend price is then: MPS (ex-dividend) MPS (cum-dividend) forthcoming dividend per share

2.7.2 Earnings per share
Earnings per share (EPS) is a company’s net profit attributable to ordinary shareholders divided by the number of ordinary shares in issue. A simple example of an EPS calculation is shown below.
Example 2.A
Earnings before interest and tax Interest on debt Earnings after debt interest Tax payable Earnings after tax available for distribution Number of shares in issue EPS £325m 175m 175 million £m 525 075 450 125 325

186 pence per share

An important point to remember is that EPS is a historical figure and can be manipulated by changes in accounting policies, mergers or acquisitions, etc. The City and company executives occasionally appear obsessed about EPS as a performance measure, an obsession which many think is quite disproportionate to its true value. It is future earnings which should concern investors, a figure far more difficult to estimate.

2.7.3 The price/earnings ratio
A common benchmark when analysing different companies is the use of the price/ earnings (P/E) ratio, which expresses in a single figure the relationship between the market price of a company’s shares and the earnings per share. It is calculated as: Market price per share (MPS) Earnings per share (EPS) Using the figures from the EPS example above, and assuming that the company’s current share price is 2,250p, the P/E ratio would be 2,250/186, or approximately 12. The P/E ratio is often referred to as the market capitalisation rate. This simply means that the market value of the company’s equity can be calculated by multiplying last year’s earnings per share by the P/E ratio (to give the share price), then multiplying by the number of shares in issue.
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2.7.4 Earnings yield
The P/E ratio is the reciprocal (in maths, a number or quantity divided into 1) of the earnings yield. Again, using the EPS example above, the gross earnings yield is 8.3 per cent (186/2,250 100), or 0.083. The P/E is therefore the reciprocal of this, that is, 1/0.083, or approximately 12. The market price will incorporate expectations of all buyers and sellers of the company’s shares, and so this is an indication of the future earning power of the company. EPS MPS

Earnings yield

2.7.5 Dividend-payout rate
The cash effects of payment of dividends is measured by the dividend-payout rate. Dividend per share (DPS) Earnings per share (EPS)

Payout rate

Assuming the cash dividend is 20p per ordinary share out of EPS of 40p, then the dividend-payout rate is 20/40 0.5 or 50 per cent. The relationship between the above investors’ ratios is usually that a company with a high P/E ratio has a low dividend payout ratio as the high growth company needs to retain more resources in the business. A more stable business would have a relatively low P/E ratio and higher dividend-payout ratio. When analysing financial statements from an investor’s point of view it is important to identify the objectives of the investor. Does the investor require high capital growth and high risk, or a lower-risk, fixed dividend payment and low capital growth?

2.7.6 Dividend yield
Dividend yield will indicate the return on capital investment, relative to market price. Dividend per share (DPS) Market price per share (MPS)

Dividend yield

Assuming a dividend of 25p per ordinary share and a market price of 250p per share, then dividend yield is 25/250 0.1 or 10 per cent. Buying the share today for 250p should give the investor a return of 10 per cent for the year, based on the dividend income. Remember that the dividend represents only part of the overall return from a share. The other part of the return is the capital gain from an increase in the value of the share. The capital gain from a share may well be far more significant than the dividend.
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2.7.7 Dividend cover
Dividend cover measures the ability of the company to maintain the existing level of dividend and is used in conjunction with the dividend yield. Dividend cover Earnings per share (EPS) Dividend per share (DPS)

Assuming EPS of 50p and net dividend of 20p, then dividend cover is 50/20 2.5 times. The higher the dividend cover the more likely it is that the dividend yield can be maintained. Dividend cover also gives an indication of the level of profits being retained by the company for reinvestment by considering how many times this year’s dividend is covered by this year’s earnings.
Example 2.B
Lilydale plc has 5,000,000 ordinary shares in issue. Its results for the year end are as follows: £ 750,000 150,000 600,000 150,000 450,000

Profit before taxation Taxation Profit after taxation Ordinary dividend – proposed Retained profit

The market price per share is currently 83p cum-dividend. The tax credit on dividends is currently 10 per cent.

Requirements
Calculate the following ratios: (i) (ii) (iii) (iv) price/earnings; dividend payout; dividend yield; and dividend cover.

Solution
Earnings per share Profit after tax Number of shares Ordinary dividend Number of shares 83p 83p 80p 80 12 3 12 3 80 12 3 6.7 25% 3.75% 4. 600,000 5,000,000 150,000 5,000,000 12p

Dividend per share MPS (ex-div)

3p

MPS (cum-div) less DPS

(i) Price earnings (ii) Dividend payout (iii) Dividend yield (iv) Dividend cover

MPS EPS DPS EPS DPS EPS EPS DPS

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2.7.8 Book value per share
From a capital point of view the balance sheet may be used in computing ratios for the investor. The book value per share indicates the asset backing of the investment Shareholders’ funds Number of equity shares in issue at the balance sheet date Assume shareholders’ funds of £2.5 million and number of equity shares in issue to be 5 million, then the asset book value per ordinary share is 2.5/5.0 £0.5, or 50p per share. Note that shareholders’ funds for this calculation must be those attributable to equity, that is, the ordinary shareholders. However, this must be interpreted with care: 1. The valuation of the balance sheet may be based on historical cost values. Other valuations of assets may be more informative. 2. The ratio may be irrelevant in service-based businesses where the major asset is the quality of staff and other intangibles which may not be included in the balance sheet. The book value per share may be compared to the market value per share to determine the market’s evaluation of the business.

2.8 Working capital management strategies
In CIMA’s Official Terminology, working capital is defined as: Working capital: The capital available for conducting the day-to-day operations of an organisation; normally, the excess of current assets over current liabilities. In accounting terms, this is a static balance sheet concept, referring to the excess – at a particular moment in time – of permanent capital plus long-term liabilities over the fixed assets of the business. As such, it depends on accounting rules, such as what is capital and what is revenue, what constitutes a retained profit, the cut-off between long term and short term (12 months from the balance sheet date for published accounts), and when revenue should be recognised. If working capital, thus defined, exceeds net current operating assets (stocks plus debtors less creditors) the company has a cash surplus (usually represented by bank deposits and investments); otherwise it has a deficit (usually represented by a bank loan and/or overdraft). On this basis, therefore, the control of working capital can be subdivided into areas dealing with stocks, debtors, creditors and cash. A business must be able to generate sufficient cash to be able to meet its immediate obligations and therefore continue trading. Unprofitable businesses can survive for quite some time if they have access to sufficient liquid resources, but even the most profitable business will quickly go under if it does not have adequate liquid resources. Working capital is therefore essential to the company’s long-term success and development, and the greater the degree to which the current assets cover the current liabilities, the more solvent the company. The efficient management of working capital is important from the points of view of both liquidity and profitability. Poor management of working capital means that funds are
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unnecessarily tied up in idle assets, hence reducing liquidity, and also reducing the ability to invest in productive assets such as plant and machinery, so affecting profitability. A company’s working capital policy is a function of two decisions:

the appropriate level of investment in, and mix of current assets to be decided upon, for a set level of activity – this is the investment decision; the methods of financing this investment – the financing decision.

2.8.1 The investment decision
All businesses, to one degree or another, require working capital. The actual amount required will depend on many factors, such as the age of the company, the type of business activity, credit policy, and even the time of year. There is no standard fixed requirement. It is essential that an appropriate amount of working capital is budgeted for to meet anticipated future needs. Failure to budget correctly could result in the business being unable to meet its liabilities as they fall due. If a business finds itself in such a situation, it is said to be technically insolvent. In conditions of uncertainty firms must hold some minimal level of cash and inventories based on expected sales, plus additional safety stocks. With an aggressive working capital policy, a firm would hold minimal safety stock. Such a policy would minimise costs, but it could lower sales because the firm may not be able to respond rapidly to increases in demand. Conversely, a conservative working capital policy would call for large safety stocks. Generally, the expected return is lower under a conservative policy than under an aggressive one, but the risks are greater under the aggressive policy. A moderate policy falls somewhere between the two extremes in terms of risk and returns.

2.8.2 The financing decision
Working capital financing decisions involve the determination of the mix of long-term versus short-term debt. When the yield curve is upward-sloping, short-term debt costs less than long-term debt. With an aggressive financing policy, the firm finances part of its permanent asset base with short-term debt. This policy generally provides the highest expected return (because short-term debt costs are typically less than long-term costs) but it is very risky. Under a conservative financing policy, the firm would have permanent financing (long-term debt plus equity) which exceeds its permanent base of assets. The conservative policy is the least risky but also results in the lowest expected return. The maturity matching policy falls between the two extremes. There is a basic difference between cash and inventories on the one hand, and receivables on the other. In the case of cash and inventories, higher levels mean safety stock, hence a more conservative position. There is no such thing as a ‘safety stock of receivables’, and a higher level of receivables in relation to sales would generally mean that the firm was extending credit on more liberal terms. If we characterise aggressive as being risky, then lowering inventories and cash would be aggressive but raising receivables would also be aggressive. The financing of working capital depends upon how current- and fixed-asset funding is divided between long-term and short-term sources of funding. Three possible policies exist, and these are shown in Figures 2.1–2.3.
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Figure 2.1

Conservative financing policy

Figure 2.2

Aggressive financing policy

Figure 2.3

Moderate financing policy

A conservative policy is where all of the permanent assets – both fixed assets and the permanent part of the current assets (i.e. the core level of investment in stocks and debtors, etc.) – are financed by long-term funding, as well as part of the fluctuating current assets. Short-term financing is used only for part of the fluctuating current assets.
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An aggressive policy for financing working capital uses short-term financing to fund all the fluctuating current assets as well as some of the permanent part of the current assets. This policy carries the greatest risk of illiquidity, as well as the greatest returns. A moderate policy matches the short-term finance to the fluctuating current assets, and the long-term finance to the permanent part of current assets plus fixed assets.

2.8.3 Multinational working capital management
The aims of a multinational enterprise in relation to cash management will be similar to those for a purely domestic enterprise, which will be to:
● ● ● ●

ensure fast collection of cash; take larger to pay out cash; optimise cash flow within the enterprise; generate the best return on cash surpluses.

Achieving these aims will be more difficult in a multinational enterprise due to the longer distances involved, the number of parties involved, and the risk of governments placing restrictions on the transfers of funds out of certain countries. Granting credit is often an essential condition to undertake international business. In addition to the normal risks of default firm granting credit, exchange rate fluctuations between the time of sale and the time the debt is collected provide an additional risk. Management of stocks is also similar to but more complex than for a purely domestic enterprise. The balance between minimising stockholdings and being able to meet customer demands is more difficult to judge. The movement is exchange rates will also influence the timing of purchases, and the level of stocks held in a particular currency. Political risk is a further consideration; multinationals will need to allow for the prospect of import or export quotas or tariffs being imposed. In certain countries, the risk of expropriation of stocks will lead to minimal stock holdings being maintained. Some countries have property taxes on assets, including stocks, where the tax payable is based on holdings on a particular date in the year, which again will influence the strategy adopted for stock management by a multinational.

2.9 Summary
This chapter has described the two principal rules within the financial management function, that is, treasury and financial control, pointing out their relationships and respective duties. Financial markets and their efficiency have been examined. An efficient capital market is one in which share prices move rationally, and reflect all information that could affect the price. Conservative and aggressive financing and investment strategies for working capital have been evaluated.

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Readings

2

The article below discusses the volatility in the UK and US stock markets during the first quarter of 2000. In doing so, it raises questions about the validity of fundamental analysis and the efficient market hypothesis.

Volatility unvanquished
Phillip Coggan, Financial Times, 8/9 April 2000. © Financial Times. Reproduced by permission.

Remember those 1960s and 1970s sci-fi films where giant computers - the kind that filled a whole room – plotted to take over the world? Maybe it is time for some sequels. This week investors suffered Turbulent Tuesday, when the tech stocks on the UK Nasdaq market briefly fell nearly 14 per cent, before recovering. Then there was Washed-Out Wednesday when a computer problem at the London Stock Exchange meant that trading could not even start until the middle of the afternoon. Perhaps we have had a glimpse of the computers’ master plan. Cause so much stress among the human population that we all die out – and leave them to take control. It is certainly as plausible an explanation as any other. Tough to argue the case for an efficient market made up of rational investors when the same stocks trade in a 14 per cent range within a matter of hours. Can earnings expectations have altered so much so quickly? It is also hard to believe in a ‘new era’ of highly productive technology when the stock exchange in one of the world’s leading financial centres can crash for several hours. So what has really been going on? Our old friends fear and greed have certainly played their part. Investors have been buying stocks in some companies, not because they have rationally analysed the fundamentals, but because they have been going up. Some in the US have been buying on margin, i.e. borrowed money. The good news for investors is that this kind of buying can drive share prices up to unimagined heights. Fundamental analysis simply does not work. Investors do not care about the price they pay for shares because they expect someone else to pay a higher price in a month’s, or a week’s time. Witness the more than doubling in the Techmark 100 index in four short months. What had changed about the fundamentals of technology stocks in that period? Not much. The big change was in investors’ perceptions. The bad news, alas, is that when the spell fades, there can be nothing to support the shares. It can be rather like those Road Runner cartoons where Wile E Coyote runs happily over the edge of the cliff – until he suddenly looks down.
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Take poor old Lastminute.com. When everybody thought they were going to make their fortunes from the shares, the spread-betting firms were quoting prices of over 500p. Once the shares started trading, the magic dissipated; the price dipped below 200p this week. Nothing has changed about the business in the meantime. All this does not necessarily signal that the overall market is in for a bloodbath. There are plenty of investors who believe in ‘buying on the dips’. They have absorbed the age-old lesson that equities outperform over the long term. Thus, market dips are not a cause for panic but a buying opportunity. That has been a pretty good general rule but it is worth remembering that there have been occasions – Wall Street during 1929–32 or the UK in 1972–74, for example – when investors needed immense patience for it to come right. Investors who bought into the Tokyo stock market in 1989 are still waiting. For the moment, the old economy gets the benefit whenever the new economy suffers and vice versa, leaving indices like the FTSE 100 stuck in a trading range. Credit Suisse First Boston points out that the nine, largely new economy, stocks that joined the Footsie on March 6 have underperformed the market by an average of 32 per cent, while the old economy groups that were dumped out of the index have outperformed by 23 per cent. Investors may also have been getting more selective, looking for the new economy stocks with established brands or strong niches, and discarding those that never looked like making a profit. They have also started to realise there are plenty of old-economy businesses that will not suffer from the internet (and there are even some that will benefit). This is a pretty healthy development but it seems unlikely that stock markets have seen the last of the kind of volatility that dominated events this week. Interest rates are still likely to rise in the US, Europe and the UK (although the Bank of England left them on hold on Thursday). New economy stocks (technology, media and telecoms) still, as a group, trade on very fancy price–earnings ratios, which suggests that there may be a lot of scope for disappointments at the individual company level. The UK market will also lose shortly the support from the ‘ISA effect’ – the end of tax year cash flows into individual savings accounts that tend to keep the market buoyant in March and April. As if the first quarter has not been exciting enough, investors could be in for a testing summer. Perhaps the computers are running amok after all.

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Revision Questions

2

Question 1
(a) Explain the weak form of the efficient market hypothesis (EMH). (4 marks) (b) Outline and appraise the empirical research undertaken to test the validity of the weak form of EMH. (4 marks) (c) If the capital markets are efficient, this has implications for corporate finance. Discuss the implications for the financial manager of a large company that is trying to maximise the wealth of its shareholders. (12 marks) (Total marks 20)

Question 2
ABC plc is a UK-based service company with a number of wholly owned subsidiaries and interests in associated companies throughout the world. In response to the rapid growth of the company, the managing director has ordered a review of the company’s organisation structure, particularly the finance function. The managing director holds the opinion that a separate treasury department should be established. At present, treasury functions are the responsibility of the chief accountant. Requirements (a) Describe the main responsibilities of a treasury department in a company such as ABC plc and explain the benefits that might accrue from the establishment of a separate treasury function. (12 marks) (b) Describe the advantages and disadvantages that might arise if the company established a separate treasury department as a profit centre rather than as a cost centre. (8 marks) (Total marks 20)

Question 3
UR is a privately owned machine tool manufacturing company based in the Rupublic of Ireland. For the past five years, it has operated an aggressive policy in respect of the management of its working capital. The following information concerns the conpany’s forecast end-of-year financial outcomes if it continues with this type of policy.
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Receivables Inventory Cash at bank Total current assets Non-current assets Trade creditors Revenue Operating costs Operating profit Earnings

€000 5,200 2,150 14,350 7,700 14,500 4,500
17,500 14,000 13,500 2,625

There are 2.5 million shares in issue. The company has been experiencing a series of problems because of the type of working capital management policy it has been following and is considering an alternative approach to working capital management. The percentage figures shown below are changes to the above forecast. These changes are anticipated to occur if a more conservative policy is adopted.
Receivables Inventory Cash (figures in €000) Non-current assets Curent liabilities Forecast revenue Operating profit and earnings 40% 20% Increase to €1,000 No change 30% 5% 5%

Requirement Evaluate the two working capital management policies described above and recommend a proposed course of action. Include in your evaluation a discussion of the problems that might have arisen as a result of operating aggressive working capital management policies and thekey elements to consider and actions to take before making a decision to change. You should calculate appropriate and relevant ratios or performance measures to support your arguments. [The calculations will earn up to 8 marks.] (25 marks)

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Solutions to Revision Questions
Solution 1
This question examines the following syllabus area:

2

The efficient market hypothesis (EMH).

(a) The weak form of EMH states that the current share price reflects all the information contained in the record of past prices. Studies have shown that share prices usually display the features of a random walk and this means that future prices do not follow past trends. This has implications for people who chart the prices of shares in fundamental analysis. Even the weak form of the EMH would make ‘charting’ a waste of time. (b) The weak form of the efficient market hypothesis has been tested by subjecting a series of share prices or indices to statistical tests to determine whether there is any correlation between past and present prices. Evidence suggests that it is not possible to predict future prices by looking at a series of past prices. Another series of tests has been to establish whether following trading rules enables above-average returns to be earned. (c) It is generally acknowledged that the prime objective of a company is to maximise the wealth of shareholders. Can financing decisions contribute to the increase in wealth of the shareholders? If the capital markets are perfect, then financing decisions will not create value. If the capital markets are efficient, on the other hand, it is possible that shareholders’ wealth could be increased by the ‘right’ decisions being made by financial managers, though it is unlikely that the benefits will be generated consistently. So managers can make investment decisions that generate positive NPVs and create value through the disequilibriums that often exist in the real markets. However, the nature of the capital markets, especially the evidence of efficiency, means that it is less likely to occur in the area of finance. If capital markets are efficient, the main implications for corporate finance are as follows:

● ●

It is not possible to generate a surplus by timing an issue of new securities at the ‘best’ time. A company can sell as many securities as it wishes without affecting the price. A company cannot mislead the markets by adopting ‘creative accounting’ techniques.

Efficient market theory has provided valuable insights into the functioning of the markets for financial assets. It appears to be sensible for corporate financial managers to assume that the financial markets are highly efficient and it is, therefore, important that this is taken into consideration when they develop strategic plans to create value for shareholders.
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SOLUTIONS TO REVISION QUESTIONS P9

Solution 2
This question examines the following syllabus areas:
● ●

The role of the treasury function; The benefits and shortcomings of establishing treasury departments as profit centres or cost centres; The control of treasury departments when established as cost centres or profit centres.

Tips

A significant minority of candidates were ignorant of the treasurer’s role and confused the job’s functions with those of the financial manager/controller. Another weakness was to confuse separation with decentralisation. The question did not require a discussion of decentralisation, or devolvement to overseas subsidiaries, although candidates were given credit for making good points.

(a) CIMA Official Terminology describes the treasury function as the function concerned with the provision and use of finance. It includes provision of capital, short-term borrowing, foreign currency management, banking, collections and money-market investment. The main functions of such a department include: 1. Establishment of corporate financial objectives. 2. Managing the firm’s liquid assets: cash, marketable securities, etc. 3. Management of the company’s funding: determination of policies (e.g. on transfer pricing), identifying sources and types of funds. 4. Corporate finance and related issues such as taxation, pension fund investment, etc. 5. In a multinational such as ABC, it will also deal with currency management: dealing in foreign currencies, hedging currency risks, etc. 6. Cash management in a multinational such as ABC can involve centralised cash management and multilateral netting of foreign currency transactions between subsidiaries and associated companies. Treasury is usually a centralised function in that the relationships mentioned above are usually concentrated in head office, that is, the parent company of a group. Financial control, meanwhile, is increasingly being devolved to individual business units, so as to be close to the customer, alert to competition, etc. Where this is the situation, a separation of treasury from control is inevitable. The skills required are also different, for example, given the liberalisation of financial markets and foreign exchanges, treasurers need to be aware of the expanding range of hybrid capital instruments (e.g. convertible preference shares issued in the name of a subsidiary registered in the Dutch Antilles) and financial instruments (forward markets and the various ‘derivatives’) and to be able to select from these the ones that are appropriate to the company’s needs in the prevailing circumstances. A separate treasury function is more likely to develop the appropriate skills: it is impossible for anyone to be expert in these matters and have time to be proactively involved in the management of individual businesses. It will also be easier to achieve economies of scale (e.g. better borrowing rates and the netting-off of balances).

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(b) As indicated in the answer to part (a), the case for a separation of treasury – not only from accounting but also from financial control – is a strong one. The question remains, however, as to how its performance/progress should be measured/assessed. Some people would argue for a ‘profit centre’ approach. This usually means that the treasury charges individual business units a market rate for the service it provides. If it writes currency options, for example, it charges the business unit a premium in line with that charged by the banks. It then has the task of managing that option (by buying and selling in the forward market, or by using derivatives) for a cost that leaves it with a profit. The main argument for this is that the treasurer is then motivated to do what is best for the company as a whole, that is, to minimise the cost of the operation. Spot checks are obviously required (e.g. by internal audit) to ensure that charges are indeed at market rates, since there is an imbalance in the amount of information available to the two parties (weighted in favour of the treasurers). There are obviously some administrative costs involved, but the main drawback in practice has been that some treasurers have interpreted the profit concept as encouraging them to speculate. If it can make a profit writing options, why not write them for other companies? If it understands the foreign currency markets, why not speculate – for example, swap funds from currencies expected to depreciate into ones expected to appreciate? Often spectacular gains can be made, but the record shows that spectacular losses are at least as likely. A sound internal control system is a necessity in any treasury function, but especially so when speculation is encouraged. Consequently there are many who advocate a ‘cost centre’ approach. This usually means that the costs of running the department are collected (and, no doubt, compared with budget) but that the substance of the transactions that they manage is reflected in the business unit’s books: for example, the ‘profit’ made on writing options is credited to the business for which it was written. Alternatively, the profits/losses are allowed to lie where they fall: for example, the business unit carries the profit or loss on an overseas sale (according to the spot rate when the cash is received) and the treasury carries the offsetting currency loss/gain respectively (the difference between the forward rate obtained and the eventual spot rate). This approach collects the total cost/benefit of hedging. It discourages speculation but may, by the same token, discourage initiative. Confrontation can occur when the business unit bears a loss, caused – as it sees it – by the treasury. The debate as to which method is appropriate mirrors that in various other aspects of business enterprise. Perhaps the most important observation is that the accounting model – whether it focuses on costs or profits - is insufficiently dynamic/long-termist to provide a platform for strategic control. What is required is a distinctive financial management approach.

Solution 3
Preliminary calculations Appropriate choice could include EPS, return on net assets and the current and/or quick ratio. Other calculations could include debtors/creditors days, stock days/turnover and the operating cycle.

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SOLUTIONS TO REVISION QUESTIONS P9 Policy Receivables Inventory Cash Current assets Non-current assets Current liabilities Forecast revenue Forecast profit Forecast earnings Current assets less current liabilities Net assets Earnings per share (€) Return on net assets (%) Current ratio Quick ratio Debtors days Creditors days Stock days Operating cycle Operating profit margin ROCE Aggressive €000 5,200 2,150 2,350 Conservative €000 3,120 2,580 1,000

€000

€000

7,700 14,500 (4,500) 17,500 3,500 2,625 3,200 17,700 1.05 19.8 1.71 1.23 108.5 117.3 56.1 47.3 20.0 13

6,700 14,500 (3,150) 16,625 3,675 2,756 3,550 18,050 1.10 20.40 2.13 1.31 68.5 88.8 72.7 52.4 22.11 15

Evaluation of the alternative policies Investment in working capital is, typically, in stocks, debtors and cash or marketable securities (highly liquid, short-term assets). In conditions of uncertainty firms must hold some minimal level of cash and stock based on expected sales, plus additional safety stocks. With an aggressive working capital policy, a firm would hold minimal safety stocks. Such a policy would minimise costs, but it could lower sales because the firm could not respond rapidly to increases in demand. Conversely, a more conservative working capital policy would call for large safety stocks. There is a basic difference between cash and stock, on the one hand, and receivables on the other. In the case of cash and stock, higher levels mean higher safety stock, hence a more conservative position. There is no such thing as a ‘safety stock of receivables’, and a higher level of receivables in relations to sales would generally mean that the firm was extending credit on more liberal terms. Possible explanations for UR’s problems/difficulties of changing policy The problems UR has been experiencing are likely to be one or more of the following:
● ● ● ●

increase in bad debts because of more liberal credit policies; increased overdraft charges because the company may have unexpected cash shortfalls; stock outs because of low stock levels and, possibly, inadequate, JIT-type systems; refusal of supplies or even legal action because of late payments to creditors.

The main difficulty likely to be experienced by a change in policy is the loss of custom. This issue is discussed further below. The key elements to consider/actions to take before making a decision The implications for change could be wide-ranging and the likely effect on customer relations and sales are key considerations. The main elements to review and evaluate before a
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decision is taken are summarised below:

Industry-related characteristics, for example if competitors offer 90 days credit. It is difficult to require a shorter payment period unless you offer a much superior product or service or other unque factor. UR’s debtors’ days are at present 108.5, which seems generous and was probably the result of a campaign to increase sales under the ‘aggressive’ policy regime. This ratio would fall to 68.5 days under the proposed policy. Industry figures are not given so it is not possible to make any valid comparisons. The current ratio, even under an aggressive policy, seems high for modern working capital management. This would rise to 2.13 under the proposed policy, which might imply under-utilised current assets. Cash lying idle in a bank account is not a good use of money and again the need is to investigate cash management systems before deciding it is simply the cash balances that are too low. A detailed cash flow budget should be prepared. The use of cash management models should be considered if the company is likely to now be always in cash surplus. A review of stock control polices should be carried out to assess whether the problems are faulty systems rather than too low stock levels. The type of product or service sold. The operating cycle for UR is expected to be 47.3 days based on the information available and the existing policies are maintained. This figure would rise to 52.4 if the proposed policy were adopted. Again, industry figures are needed but transport and distribution does not have a long cycle and these figures may not be untypical. Volume of sales: organisations such as supermarkets have very high volume sales but, typically, low margin. The operating profit margin for UR is currently only 20 per cent seems low for a company such as this. This would rise to 22.1 per cent under the proposed policy, but this is fairly marginal. Level of centralisation of working capital management: the more centralised the tighter the control (usually) that allows a more aggressive approach. UR is a relatively small company and it is likely their WCM will be centralised. This would favour an aggressive policy so before a decision is taken the real reason for the problems should be reviewed and evaluated. The efficiency of the credit control department in an organisation. If the company has a long period between invoice production and despatch, it needs to recognise this in the credit period allowed. This is unknown from the information in the question, but the 108.5 debtor’s days suggest this could be investigated.

Recommendation The figures calculated in support of the evaluation suggest that profits, EPS and return on net assets will increase if UR adopts the proposed policy. The current ratio rises from 1.71 to 2.13 (quick ratio from 1.23 to 1.31). This is not a dramatic change and, given modern debt collection, ordering and banking practices and the installation of a new computer system, a ratio of 1.71 might be considered comfortable enough. However, before a decision is taken, UR should consider the effect on its customers, suppliers and staff. The company should review the various components of working capital and the procedures as well as policies for their management. The calculations so far do not provide an overwhelming case for a change in policy. The current ratio is already generous and the likely increases in profits, earnings and return on net assets are relatively small. It is possible that the same benefits could be obtained by better management of the existing policies rather than risking customer relations and loss of custom.
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Sources of Long-term Finance

3

LEARNING OUTCOME
After completing this chapter you should be able to: Identify and calculate optimal strategies for the satisfaction of longer-term financing requirements.

3.1 Introduction
The topics covered in this chapter are as follows:
● ● ● ● ● ●

Types of share capital. Equity issues; new and rights issues. Long-term debt finance. Methods of issuing securities. Operating and finance leases. The difference between the coupon on debt and the yield to maturity.

3.2 Shareholders’ funds
3.2.1 Ordinary shares
An equity interest in a company can be said to represent a share of the company’s assets and a share of any profits earned on those assets after other claims have been met. The equity shareholders are the owners of the business – they purchase shares (commonly called ordinary shares), the money is used by the company to buy assets, the assets are used to earn profits, and the assets and profits belong to the ordinary shareholders. Equity shares entail no agreement on the company’s part to return to the shareholders the amount of their investment. Ordinary shares are sometimes referred to as the risk capital of a business; it is the ordinary shareholders who take most of the risk in business. Nominal value Ordinary shares may be issued with a nominal value of, say, 10 pence each. These shares will continue to be referred to as 10 pence shares, even though the price at which they are
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bought and sold on the stock market may differ substantially from this. Shares without a nominal value, or shares of no par value, are common in the USA and have for some years been advocated in the UK, but their issue would be illegal under current legislation. Dividends are usually paid in pence per share and are not based on nominal values, which is usually the case with fixed-interest securities. There is no express relationship between the nominal value and the market value of a share. However, company law in the UK prevents shares from being issued below their nominal value. This means that a company whose share price has fallen below the nominal value would not be able to raise additional funds by way of a share issue. Book value Book values apply to both assets and liabilities. The book value of an asset is the net result of the accounting procedures and adjustments to which the balance has been subjected, for example, depreciation charges. However, it is not necessarily any guide to the market, or realisable-value of the asset. In Financial Strategy we are likely to be more concerned with the differences between book and market values of shareholders’ equity. The book value of equity is the sum of the ordinary share capital shown in the balance sheet plus the value of shareholders’ reserves (share premium account, revaluation reserve, retained earnings, etc.). This value may be quite different from the market value of equity. This is mainly because the book value: (a) reflects accounting procedures and adjustments; and (b) is a historical figure. Market values reflect investors’ expectations about future earnings. Market value This is the value of an asset based on the amount it is believed it would command if sold. Some assets, such as securities, are traded regularly on an organised market and their value is relatively simple to establish. However, the market value of, for example, specialised plant and machinery may be more difficult to establish. The market value of shares is simply the share price multiplied by the number of shares in issue. The share price reflects investors’ expectations of future earnings; the book value reflects the accounting value of past earnings. An error sometimes made by students is to calculate the market value of equity by correctly multiplying the share price by the number of shares in issue, then adding the accounting value of reserves. The market value of equity, the market capitalisation, is calculated by multiplying the market price of an ordinary share by the number of shares in issue; the value of the reserves is already included in the market price of the shares and should not be double counted.

3.2.2 Preferred and deferred ordinary shares
The ordinary shares of a company are sometimes subdivided into preferred and deferred ordinary shares. Preferred ordinary shares rank for a dividend at a pre-agreed rate before the deferred ordinary shares. The dividend payable to the holders of deferred ordinary shares on the other hand is not at a pre-agreed fixed rate. Sometimes preferred ordinary shares are issued that entitle holders to the preagreed fixed dividend, and also to participate in a further dividend with the deferred ordinary shareholders.
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3.2.3 Preference shares
Preference shares entitle their holder to a fixed rate of dividend from the company each year. This dividend ranks for payment before other equity returns and so the ordinary shareholders receive no dividend until the preference shareholders have been paid their fixed percentage. Preference shares carry part ownership of the company and allow due participation in the profits of the business. In fact, their dividend is an appropriation of profits and so if a bad year means no profits, it also means no dividend for the preference shareholders. This point constitutes the essential distinction between preference shares and debentures. Debenture holders are not part owners of the company; their interest claims have to be met whether the company has made a profit or not. Interest payments are not an appropriation of profits. It is for this reason that the tax treatment of each of the two forms of fixed percentage capital is different. Debenture interest, as a charge, is a tax-deductible expense and, like any other form of tax-allowable expenditure, it reduces the company’s tax bill. Preference dividends, as an appropriation of profits, are not tax-deductible. Tax is payable on the profits figure before the preference dividends are deducted. Consequently, a company earning profits and committed to paying out, say, 8 per cent on capital raised, would prefer to be paying it on debentures (for which the interest charge is net of tax) than on preference shares for which the company would have to stand the gross cost.

3.2.4 Reserves
Reserves include share premiums, revaluation reserves and retained profits. Regardless of how the reserve was created, it is included as part of the equity of the company. Retained profits are the most important source of finance for most businesses. In part this is because retaining profits avoids issue costs associated with other sources of finance. It often thought that retained profits are a free source of finance, but this is not the case. There is an opportunity cost reflecting the dividend forgone as a result of retaining profits instead of paying them out as a dividend. It is important to appreciate that reserves are a historical source of funds, and so are unlikely to be represented by an equal amount of cash on the balance sheet.

3.3 Raising share capital – the stock market
The stock market is a key feature of English-speaking economies – and seems to be set to grow elsewhere, as communism is replaced by capitalism, and even Western European economies are privatising formerly public sector enterprises. Its activities are mainly concerned with the secondary market, that is, enabling investors to buy and sell shares in particular companies, without the companies themselves being directly affected. This is a vital role in the sense that without the prospect of being able to sell shares when they wished, investors would be far less willing to buy them in the first place. Investors may buy and sell shares, hoping to make a capital gain as the share price rises. The capital gain will be realised when the share is sold to another investor at a price higher than that originally paid. Shares may be traded in one of two markets, according to the size and status of the company concerned. The largest companies will be traded on the Stock Exchange. The financial and other criteria necessary for a company to receive a full
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Stock Exchange quotation (or listing) are stringent. Companies that do not satisfy these criteria may be traded through the Alternative Investment Market (AIM), where entry conditions are significantly easier. Although AIM companies face similar regulations to fully listed companies, the entry procedures and ongoing obligations are much less onerous. In particular, there are no criteria concerning the capitalisation of the company or its trading history. Investors may speculate by buying shares in a particular company or sector of the market, believing that the value of those shares will rise shortly. Such a speculator is known as a ‘bull’. Conversely, a ‘bear’ speculator is one who sells shares in the belief that their value is about to fall. If the company were to fail altogether, the shares would be worthless, but the shareholder would not normally be required to use his or her own money to pay off the company’s debts. Liability is said to be limited to the original investment. Creditors of the company need to be aware of this when trading or lending to the company, hence the need to include plc or Ltd in the company name. Companies may become publicly quoted merely by making shares available by way of an ‘introduction’, that is, existing shareholders being willing to sell some at a price. Otherwise, additional funds may be raised (i.e. for the company as well as existing shareholders) by means of new issues.

3.3.1 New issues
Shares that come into circulation for the first time are called new issues. This section will briefly outline the ways in which this happens. Offer for sale These offers may be of completely new shares or they may derive from the transfer to the public of shares already held privately. An issuing house, normally a merchant bank, acquires the shares and then offers them to the public at a fixed price. The offers are usually made in the form of a prospectus detailed in the Financial Times and other newspapers, sometimes in an abbreviated form. Buying new issues through the prospectus in the newspaper avoids dealing charges. An example of an invitation to bid for shares is included below. Other examples of such issues include:
● ●

government privatisations; and privately held shares transferred to the public.

It is easier for prospective purchasers to form a judgement about such companies where there is some track record, rather than with offers for a completely new company such as Eurotunnel. Some investors apply for new issues in the hope of selling immediately and reaping a quick profit. For this to succeed the number of shares purchased must be sufficiently high to cover selling charges. For oversubscribed issues, the allocation may be scaled down and the applicant may receive only a small number of shares. The strategy of selling immediately is called stagging (and investors who do it are called stags). There have been some notable successes for stags, particularly in some of the privatisation issues, but there have also been cases where the initial dealing price has been substantially below the offer price. The most notable example of the latter was the offer for sale of BP shares in 1987.
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Offer for sale by tender This method of issue is similar to that above, the only difference being that the shares are not issued at a fixed price. Subscribers must tender for the shares at, or above, a minimum fixed price. The shares are allotted at the highest price at which they will all be taken up. This is known as the strike price. Prospectus issue In a prospectus issue, or public issue, a company offers its shares direct to the general public. An issuing house may act as an agent, but this type of issue will not be underwritten. This makes this type of issue risky, and also very rare. Placing In this type of issue the shares are not offered to the public, but the issuing house will arrange for the shares to be issued to its institutional clients. This method has become the most popular method of issue in the UK, being cheaper and quicker to arrange than most other methods. Introduction Here, no new shares are issued, and the company is not seeking to raise any new finance. The company may already be quoted on another stock exchange, or else the ownership of the shares is already widespread and the owners are now seeking a quotation for their shares. The company becomes publicly quoted as a result of existing owners being willing to sell some of their holdings to generate a free market.

3.3.2 Rights issues
In a rights issue, the company sets out to raise additional funds from its existing shareholders. It does this by giving them the opportunity to purchase additional shares. These shares are normally offered at a price lower than the current share price quoted, otherwise shareholders will not be prepared to buy, since they could have purchased more shares at the existing price anyway. The company cannot offer an unlimited supply at this lower price, otherwise the market price would fall to this value. Accordingly the offer they make to the existing shareholders is limited. For example, they may offer one new share for every four held. A rights issue may be defined as: ‘an offer by a company to its existing ordinary shareholders of the right to subscribe for new ordinary shares or other convertible securities having an equity element in direct proportion to their existing shareholding’. Selection of an issue price In theory, there is no upper limit to an issue price but in practice it would never be set higher than the prevailing market price (MPS) of the shares, otherwise shareholders will not be prepared to buy as they could have purchased more shares at the existing market price anyway. Indeed, the issue price is normally set at a discount on MPS. This discount is usually in the region of 20 per cent. In theory, there is no lower limit to an issue price but in practice it can never be lower than the nominal value of the shares. Subject to these practical limitations, any price may be selected within these values. However, as the issue price
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selected is reduced, the quantity of shares that has to be issued to raise a required sum will be increased. Underwriting Underwriting avoids the possibility that the company will not sell all of the shares it is issuing, and so receive less funds than it expects. Underwinters are normally financial institutions such as insurance companies and pension funds. In return for a fee, they agree to buy any shares that are not subscribed for in the issue. Underwriters receive their fee whether or not they are required to take up any unsubscribed shares. The underwriting costs could potentially be avoided through a deep-discounted rights issue. In such an issue, the issue price is set at a large discount to the current market price so reducing the possibility of shareholders not taking up their nights. Selection of an issue quantity It is normal for the issue price to be selected first and then the quantity of shares to be issued becomes a passive decision. The effect of the additional shares on earnings per share, dividend per share and dividend cover should be considered. The selected additional issue quantity will then be related to the existing share quantity for the issue terms to be calculated. The proportion is normally stated in its simplest form, for example, 1 for 4, meaning that shareholders may subscribe to purchase one new share for every four they currently hold. Terms of an issue Once the issue price and share quantity have been selected by the company, the terms of the rights issue can then be announced. For example, Lauchlan plc has 2 million £1 ordinary shares in issue with a current MPS of £5. It decides to raise £2 million by means of a rights issue at £4 per share. Since 500,000 additional shares will now have to be issued, the terms of the rights issue may be summarised as ‘1 for 4 at £4’. The theoretical ex-rights price (TERP) Assuming this rights issue is taken up by the existing shareholders, the market price of the shares will readjust to a value above that of the rights issue but below the original market price. Using the data above for Lauchlan plc, the following TERP calculation results:
1 ‘new’ share at 400p 04 ‘old’ shares at 500p 05 TERP 480p p 400 2,000 2,400

This calculation may be expressed by way of a formula as: TERP Pp Pn No Nn N
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TERP

500p 2,000,000 2,500,000 400p 80p

400p 500,000 2,500,000

TERP

480p

Value of a right The value of a right is the theoretical gain a shareholder can make from taking up their rights. The value of a right will be the difference between the theoretical ex-rights price and the issue price of the shares. In the example above, the value of a right is calculated as: TERP Issue price Value of the right 480p 400p 80p per ‘new’ share

(80

4)

20p per ‘old’ share.

If a shareholder decides not to take up the rights to a rights issue, the rights may be sold to another investor. Theoretically the investor could sell the right to subscribe for one new share for 80p. Shareholder options A shareholder receiving notification of a rights issue from a company has a number of options available. Consider the position of a shareholder in Lauchlan plc owning 1,200 shares and, then, being offered 300 shares at £4 each. Option 1 – Do nothing. In this situation, the market value of the investment could be expected to fall by £240 from £6,000 to £5,760 (1,200 @ £4.80). The company would normally reserve the right to sell any ‘unaccepted’ shares for the best price available in the market. After having deducted any expenses and, of course, £4 per share, the balance would be sent to the shareholder. This cash balance could fully or partially compensate the shareholder for the reduction in market value. The shareholder’s percentage share of the company will reduce. Option 2 – Sell the rights. In this situation, the shareholder decides to sell the right to buy the shares at £4 each to another investor. A rational investor would not be expected to pay more than 80p per share (TERP £4) for such a right. The existing shareholder might receive £240 (300 @ 80p) less any dealing costs incurred. The shareholder’s percentage share of the company will be reduced. Option 3 – Fully subscribe. In this situation, the shareholder will have to increase the value of the shareholding by paying the company £1,200 for the 300 new shares. The shareholder will then own 1,500 shares which, using TERP, will be valued at £7,200. The shareholder’s percentage share of the company will be maintained. Option 4 – Sell some to buy some. In this situation, the shareholder may be unable or unwilling to invest more funds in the company. Since the rights can normally be sold in the market, the shareholder could sell sufficient of the rights to purchase the balance. In the Lauchlan plc example, each block of 5 rights sold at 80p raises
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sufficient cash to purchase one new share at £4. The shareholder could sell 250 @ 80p to raise £200 which would be sufficient to purchase 50 @ £4. The value of the investment will be maintained at £6,000 but the shareholder’s percentage share of the company will be reduced. Yield-adjusted ex-rights price The calculations of theoretical ex-rights price above assume that the additional funds raised will generate a return at the same rate as existing funds. If a company expects (and the market agrees) that the new funds will earn a different return than is currently being earned on the existing capital then a ‘yield-adjusted’ TERP should be calculated. Yield-adjusted TERP Pp Pn Yo Yn No Nn N Pp No N Pn Nn N Yn Yo

Pre-issue price New-issue price Yield on ‘old’ capital Yield on ‘new’ capital Qty of ‘old’ shares Qty of ‘new’ shares Total quantity of shares

Using the figures for Lauchlan plc and assuming:
● ●

the rate of return (yield) on the new funds 15% the rate of return on the existing funds 12%

The yield-adjusted ex-rights price becomes: 500p 2,000,000 2,500,000 400 400p 500p Alternatively, this may be calculated as:
1 ‘new’ share at 400p 04 ‘old’ shares at 500p 05 TERP 500p 15/12.5 p 500 2,000 2,500

Yield-adjusted TERP

400p 500,000 2,500,000

15 12

80p 100p

15 12

Notice that if the new funds are expected to earn a return above the rate generated by existing funds, there will be less dilution of the market price than suggested by the original TERP calculation.
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Exercise 3.1
Rosenior plc makes a 2-for-3 rights issue at an issue price of £2. The cum rights price is £4. You are required to calculate the theoretical ex rights price (TERP).

Solution
TERP £4 5 £2.40 £3.20 3 £0.80 £2 5 2

TERP

Exercise 3.2
Molson plc has a paid-up ordinary share capital of £2,000,000 represented by 4 million shares of 50p each. Earnings after tax in the most recent year were £750,000 of which £250,000 was distributed as dividend. The current price/earnings ratio of these shares, as reported in the financial press, is 8. The company is planning a major investment that will cost £2,025,000 and is expected to produce additional after-tax earnings over the foreseeable future at the rate of 15 per cent on the amount invested. The necessary finance is to be raised by a rights issue to the existing shareholders at a price 25 per cent below the current market price of the company’s shares. (a) You are required to calculate: (i) the current market price of the shares already in issue; (ii) the price at which the rights issue will be made; (iii) the number of new shares that will be issued; (iv) the price at which the shares of the company should theoretically be quoted on completion of the rights issue (i.e. the ‘ex-rights price’), ignoring incidental costs and assuming that the market accepts the company’s forecast of incremental earnings. (8 marks) (b) It has been said that, provided the required amount of money is raised and that the market is made aware of the earning power of the new investment, the financial position of existing shareholders should be the same whether or not they decide to subscribe for the rights they are offered. You are required to illustrate and comment on this statement. (7 marks)

Solution
(a) (i) Current market price of shares already in issue: Earnings per share £750,000 4,000,000 18.75p
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P/E ratio

Market price per share Earnings per share 8 8 18.75p £1.50

Market price per share

(ii) Price at which rights issue will be made: £1.50 75% £1.125 (iii) Number of new shares that will be issued: £2,025,000 £1.125 1.8 million

(iv) Ex-rights price is £1.50 4,000,000 5,800,000 £0.419 £1.125 1,800,000 5,800,000 15% 12.5%*

£1.034 £1.453

*The price/earnings ratio is given as 8. This would imply an earnings yield of (1 8) 12.5%. This is assumed to be the yield or rate of return on existing funds. (b) This statement can be illustrated as follows: For every 20 shares held the rights issue means another nine shares. At least in theory, the selling price of the right to purchase one share will be £1.453 less £1.125, that is, £0.328.
A shareholder with 20 shares taking up the rights: Market value of 29 shares at £1.453 each Less: Cost of taking up rights of nine new shares at £1.125 each £ 42.137 10.125 32.012

A shareholder with 20 shares selling the rights: Market value of 20 shares after rights issue at £1.453 each Add: Sale of nine rights at £0.328 each £ 29.060 32.952 32.012

The above, however, assumes no transaction costs. Furthermore, the market may read a particular message into the rights issue that would affect the above calculations.

3.3.3 Share splits and bonus issues
These are shares issued without payment to holders of existing ordinary shares. They are issued because the price of the existing shares has become unwieldy. Bonus issues are at the initiative of the company directors, with the subsequent approval of the shareholders. Obviously, these additional shares are normally accepted by the shareholders, but they are not getting something for nothing even though they are called bonus shares. This is because
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if all other things are unchanged, the value of the company remains unaltered. Accordingly if, before the bonus issue, there were 1 million shares each valued at 220 pence, then if there was a one for one bonus issue resulting in the number of shares increasing to 2 million the price of the shares would fall to 110 pence. Thus, the shareholders would have twice as many shares each with half the value. In many cases, bonus issues are made in different ratios to one new share to each existing share but the same principle remains that the value of the holding is unchanged. Consequently, selling the shares from the bonus issue reduces the value of the individual’s holding. Usually bonus issues are of ordinary shares but the issue can be in the form of preference shares.

3.4 Debt finance
3.4.1 Debentures
A debenture is a document issued by a company containing an acknowledgement of indebtedness. It need not give, although it usually does, a charge on the assets of the company. The Companies Acts define ‘debenture’ as including debenture stock and bonds. It is quite common for the expressions debenture and bond to be used interchangeably. Company debentures can also be referred to as ‘loan stock’. Usually a debenture is a bond given in exchange for money lent to the company. Debentures can be offered to the public only if the application form is accompanied by a prospectus. The company agrees to repay the principal to the lender by some future date and in each year up to repayment it will pay a stated rate of interest in return for the use of the funds. The debenture holder is a creditor of the company and the interest has to be paid each year before a dividend is paid to any class of shareholder. Secured or unsecured Debentures and debenture stock can be secured or unsecured. It is usual, however, to use the expression ‘debenture’ when referring to the more secure form of issue and the term ‘loan stock’ for less secure issues. When the loan is secured this is by means of a trust deed. The deed usually charges, in favour of the trustees, the whole or part of the property of the company. The advantages of a trust deed are that a prior charge cannot be obtained on the property without the consent of the debenture holders, the events on which the principal is to be repaid are specified and power is given for the trustees to appoint a receiver and in certain events to carry on the business and enforce contracts. The debentures can be secured by a charge upon the whole or a specific part of a company’s assets, or they can be secured by a floating charge upon the assets of the company. In this latter case the company is not precluded from selling its assets. The latter case is known as a general lien, whereas the debenture issued on the security of a specific asset is a mortgage debenture or mortgage bond. With a floating charge, when the company makes a default in observing the terms of the debentures, a receiver may be appointed and the charge becomes fixed, with the power to deal in the assets passing into the hands of the receiver. Such restrictions are referred to as ‘covenants’. Deep-discounted bonds Deep-discounted bonds are debt instruments that are issued at a price well below their nominal value. At the eventual redemption date they will be redeemed at their nominal (par) value. For example, a company might raise £5,000,000 by issuing deep-discounted bonds in
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2004 at a price of £60 per £100 nominal that will be redeemed at par in 2015. The deep discounting means that the interest rate on the bond will be much lower than current market rates. This will give a cash-flow benefit to the issuing company as interest payments will be low throughout the life of the bond. Investors will be prepared to sacrifice interest for the capital gain on redemption they can lock into. This may be appealing to investors who would prefer capital gains to income. Zero-coupon bonds The lower the issue price of a bond in relation to its nominal value, the greater the potential for a capital gain on redemption. The interest rate can therefore be reduced until we reach a stage where no interest is paid on the bond at all during its life. This is referred to as a zero-coupon bond. With a zero-coupon bond, all of the investor’s return is wrapped up in a capital gain on redemption.

3.4.2 Debt yields
The rate of return, or yield, on debentures, loan stocks and bonds is measured in two different ways. Interest yield Interest yield is also referred to as running yield or flat yield and is calculated by dividing the gross interest by the current market value of the stock as follows: Interest yield gross interest market value 100%

Example 3.A
A 6 per cent debenture with a current market value of £90 per £100 nominal would have an interest yield of: 6 90 100% 6.7% gross or pre- tax

Yield to maturity (redemption yield) The yield to maturity (or redemption) is the effective yield on a redeemable security, taking into account any gain or loss due to the fact that it was purchased at a price different from the redemption value.

Exercise 3.3
You are asked to put a price on a bond with a coupon rate of 8 per cent. It will repay its face value of £100 at the end of 15 years. Other similar bonds have a yield to maturity (YTM) of 12 per cent.

Solution
The price of the bond is: £8 (annuity factor for t (£8 6.811) (£100 15, r 12) £100 0.1827) £72.76. (discount factor for t 15, r 12)

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What we are doing here is adding the NPV of 15 years of interest payments to the present value of the sum receivable on redemption. We can turn this example round to calculate the YTM. If the price of the bond is known to be £78.40, what is the yield to redemption? This is basically an internal rate of return calculation and the answer is approximately 11 per cent. The calculation is as follows. Assume two discount rates as for an IRR interpolation, between which the required percentage is likely to fall. Let us say, in this case, 10 per cent and 14 per cent. Then the equations are: t t 15; r 15; r 10, so £8 14, so £8 7.606 6.142 £100 £100 0.239 ≈ £84.75 0.140 ≈ £63.14 10 is closer to £78.40 than is r 14, so

Then, by interpolation, bearing in mind that r that the required rate must be nearer 10, then: Redemption yield 10% 10% 11% 84.75 84.75 1.17% 78.40 63.14

4%

Coupon rate A connected issue that is often misunderstood is the relationship of face value to market value and coupon rate (on debt) to rate of return. When a bond or debenture or any fixed-interest debt is issued, it carries a ‘coupon’ rate. This is the interest rate that is payable on the face, or nominal, value of the debt. Unlike shares, which are rarely issued at their nominal value, debt is frequently issued at par, usually £100 payable for £100 nominal of the bond. At the time of issue the interest rate will be fixed according to interest rates available in the market at that time for bonds of similar maturity. The credit rating of the company will also have an impact on the rate of interest demanded by the market.

Example 3.B
A company issues bonds at par (the face or nominal value) with a coupon rate of 12 per cent. This means that for every £100 of debt the buyer will receive £12 per annum in gross interest. Assume that interest is payable annually (it is usually paid bi-annually but this would require more tricky calculations). Mr A bought £1,000 of this debt on 1 January 1995. He will receive £120 in interest every year as long as he owns the bond. This might be until it matures or it might be when he sells it in the market. If the opportunity cost to investors of bonds of similar risk and maturity is 12 per cent, then the coupon rate and the rate of return are the same. However, assume that inflation increases at a much higher rate than expected by the market when the bond was issued. In January 1997, the opportunity cost to investors of similar bonds has risen to 15 per cent. Mr A continues to receive £120 on his £1,000 nominal value, but no new buyer would now pay £1,000 to get a return of 12 per cent – they now want 15 per cent. The price of the bond therefore falls to the level where the return on the debt is 15 per cent. This is £80 per £100 nominal of the bond. Mr B buys £1,000 nominal of the bond in January 1997. He will receive £120 per year in interest, just like Mr A, but as Mr B paid only £800, his return is 15 per cent (120/800 100). The coupon rate stays at 12 per cent, the nominal value at £1,000, but the rate of return is 15 per cent and the market value £800.

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3.4.3 Convertibles
Convertibles are hybrids between equity and debt finance. They offer investors a fixed return but also give the investor the right to convert into the underlying ordinary shares of the company at fixed terms. There are various types of convertible: convertible debentures, convertible loan stock, and convertible preference shares. All carry the right to convert into the underlying ordinary shares, and represent less risk to the investor than ordinary shares because they have greater priority for repayment should the company be liquidated. The most secure is the convertible debenture which is secured upon the tangible assets of the company. One advantage that is often quoted for convertible debt is that it is cheaper than ordinary debt finance since the conversion option allows the security to be issued with a lower coupon rate than would otherwise be the case. Although it is true that the coupon on convertibles is lower, this does not mean that the overall cost is lower, since one must also consider the expected cost of the conversion option. The lower coupon rate of a convertible may, however, be advantageous from a liquidity point of view. This form of finance may suit a project where the cash inflows are expected to be low in the early years. Prior to conversion, the security will represent debt finance and will therefore increase the level of gearing of a company. Convertibles are seen as a way of issuing deferred equity. This may be particularly advantageous if existing shareholders want to minimise any loss of control since the number of shares issued via a convertible (assuming conversion takes place) will be smaller than if straight equity were issued. A useful aspect of convertibles is that, assuming the company’s share price rises sufficiently to force conversion, the debt is self-liquidating. Since it is replaced by equity, conversion will reduce the level of gearing and thereby enable the company to issue further debt finance. While convertibles remain as debt, the interest is tax-deductible. This gives rise to the tax advantage that also accompanies other forms of debt finance. However, since the coupon rate on this security is lower than that associated with normal debt, the tax advantage is consequently reduced also. As the convertible stock carries the right of conversion into the underlying ordinary shares, its price will be directly linked to that of the equity for as long as the conversion option exists. As the ordinary shares increase in price, so will the convertible and vice versa.

Conversion value and conversion premium The relationship between the price of the ordinary share and the convertible is usually expressed in one of two ways as illustrated below.

Exercise 3.4
Oldham plc has in issue convertible loan stock with a coupon rate of 10 per cent. Each £100 nominal is convertible into 20 ordinary shares. The market price of the convertible is £108, while the current ordinary share price is 480p. Calculate (i) the conversion premium and (ii) the conversion value.
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Solution
The conversion terms are: £100 loan stock 20 ordinary shares. This is known as the conversion ratio. The conversion terms could also be expressed as: £5 loan stock one ordinary share. (i) The conversion premium measures how much more expensive it is to buy the convertible loan stock than the underlying ordinary share. The cost of buying £5 loan stock is: £5 108 100 £5.40

compared with the cost of buying one ordinary share, £4.80. The conversion premium is therefore: 5.40 4.80 4.80 12.5%

In this case, it is more expensive to purchase the loan stock and convert, than to purchase one ordinary share directly. (ii) The conversion value is calculated as the market value of ordinary shares that is equivalent to one unit of the convertible. Conversion value conversion ratio 20 £4.80 £96 Note that from this calculation of conversion value, the conversion premium may also be stated as: £108 £96 £96 12.5%. MPS (ordinary shares)

3.4.4 Warrants
Warrants are options to buy shares in the company at a given price within a given period. They can be traded on the market and are sometimes issued with loan stock as a ‘sweetener’. Share warrants issued in conjunction with a debt security will put the holder in an overall position that is very similar to that of a convertible holder. Thus, it follows that the holder has both debt and equity interest in the issuing firm. However, it may be argued that investors will find warrants more attractive than a convertible since they can sell warrants separately, whereas the conversion option is an integral part of convertible securities. The warrant, like the conversion option, will enable the coupon rate to be reduced on the debt instrument. The amount of this reduction will depend upon the value of the warrant. Unlike a convertible, the debt issued with warrants will run to maturity, thus maintaining the tax deduction. The warrants, if exercised, will also result in new capital being raised; this may be useful if expansion of the project originally undertaken is being contemplated. However, the timing of the exercising of warrants is determined by investors and may not result in extra capital when needed by the company.
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Debt issued with warrants is not self-liquidating and therefore additional finance will be needed for redemption. The use of both convertibles and warrants represents an attempt to make debt capital more attractive to investors; they also have characteristics that may make them useful to a company as part of its financing.

3.5 Medium-term financing
The distinction between short-, medium- and long-term finance is not well defined but, as a guide, short-term is up to 1 year, medium-term is from 1 to 5 years, and long-term is from 5 years upwards. The major sources of medium-term financing in recent years have been either term loans or leasing. Most medium-term finance is used by small businesses, as a result of the problems they face in raising capital.

3.5.1 Term loans
Term loans are offered by the high street banks and their popularity has increased for a number of reasons, not least their accessibility, which is of importance to smaller businesses. A term loan is for a fixed amount with a fixed repayment schedule. Usually, the interest rate applied is slightly less than for a bank overdraft. The lender will require security to cover the amount borrowed and an arrangement fee is payable dependent on the amount borrowed. Term loans also have the following qualities:

They are negotiated easily and quickly. This is particularly important when a cash-flow problem has not been identified until recently and a quick but significant fix is needed. Banks may offer flexible repayments. High street banks will often devise new lending methods to suit their customers; for example, no capital repayments for, say, two years, thus avoiding unnecessary overborrowing to fund capital repayment. Variable interest rates. This may be important given the uncertainty that exists with interest rates.

3.5.2 Mezzanine finance
Mezzanine finance is a term that has come to prominence in management buy-out (MBO) situations. Also known as intermediate or subordinated debt, mezzanine finance refers to unsecured loans that rank after secured or senior debt but ahead of equity in the event of liquidation. Banks will be prepared to lend only up to certain gearing limits, and many MBOs will require additional finance to bridge the gap between the amount banks are willing to lend and the level of equity funding available. Mezzanine finance can fill this gap. Greater risk brings with it higher interest, and the interest rate on mezzanine loans will tend to be above interest rates on bank loans, with yields typically 4–5% above the London Interbank Offered Rate (LIBOR). Mezzanine also sometimes involves additional compensation for the provider of finance in the form of warrants or options that entitle the holder to subscribe to a future equity stake in the company.
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Providers of mezzanine will base their investment decisions on the ability of the company to generate cash. With high levels of gearing, cash generation is important in order to meet the interest commitments on debt. Mezzanine finance would usually be raised through a private placing or direct borrowing from on institution.

3.5.3 The lender’s assessment of creditworthiness
When a company is seeking to raise loan finance, the lender will carry out an assessment of the company. The factors that the lender will consider before extending finance will include:
● ● ● ● ● ● ●

the purpose of the loan; the amount of the loan; the duration of the loan; if there are assets available to offer as security for the loan; the credit rating of the borrower; how the borrower is proposing to repay the loan; the level of borrowings currently outstanding.

3.5.4 Leasing
A business may buy equipment outright, or on hire purchase or lease it. Lease: A contract between a lessor and a lessee for the hire of a specific asset. The lessor retains ownership of the asset but conveys the right to the use of the asset to the lessee for an agreed period in return for the payment of specified rentals. (Official Terminology, 2000) There are two kinds of lease, the finance lease and the operating lease. Finance lease: A lease that transfers substantially all the risks and rewards of ownership of an asset to the lessee. (Official Terminology, 2000) Operating lease: A lease other than a finance lease. The lessor retains most of the risks and rewards of ownership. The justification for leasing relies heavily on two distortions in the capital market: taxation and accounting. The UK tax system, because it is based on a version of accounting profits rather than cash flows, has an adverse effect on investment. If for any reason the enterprise is not paying mainstream tax (including local authorities and other ‘not-for-profit’ organisations, for example), it will not be able to utilise the capital allowances – making the net present value even more negative. Leasing enables another company with tax capacity to buy the asset, claim the capital allowances and pass on at least part of the benefit to the user in the form of a lower financing charge than would otherwise be the case. On a smaller scale, where the lessee’s effective tax rate is lower than the lessor’s (e.g. UK small-company rate of 19 per cent versus standard rate of 30 per cent) a benefit can be created and shared. The restrictions that are placed on directors’ freedom of manoeuvre – in articles of association, banking covenants and Stock Exchange agreements – are expressed in terms of accounting numbers. Total borrowings, for example, are usually limited to a defined percentage of the net worth (equity capital) of the enterprise. Where these limits have been
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reached, or are forecast to be reached, and the company cannot or does not wish to increase its permanent capital, there is obviously something to be said for an arrangement that enables it to have the use of an asset that does not have to appear in its accounts. Who bears the risk? The dividing line between finance and operating leases is determined by the proportion of the value of the asset that is in the contract – above 90 per cent is a finance lease and below it is an operating lease. This has spawned a large number of deals that are technically just below 90 per cent, or involve third parties that cloud the issue. The accounting standard setters are anxious to minimise the number of arrangements that are classified as operating leases, arguing for an ‘economic substance over legal form’ rule, that is, to bring such assets and a corresponding borrowing on to the balance sheet. If successful, many of the currently popular arrangements will cease to be attractive. Lease finance is sold as being:

● ● ●

● ●

stable – in the sense that, once negotiated, it will remain in place and not be subject to cancellation like an overdraft facility; the risk associated with the residual value of the asset can be transferred to the lessor; fixed price or suitably hedged; smooth, in terms of its effect on cash flow (as compared with outright purchase); cheap – thanks to greater security for the lender, that is, the legal ownership of the asset (though some assets depreciate very quickly, or would be difficult to reuse); tailored to individual needs and flexible, for example, inclusive of a facility to upgrade; ‘off balance sheet’, thereby protecting key ratios such as gearing that either directly or indirectly, via credit rating, may determine the cost of other forms of finance; inclusive of some services, for example, buying and selling, registration and other administration, maintenance and disaster recovery.

There are some drawbacks, of course, including the possibility that some government grants might be missed. The economic effect of leasing stems from the fact that it is the owner (who is not necessarily the user) of the asset who is entitled to the capital allowances. They may be worth more, say, to a bank that has high profits and low capital expenditure, than to a manufacturer with a big capital expenditure programme relative to its taxable profits. The practice was very popular, for example, in the days of high inflation, price control, and 100 per cent first-year capital allowances. In some situations, therefore, the interest built into the leasing arrangement, being in effect after tax, can be lower than that which would be incurred by the user had he/she borrowed money in the usual way (e.g. if the company is not making a taxable profit, and is not able to use the tax allowance). Finance leases Finance leases are essentially term loans. These have to be shown in the lessee’s accounts as assets and liabilities and the depreciation and financing charged against profits. The term of the lease normally extends over the full useful life of the asset. The lessor therefore receives lease payments that will fully cover the cost of the asset. The agreement will usually not be cancellable and will not provide for any maintenance of the asset. The leasing company is not normally involved in dealing with the assets themselves, being a bank
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or finance company. The asset is selected by the firm that will use it, who negotiates price, delivery, etc. The leasing company simply buys the asset and arranges a lease contract with the lessee. At the end of the lease period there will usually be an agreement where the sale proceeds from the asset are shared between the lessor and lessee, or if the lessee desires it can carry on using the asset for payment of a nominal amount each year, called a peppercorn rent. Sale and leaseback Companies can use what is known as a sale and leaseback arrangement in order to convert certain assets that the company owns into funds yet still continue to use the assets. For example, if a building is sold to an insurance company or some other financial intermediary and then leased back from the purchaser, the company has secured an immediate cash inflow. The only cash outflow is the rental payments that it now has to make. These rental payments are allowed as a tax-deductible expense. However, the company may be subject to capital gains tax, which will arise if the sale price is in excess of the written-down value as agreed by the tax authorities. It must be remembered, however, that the leased asset no longer belongs to the company; the lease may one day come to an end and then alternative assets will have to be obtained. This financing possibility is particularly applicable to assets that appreciate in value, such as land, buildings or some other forms of property. It is particularly appropriate to companies owning the properties freehold, and to institutions such as insurance companies or pension funds that are interested in holding long-term secure assets. The property is leased back at a negotiated annual rental, although with long leasebacks there will need to be a provision for the revision of the rental at certain intervals of time. Clearly the sale and leaseback releases funds that can be used for some other investment. In the 1980s and 1990s a number of takeovers were financed by this means. Assets were sold and leased back; the cash obtained from the sale was used to finance the purchase of another company. If the acquired company had substantial property, this could then be sold to an insurance company and leased back. Operating leases Operating leases are treated very much like contract hire. They do not appear on the lessee’s balance sheet and the fee for the hire is charged directly against profits. These agreements will usually not last for the full life of an asset. They are offered by companies who manufacture or deal in the particular product, often incorporating maintenance and other services. The lease can be cancelled and the equipment returned. Operating leases are common for office and business equipment, for example, typewriters, photocopiers, computers and motor vehicles. The lessor will not recover his/her full investment on any one lease but will hope to lease a particular asset several times over its life. Operating leases are particularly useful for industries where there is a rapid change in technology that makes it necessary to have the latest equipment, for example, computers. Hire purchase Hire purchase is similar to leasing, except that the legal title to the asset passes to the hire purchase customer on payment of the final instalment payment. In a lease agreement ownership of the asset does not transfer to the lease.
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Exercise 3.5
Wilson plc is to use a lease agreement to acquire machinery on 31 May 2005. The lease term is 5 years and lease rentals of £10,000 each year are payable annually in advance. You are required to calculate the present value of the lease rental payments at 31 May 2005 using an annual discount rate of 10%.

Solution
As the lease rentals are equal amounts each year, the solution may be found using annuity factors. The annuity factor for 4 years at 10% is 3.17. The annuity factor for four years is relevant as rentals are payable in advance. To this must be added the discount factor for the first rental payable at year 0. We then multiply the resulting figure (1.0 3.17) by the constant annual rental payment of £10,000. (1.0 3.17) £41,700. £10,000

3.5.5 Lease-or-buy decisions
The decision to lease or buy an asset is a financing decision that will be made only once the decision to invest in the asset has been taken. The decision to invest in the asset would be determined by discounting the operational costs and benefits from using the asset at the cost of capital normally used by the enterprise to evaluate projects, typically its weighted average cost of capital. Investing in the asset would be justified if a positive NPV is obtained. The financing decision is then concerned with identifying the least-cost financing option. In evaluating the financing decision, it is usually assumed that the enterprise would have to borrow funds in order to purchase the asset.
Example 3.C
Pleasure-boat operators Woodfield and Hills Ltd are considering investing in a new boat for their fleet. The company can either borrow the necessary funds from its bank at 9 per cent and purchase the boat, or enter into a finance lease involving five annual year-end payments of £24,000. The new boat costs £100,000 and would attract capital allowances at 25 per cent on a reducing balance over its 5-year life for its owners. Corporation tax is 33 per cent, payable in the year of the relevant profits. You are required to calculate which of the two options, borrowing or leasing, is financially more advantageous for Woodfield and Hills Ltd.

Solution
(i) Borrow and purchase The first stage is to calculate the capital allowances attracted by the purchase of the boat. The first capital allowance is assumed to be claimed at the end of year 1. Year 1 2 3 4 5
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£100,000 25% (£100,000 £25,000) 25% (£75,000 £18,750) 25% (£56,250 £14,063) 25% Bal. (£100,000 £68,360)

Allowance £ 25,000 18,750 14,063 310,547 68,360 331,640 100,000

Tax shield (33%) £ 8,250 6,188 4,641 3,481 10,441

MANAGEMENT ACCOUNTING – FINANCIAL STRATEGY
The after-tax cash flows associated with this financing option should be discounted at the after-tax cost of borrowing, which is 9% (1 0.33) 6%. Present value £ (100,000) 7,780 5,507 3,898 2,757 1 7,799) .(72,259)

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Year 0 1 2 3 4 5

Investment £ (100,000)

Tax shield £ 8,250 6,188 4,641 3,481 10,441

Discount factor @ 6% 1.000 0.943 0.890 0.840 0.792 0.747

Note that the interest charges from borrowing are reflected in the discount rate used.

(ii) Finance lease Under current UK legislation depreciation on leased assets is treated as a tax-deductible expense, as is the interest element of the finance lease payments. However, for examination purposes we shall assume that it is the full finance lease payment that is allowable for tax. The after-tax cash flows associated with this financing option should again be discounted at the after-tax cost of borrowing on the basis that the minimum return necessary to accept the lease contract will be the after-tax return obtainable on a similar loan. Lease payment £ (24,000) (24,000) (24,000) (24,000) (24,000) Tax shield 33% £ 7,920 7,920 7,920 7,920 7,920 Present value £ (15,163) (14,311) (13,507) (12,735) (12,012) (67,728)

Year 1 2 3 4 5

Net cash £ (16,080) (16,080) (16,080) (16,080) (16,080)

Discount factor @ 6% 0.943 0.890 0.840 0.792 0.747

In this example, the finance lease is financially the most advantageous method of financing the investment in the boat.

Selecting the discount rate An issue in this kind of evaluation, in examination questions at least, is the discount rate to use: the cost of capital to the entity (which has presumably been used to evaluate the decision to acquire the plant) or the cost of the next best alternative means of finance (e.g. an overdraft). The discount rate that should be used in all investment decisions is the opportunity cost. If we argue that leasing is a direct substitute for borrowing, the opportunity cost of leasing is the cost of borrowing. There can be a complication when, say, £100-worth of leasing is not replacing £100-worth of borrowing. It could be that the debt capacity of the kind of equipment being leased is different from that of the existing assets of the company. The leased equipment could then either increase or decrease the gearing possibilities of the lessee. If £100 of lease liability is a substitute for less than £100 of debt, then a cost of capital other than the borrowing rate will have to be used. Repayment of borrowings Under the borrow and purchase option in the above example, no consideration was given as to how or when the borrowings were to be repaid. This is common in examination questions on this area, and simplifies the arithmetic required to calculate the present value of this financing option.
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Example 3.D
Let us now consider the workings required if the borrowings of £100,000 were to be repaid to the bank in equal annual year-end instalments comprising principal and interest at 9 per cent per annum.

Solution
The first stage is to identify the amount of the equal annual instalments required to service the bank loan. Dividing the amount of the loan by the annuity factor for 5 years at 9 per cent: £100,000 3.890 £25,707

Each instalment then needs to be split down between the repayment of principal and interest on an actuarial basis. Interest @ 9% £ 9,000 7,496 5,857 4,071 2,111* Annual instalment £ (25,707) (25,707) (25,707) (25,707) (25,707)

Year 1 2 3 4 5

Balance b/f £ 100,000 83,293 65,082 45,232 23,596

Balance c/f £ 83,293 65,082 45,232 23,596

*Rounding difference

When discounting the cash flows associated with the borrow and purchase option at the after-tax cost of borrowing, it should be remembered that the annual instalment includes the interest payments on the loan and so the tax shield relating to the interest must be included as a cash flow. Tax shield on capital allowances £ 8,250 6,188 4,641 3,481 10,441

Year 1 2 3 4 5

Annual instalment £ (25,707) (25,707) (25,707) (25,707) (25,707)

Tax shield on interest £ 2,970 2,474 1,933 1,343 697

Net cash flow £ (14,487) (17,045) (19,133) (20,883) (14,569)

Discount factor @6% 0.943 0.890 0.840 0.792 0.747

PV £ (13,661) (15,170) (16,072) (16,539) (10,883) (72,325)

Allowing for rounding differences, the present value obtained should be identical to our original answer for the borrow and purchase option in the previous section. Lessee and lessor In the example above we had only to consider the position of the lessee and whether they should lease or buy. We should also look at the arrangement from the perspective of the lessor. If the lessor and lessee can both claim the same capital allowances, both have the same cost of capital. If the leasing company does not add on a profit percentage, or if the cost of capital to the lessee plus the add-on percentage is the same as the cost of capital to the lessor, then the lessee will be indifferent whether he/she leases or buys. Leasing can be attractive to a lessee when faced with cash flows different from those of the lessor. The lessor will receive capital allowances if purchasing the asset, and will receive the lease payments as income.
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Example 3.E
Using the information from the Woodfield and Hills Ltd example above, evaluate the finance lease from the point of view of the lessor, assuming the lessor’s required rate of return is 15 per cent after tax.

Solution
Year 0 1 2 3 4 5 Investment £ (100,000) Tax shield £ 8,250 6,188 4,641 3,481 10,441 Lease £ 24,000 24,000 24,000 24,000 24,000 Tax £ (7,920) (7,920) (7,920) (7,920) (7,920) Net cash flow £ (100,000) 24,330 22,268 20,721 19,561 26,521 15% DF 1.000 0.870 0.756 0.658 0.572 0.497 PV £ (100,000) 21,167 16,835 13,634 11,189 (1)13,181) (23,994)

Perhaps not surprisingly, the leasing company could not justify repayments of £24,000, as this leads to a negative NPV. The lessor will have to increase the lease rentals.

Exercise 3.6
Cheesley plc is considering whether to buy or lease an asset which has a 10-year economic life with a zero 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. How should the company finance this asset? The required rate of return is 10% per annum. Ignore taxation.

Solution
Buy Lease £80,000 (Annuity factor @ 10% for 9 years (5.759 £81,108 The company should buy the asset. 1) £12,000 1) £12,900

Exercise 3.7
Ritchie plc is considering whether to buy or lease 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 company finance the asset? The required rate of return is 10% per annum. Ignore taxation.
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Solution
Buy £81,000 £56,163 Lease (Annuity factor @ 10% for 5 years) 3.791 £14,000 £53,074 The company should lease the asset. £14, 000 £40,000 (1.1)5

3.6 Financing of small businesses
Individual enterprises come into being, they grow, they shrink, they cease to exist. Positive encouragement of small businesses is advocated in many quarters, as the natural offset to the decline of the very large corporations. Indeed, either voluntarily, or as a result of the attention of predators, some large companies have been subject to ‘unbundling’ or ‘demerging’. Small businesses tend to be privately owned, of course, and part of the problem is that owners are anxious not to cede control to (or share equity rewards with) outsiders. This can have the effect of restricting the rate of growth to that which can be funded by retentions, but judicious subcontracting and the use of leasing, hire purchase, factoring, licensing, etc., can mitigate this. Owners of small businesses are especially critical of the High Street banks, particularly now that authority previously devolved to local managers has been centralised, and there has been a shift away from customers to products. Consequently, as one consultant remarked: ‘When you ask your local bank manager for a loan, don’t be surprised if he says he has to refer it to head office, but meanwhile tries to sell you some life assurance.’ Lending to small businesses used to be seen as an attractive part of any bank’s portfolio. The rate of interest was good and the client was likely to need other services on which the banks could make money. From time to time, however, attention is drawn to the difficulties small businesses have in obtaining the finance to support their growth strategies, at anything less than penal rates of interest (several percentage points higher than that at which large businesses can borrow) and the additional charges they face (e.g. manager’s time attending a lunch hosted by the client!). Among the explanations given for this situation are that:

the costs of monitoring such loans are high or even prohibitive, in which case the risk is greater, that is, the investment has more of the characteristics of equity than lending; the banks themselves are involved in a competitive struggle for existence and have gone through difficult times, incurring substantial bad debts during recessions and in the emergence from recessions, exacerbated recently by the unprecedented fall in the values of properties used as security; (consequently?) the regulators attach a higher risk weighting to corporate loans when assessing capital adequacy, with the result that banks are predisposed towards property and government loans; some of those other services are being provided by ‘niche’ players who are able to specialise and therefore offer better terms than the full-range banks.

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As regards this situation, the following trends are worth noting.

● ●

The banking industry is itself in transition, with strategies based on consolidation and focus clearing the way for a stronger role to be played – possibly involving greater use of long-term loans. An enquiry mounted by the Bank of England reported, in January 1994, that banks were ‘committed to the finance of the small-firm sector and were trying to provide alternatives to the traditional overdraft’. Some banks are even prepared to consider equity stakes, so as to share in the successes as well as the failures. Schemes involving more specific securitisation of assets are being developed. Perhaps the most significant trend for financial managers is that some banks are calling for more information to justify the original facility, and to monitor its use. The key information is likely to take the form of a cash-flow forecast. If this prompts them to place less emphasis on accounting statements, they will be more amenable at the time the small company needs their help – ahead of an expansion that has an adverse effect on the short-term profit/asset profile of the business.

3.6.1 Venture capital
Venture capital is the name given to equity finance provided to young, unquoted businesses to help them to expand. The traditional structure of a venture capital fund has been a 10-year partnership (of investors such as pension funds) but, in recent years, there have been moves to create more flexible forms, for example rolling 1-year funds, a guarantee to return funds on request or, potentially, funds with unlimited life. There has also been a move towards a market in portfolios, with a view to offloading unsatisfactory performers, seeking economies of scale, etc. The managers are rewarded by means of an annual fee (typically 2 per cent of the funds invested, but tending to taper off as funds get bigger) and part of the capital gain when the investments are realised. Though extremely significant in the 1980s, venture capital has been in decline in recent years, for a number of reasons.

Investors have been disappointed with the results achieved so far and are reluctant to commit further funds. The economic recession and the consequent difficulties for small businesses have been a factor, but the level of management fees has also caused concern. The valuation of funds is not easy, which militates against reliable measurement of performance, assessment of potential and hence monitoring of the progress. Investee companies have been concerned at the short-termism displayed by the venture capitalists in terms of requiring early reported profits – at the time of writing, with base rates well down into single figures, funds are telling prospective investees that they are looking for constant compound internal rates of return in excess of 30 per cent per annum (in the jargon of the industry, plums have to pay for lemons) and an early exit ( by way of flotation, a trade sale or re-financing on a more permanent basis).

The two problems interact, of course, with the moment of exit being the only time when a comprehensive measure of performance is possible. The funds tend to seek a definitive long-range plan and rely on accounting numbers. Indeed, most funds are run by accountants and financiers (rather than experienced industrialists) and tend, therefore, to be risk averse. This may explain their apparent lack of interest in start-up finance schemes, which are relatively more time-consuming, higher risk and take longer to produce results. Rather, they have tended to concentrate on later-stage development and changes of
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ownership: management buyouts, buy-ins and the hybrid ‘bimbos’ (involving both existing and new managers). Some tend to favour particular geographical areas, while others specialise in particular industries. Styles vary from hands on (most common where funds concentrate on particular industries or markets) through close monitoring to hands off. Equity funds provide a basis for the company to raise further bank finance. Dividends can be delayed until the company is making profits.

3.6.2 Business ‘angels’
To judge from deals reported, venture capital funds are rarely interested in investing less than £250,000 on the grounds that monitoring progress is uneconomic. Below this level, companies may think in terms of business ‘angels’ (a term borrowed from show business), that is, private individuals (e.g. big-company directors/managers who have retired with ‘golden handshakes’), usually with time and expertise available as well as cash and hence looking for a local, hands-on involvement. They may come together in syndicates, led by an ‘archangel’. This practice is very big in the US, where it is estimated to be three times as large a source of funds as the formal venture capital industry. There, lawyers and accountants tend to act as brokers. In the UK it is a growing source, and the government say they are keen to arrange introductions, via Training and Enterprise Councils and similar organisations as well as to foster cooperation between small and large organisations. Angels are more likely to be persuaded by outward-looking and forward-looking considerations, like strategic vision, intuition, flexibility and the identification of sources of competitive advantage, as well as the skills required to develop appropriate tactics and to manage operations. They would also look for the appropriate information systems, covering forecasting, decision support and monitoring.

3.6.3 Government assistance
The UK government has introduced a number of schemes to help businesses, many of which are targeted at small- and medium-sized enterprises. The Enterprise Initiative Scheme was introduced as the successor to the Business Expansion Scheme, with effect from January 1994. The scheme enables a company to raise up to £1 million, in a form that is tax-efficient for the investor. Specifically:

investors get tax relief (but restricted to the 20 per cent rate) on total investments of up to £100,000 per annum. The investment must be held for a minimum of 5 years, capital gains also being tax-free (and capital losses may be set against income tax or capital gains tax); the investor can take an active interest, through a paid directorship, but financial involvement is limited to 30 per cent of the shares in issue; capital gains from elsewhere can be postponed to the extent that proceeds are invested in an EIS opportunity.

Venture capital investment trusts were launched in 1995. These invest in unquoted companies and allow investors to receive 20 per cent income tax relief on dividends received as long as the investment is held for 5 years. Relief is also given from capital gains tax. The maximum investment by an investor is £100,000, while the maximum that a trust may invest in any one unquoted company is £1,000,000.
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Small companies already pay a lower rate of corporation tax (currently 20 per cent instead of 30 per cent) on their profits but this is payable whether profits are distributed or not. Given the strong desire on the part of owners to remain independent, expansion would be encouraged if corporation tax were not chargeable on retentions. Regional Selective Assistance (RSA) is aimed at giving discretionary grants to businesses that want to expand or relocate in an area that has been identified for special support. The grant is intended to help with projects that will create new jobs or protect existing ones. An example of this would be the Regional Enterprise Grant (REG), which is aimed at smaller businesses, whereby up to 15 per cent of the cost of a capital project (up to a maximum of £15,000) may be provided in the form of a grant. Other support is aimed specifically to promote innovation and technology. These awards are not geographically targeted. Examples of these are: a SMART Award, which is worth up to £45,000 to support innovative technology in businesses with 50 employees or less; and the Teaching Company Scheme (TCS), which enables small businesses to employ a graduate for approximately 30 per cent of the market rate for up to two years. The UK government has recently announced the launch of a new Enterprise Fund aimed at supporting high-technology start-up companies, although to finance this new fund the government has decided to axe its long-standing loan guarantee scheme.

3.7 Summary
Reliance on equity capital as the main form of corporate finance is a distinguishing feature of the UK and US economies. The value of a company to its equity shareholders is a function of projected cash flows to them (dividends minus rights issues). Equity capital is, however, not the only form of finance for a company, and you should be aware, not only of the different forms of debt but, by reference to other chapters, of the impact on a company’s cost of capital of combining debt and equity. Small businesses, for example, private companies, often claim that it is difficult for them to raise capital at anything other than penal rates. This may reflect perceptions of risk, especially as regards the probability of repayment. The venture capital industry has not been as active as perhaps it should have been in financing small businesses, which might be why we have seen the creation of business ‘angels’ and buy-in teams.

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Readings

3

The article below draws on BT’s experiences of raising funds from a rights issue in 2001 to explain the finer points of the technique.

Know your rights
Ben Ukaegbu, Financial Management, February 2002

The rights issue has become an increasingly rare beast on both sides of the Atlantic over the past few years, but BT’s recent campaign to raise £5.9 billion shows that this alternative method of drumming up capital is not quite extinct. So what exactly is a rights issue? It’s when a company gives existing shareholders the right to buy a new issue of ordinary shares at a discount price. The number of shares an individual shareholder is offered is determined by the proportion of their holding relative to the total number of shares in the company. The shareholders have four possible courses of action. The first is to exercise their rights. Here they simply buy the new shares at the offered price and retain them, thus maintaining their percentage holding. Another option is to renounce their rights and sell these on the open market. This will mean that the shareholder will hold a lower percentage of the company’s equity and the total value of this will be reduced (assuming that the actual market price after the issue is close to the theoretical ex-rights price). The third line a shareholder can take is to renounce part of their rights and exercise the remainder. For example, they may sell enough of their rights to enable them to buy some of the shares from the proceeds of the sale. Lastly, they can choose to do nothing. In this instance they might be protected from the consequences of their inaction, because unexercised rights can be sold on their behalf by the company. But if the amount involved is small these shares can be sold for the benefit of the company. The shareholder (or the company) will then receive the difference between the issue price and the market price after the issue. The share price of a company usually falls when it announces a rights issue. The size of the drop depends on the discount and the market’s reaction to the issue. The price is likely to fall because there will be more shares on offer and the new ones are being sold cheaply. It’s also likely that there’ll be a general marking down by ‘market makers’ in the expectation that a significant number of shareholders will sell their rights because they don’t have enough funds to buy all the new stock on offer to them. But there are occasions when the share price rises following a rights offer – there may be a strong demand for shares if the company is growing fast or investors think it’s a particularly exciting investment prospect.
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On 10 May 2001 BT’s board announced a rights issue on the basis of three new shares for every 10 existing shares held at the close of business on the previous day. The new shares were priced at 300 pence, against the closing middle market price of 568.5 pence, representing a 47 per cent discount. In theory, such a pricing strategy ensures that the rights issue is taken up. But in practice it presents a number of difficult questions for financial managers and investors alike. For managers contemplating a rights issue, the following issues are crucial: the number of shares to offer, the cost of the capital to be raised and the market’s reaction. The shareholders must also consider the value of these rights, what action(s) to take and the impact of the issue on the company’s future earnings. The financial manager must be satisfied that there will be enough new funds to achieve the objective for which the capital is being raised – in BT’s case, to hit its debt-reduction target of £10 billion. Another factor is the size of the capital outlay relative to the shareholders’ existing stake. Shareholders are more likely to subscribe to an issue amounting to, say, a 30 per cent addition to the shares they hold than they are to a 60 per cent addition. At BT, it was three new shares for every 10 already held – i.e., a 30 per cent addition. The financial manager must also consider whether the earning potential of the extra funds, when capitalised with the appropriate cost-of-capital rate, would increase the market value of the company. The minimal offer price must at least be equal to the nominal value of the company’s shares. This prevents the company from breaking the Companies Act rule on the issue of shares at a discount. Investors are also interested in determining the theoretical value of the shares after a rights issue. Using this value they can estimate the investment status of shares without rights attached (ex-rights). Therefore, the value of the shares ex-rights will influence their decision to sell rights, to retain their present position or to add to their holding. From a financial manager’s viewpoint, this information and the resulting decisions are hugely important, because they can spell success or failure for a rights issue.

The Ex Factor
The formula for calculating the theoretical ex-rights share price is where Pp No Pn Nn N pre-issue price number of shares already held rights issue price number of new shares offered total number of shares 568.5 10 300 3 13 Pp(No) N Pn(Nn)

In BT’s cases Pp No Pn Nn N

So BT’s theoretical ex-rights price was

568.5(10) 300(3) 13

506.5

In the case of BT, the theoretical ex-rights price was 506.5 pence per share (see panel for calculation). Consider the position of someone who held 10,000 BT shares when the rights offer was made. These each had a market value of 568.5 pence, so the shareholder owned
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shares with a total value of £56,850. If they exercise their rights, they will be able to buy 3,000 new shares. The price of the new share is 300 pence, so their new investment will be £9,000, making a total holding of £65,850. Based on the theoretical ex-rights price, the value of their 13,000 shares is now £65,850 (13,000 506.5 pence) – i.e., exactly what they have invested in the company. Alternatively, if the shareholder sells their 3,000 ‘rights’, which have a value that is simply the difference between the theoretical ex-rights price and the issue price of the new shares, they would have 3,000 (506.5 300) £6,200. They would now have their original shares plus £6,200. But their 10,000 shares now have a market price of 10,000 506.5 £50,650. This amount plus the £6,200 is the same as the original investment of £56,850 that they had in the company. From a purely arithmetical standpoint, the shareholder neither gains nor loses from the sale of additional shares through rights issue. It can be shown that if the market correctly estimates the earnings from investing in the new funds, and if the ex-rights share price is based on a correct estimate of future earnings, the price at which the new rights shares are offered needn’t bother the shareholders. They will be at least as wealthy after the issue as before. This apparently satisfies the cost-of-capital constraints – that new issues should not leave shareholders worse off than they were before the rights issue, whether they exercise their rights or sell them. But there may be occasions when the actual value of a right may differ from its theoretical value. This may happen as a result of transaction costs, speculation or the sale of rights over the subscription period. If the price of a right is significantly higher than its theoretical value, investors will sell their rights and buy shares in the market. This action will force down the market price of the right and push up the theoretical value. Conversely, if the price of the right is significantly lower than its theoretical value, speculators will buy the right, exercise their option to buy shares and then sell them in the market. This would put a downward pressure on the theoretical value of the right and an upward pressure on its market price. The cost of capital depends upon the proportion of the new issue taken up by the existing shareholders. When the issue is successful, the cost of the rights funds may be viewed as similar to the cost of equity funds. But, if the shares are undervalued at the ex-rights prices and the existing shareholders do not take up all their rights, the cost of rights funds will be higher than the cost of new equity. The reason the cost of capital behaves in sympathy with the success (or failure) of the rights issue is that the company is likely to compensate the existing shareholders for the ‘unjustified’ dilution of their holdings. This implies that when profits are made the company will be giving a higher return than necessary to the shareholders who bought more shares through the rights issue. Rights issues are typically arranged using standby underwriting. Here the underwriter commits to taking up the unsubscribed part of the issue. The underwriter usually gets a standby fee and additional amounts based on the shares taken up. Standby underwriting protects the issuer against undersubscription, which can occur if investors ignore their rights or if bad news causes the market price of the share to fall below the subscription price. In practice, only a small percentage of shareholders fail to exercise their rights. It was therefore not surprising that BT decided not to go to the expense of underwriting its issue. If a rights issue takes place and shares are offered at a discount on the full market price, the shareholders may seem to have received something of a bonus. But the share price in the year of the rights issue is not the same as the share price the year before. Therefore the worth of a share in 2001 is equal to the sum of the share in 2000 and the bonus element of the rights issue. To get comparable figures over time, FRS 14 states that it’s necessary to adjust the number of shares in issue before the rights issue to reflect the inherent bonus
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element, and that ‘notes to the financial statements should state that such adjustments have been made’. The change is necessary, because after the rights issue each new share is not claiming quite as much of the earnings as each old share. So, after the rights issue, the figures for earnings per share produced by the company will be based on the new type of share. Hence previous EPS figures should be scaled downwards for comparative purposes. There is also a problem in the year in which the rights issue is made. A different number of shares will have been issued at the end of the year to that at the start. FRS 14 recommends that the weighted-average share capital for the period should be calculated. This is the average number of shares ranking for dividends during the year, weighted on a time basis. The rights issue is an alternative way for a plc to raise capital. It is less costly than a public offer, yet it is not a popular route. Financial managers should not see such discounted offers as a ‘giveaway’. The shareholder who acts neither wins nor loses. The shareholder who sells their rights on the market is theoretically compensated for the fall in the value of their shares. But the shareholder who fails either to exercise or to sell their rights would lose out. Consequently, a rights issue represents not a handout to shareholders but an imposed obligation. In order to protect themselves from loss, they have to act.

Discussion question
1. Discuss whether a rights issue will only be attractive to a company if the stock market is rising. 2. Look through the financial pages of a newspaper for details of a company that has announced a rights issue. Find out the terms of the rights issue. Calculate the theoretical ex-rights price. Track the share price from the announcement of the issue through to the ex-rights date, and see if the ex-rights price turns out to be the same as your TERP calculation. Outline solution 1. In theory a rights issue can be made under any market conditions. Practically, the key issue is the purpose of the rights issue, and the market’s interpretation of that purpose. In a falling market the company’s share price will fall, which means that the company will need to issue more shares than if the market was rising. This may lead to higher dividend payments in the future if the directors feel obliged to maintain dividends per share. The amount subscribed by each shareholder will be the same whatever the issue price or state of the market. Shareholders will also have the opportunity to maintain their percentage shareholding whatever the market conditions.

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Revision Questions

3

Question 1
(a) List and explain the major functions performed by the capital markets. (5 marks) (b) Discuss the reasons why rights issues are often used to increase the equity of both small and relatively large companies. (5 marks) (c) Explain the different forms of debt that are available and suggest which form would be most appropriate for use by a company that wishes to expand. (10 marks) (Total marks 20)

Question 2
Assume you are a newly recruited junior consultant with Q, Y & R, a large international firm of accountants and financial consultants. A number of its clients are currently examining the methods available for financing or refinancing their businesses. You have been asked to review two of Q, Y & R’s clients. Only brief details are available at present. These are given below. Client number 1: ABC Ltd ABC Ltd is a software house in the south of England. The company was established 4 years ago by five telecommunications specialists who had been made redundant. The initial investment was £250,000 in equity and a bank loan of £250,000, repayable over ten years at a fixed rate of interest of 12 per cent. The original five shareholders are still the only shareholders. The company was formed to develop and market a range of specialist software for the telecommunications industry. At present, the company’s main customers are in the United Kingdom and part of Western Europe. Extracts from the company’s financial statements for last year and forecast for the current year are as follows:
Income account (extracts) for years 1993 Actual £000 2,350 485 440 1994 Forecast £000 3,250 763 563

Revenue Profit after tax Dividends payable (net of ACT)

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REVISION QUESTIONS P9 Balance sheet (extracts) at end of year 1993 Actual £000 250 1,093 1(778) 1,565 1994 Forecast £000 350 1,472 (1,082) 1, 740)

Non-current assets ( NBV ) Current assets Current liabilities Total net assets Financed by: Issued share capital (ordinary £1 shares) Reserves Long-term loan (10-year bank loan) Total financing

250 165 150 565

250 365 125 740

Notes: 1. The non-current assets are primarily vehicles, furniture and fittings and computers. The company’s premises are rented. The net book value is after charging depreciation of £100,000 and £150,000 in 1993 and 1994 respectively. 2. The tax charge for 1993 was £220,000 and the forecast for 1994 is £375,000. 3. Inflation, as it affects this company’s business, has been negligible over the 3-year period.

ABC Ltd is now considering expanding its product range and moving into new international markets. These markets are highly competitive but expected to be very profitable in the long term. The company estimates it will need £2 million to establish local operations and support facilities in three main centres outside Western Europe. If financing can be obtained and the expansion proceeds, revenue and profits could treble by 1997. The shares of listed companies trading in ABC Ltd’s industry are currently capitalised at P/E ratios between 16 and 20. Client number 2: DEF plc DEF plc is a clothes retailing company that has been established for over 50 years. It has shops mainly in small towns in the UK, selling to low-income families. The company has been listed on the Stock Exchange since 1962. Summary financial statistics for 1993 and forecasts for 1994 are as follows:
Income account (extracts) for years Revenue Profit after tax Dividends payable Balance sheet (extracts) at end of year Non-current assets (NBV) Current assets Current liabilities Total net assets Financed by: Issued share capital (ordinary 25p shares) Reserves Long-term debt 9% (redeemable in 2002) Total financing Share price (pence, average) 1993Actual £ million 1,250 113 60 1993 Actual £ million 925 153 (195) . 883. 1994 Forecast £ million 1,450 118 72 1994 Forecast £ million 915 229 (215) . 929.

100 573 210 883 314

100 619 210 929 n/a

The company has recently launched a profit-improvement programme. A number of costcutting measures have been implemented and the product range has been revised; a number of older products have been discontinued and new ones introduced. Overall, the company is moving into a higher-priced section of the market and believes it can now open new shops in
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towns where it has had no presence and where it will come into direct competition with the major retailing stores. It estimates it will require £250 million to undertake this expansion. The current share price is 245 pence. Debt of similar risk and maturity to that in DEF plc’s balance sheet is currently trading in the market at £125 per £100 nominal. The methods of finance being considered by the two companies include, but are not limited to, the following:
● ● ● ● ● ●

equity; debt with warrants; mortgage debt; leasing; convertible debt; preference shares.

You are required to: (a) describe, very briefly, three of the methods of finance listed above; (6 marks) (b) prepare, for discussion with the senior consultant, a set of briefing notes for each of your clients. These should contain reasoned arguments for an appropriate method, or methods, of financing, taking into account the circumstances of each company. Make whatever assumptions you think necessary, but state them clearly in your notes. (24 marks) (Total marks 30)

Question 3
(a) CP plc is a company operating primarily in the distribution industry. It has been trading for fifteen years and has shown steady growth in turnover and profits for most of those years, although a failed attempt at diversification into retailing 4 years ago caused profits to fall by 30 per cent for 1 year. The figures for the latest year for which audited accounts are available are:
Revenue Profit before tax: £35.2 million £13.7 million

The company has been financed to date by ten individual shareholders, three of whom are senior managers in the company, and by bank loans. Shares have changed hands occasionally over the past 15 years, but the present shareholders are predominantly those who invested in the company when it was formed. Some of the shareholders are now keen to realise some of the profits their shareholdings have earned over the years. At the last annual general meeting, it was proposed that the company should consider a full listing on the Stock Exchange. You are required to: (a) (i) discuss the advantages and disadvantages of a flotation on the Stock Exchange in the circumstances described above; (ii) explain and compare the following methods by which the company’s shares could be brought to the market: ● private placing; ● offer for sale at fixed price; ● offer for sale by tender. (8 marks)
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(b) Describe the services that are likely to be provided by the following financial institutions in connection with a public offering of shares: ● merchant banks; ● stockbrokers; ● institutional investors. (8 marks) (Total marks 16)

Question 4
Z plc is a long-established company with interests mainly in retailing and property development. Its current market capitalisation is £750m. The company trades almost exclusively in the UK, but it is planning to expand overseas either by acquisition or joint venture within the next 2 years. The company has built up a portfolio of investments in UK equities and corporate and government debt. The aim of developing this investment portfolio is to provide a source of funds for its overseas expansion programme. Summary information on the portfolio is given below.
Type of security UK equities US equities UK corporate debt Long-term government debt 3-month Treasury bonds Value £m 23.2 9.4 5.3 11.4 3.2 Average % return over last 12 months 15.0 13.5 8.2 7.4 6.0

Approximately 25 per cent of the UK equities are in small companies’ shares, some of them trading on the Alternative Investment Market. The average return on all UK equities over the past 12 months has been 12 per cent. On US equities it has been 12.5 per cent. Ignore taxation throughout this question. Requirements (a) Discuss the advantages and disadvantages of holding such a portfolio of investments in the circumstances of Z plc. (10 marks) (b) One of Z plc’s corporate debt investments is £50,000 nominal in a convertible loan stock 1997–99, currently selling at £106.50 per £100 of stock. The coupon rate is 6 per cent. If not converted, it is repayable on 31 December 1999 at par. Interest is payable annually and has just been paid for 1997. Bonds of similar risk without a conversion feature are currently selling to return 7 per cent. The 1997 date for conversion is 31 December 1997 at a conversion ratio of 20 shares per £100 of stock. The ratio applicable for conversion in 1998 is 18 shares per £100 of stock. The market price of the ordinary shares is 540 pence. At the time the bonds were purchased by Z plc in 1996, the equity share price was 480 pence. Assume that interest rates have remained unchanged since the bonds were purchased. You are required to: (i) explain what is meant by the terms conversion premium and conversion discount; (ii) advise the company’s treasurer about the factors to consider before deciding whether to convert the loan stock in 1997 or 1998. Include all relevant calculations in your advice. (10 marks) (Total marks 20)
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Question 5
The directors of Denetter plc wish to make an equity issue to finance an £8 million expansion scheme, which has an expected net present value of £1.1 million, and to re-finance an existing £5 million 15 per cent term loan that is due to mature in five years’ time. There is a £350,000 penalty charge for early redemption of this loan. Denetter has obtained approval from its shareholders to suspend their preemptive rights and for the company to make a £15 million placement of shares which will be at the price of 185 pence per share. Issue costs are estimated to be 4 per cent of gross proceeds. Any surplus funds from the issue will be invested in commercial paper, which is currently yielding 9 per cent per year. Denetter’s current capital structure is summarised below:
Ordinary shares (25 pence per share) Share premium Revenue reserves 15% term loan 11% debenture 1998–2001 £000 8,000 11,200 23,100 42,300 5,000 59,000 56,300

The company’s current share price is 190 pence, and debenture price £102. Denetter can raise debenture or medium-term bank finance at 10 per cent per year. The stock market may be assumed to be semi-strong form efficient and no information about the proposed uses of funds from the issue has been made available to the public. Taxation may be ignored. Requirements (a) Discuss the factors that Denetter’s directors should have considered before deciding which form of financing to use. (5 marks) (b) Explain what is meant by pre-emptive rights, and discuss their advantages and disadvantages. (6 marks) (c) Estimate Denetter’s expected share price once full details of the placement, and the uses to which the finance is to be put, are announced. (11 marks) (d) Suggest reasons why the share price might not move to the price that you estimated in (c) above. (3 marks) (Total marks 25)

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Solutions to Revision Questions

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Solution 1
This question examines the following syllabus areas:
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Types and features of domestic and international long-term finance; Criteria for selecting sources of finance

(a) The capital markets provide the means by which organisations and people who are trying to obtain funds can be linked to lenders and investors. The capital markets provide a means by which a corporate financial manager has access to a range of different alternative sources of funds. The capital markets can be divided into two main categories, namely the primary and secondary markets. Primary markets provide new capital by making it possible for new shares to be issued to new or existing shareholders or, alternatively, by bringing borrowers and lenders together so that loans can be negotiated. The secondary markets provide the investors with the means to either increase or decrease the number of shares they own. Similarly, it is possible to either increase or decrease the amount that is borrowed or lent depending on the liquidity requirements of each party. The facility for trading in shares and other financial instruments has implications for the whole economy and includes the following: ● Savings and investment are promoted as the financial requirements of both savers and lenders can be brought together and funding provided for new or existing projects. ● Banks, pension funds and other institutional investors act as financial intermediaries by gathering funds from savers and channelling the funds to users of the funds through loans, leasing arrangements and other forms of financing. These functions are extremely important within the economy and it is essential that a developed country has facilities of this nature to enable the economy to prosper. (b) A rights issue is an invitation to existing shareholders to purchase additional shares in the company. If the existing shareholders buy the same proportion of the rights issue that they currently hold, the company acquires additional funds and the current owners of the company retain their proportion of the total company. This has implications for their voting rights. The problem of existing shareholders who are not able to take up their allocation of shares, is resolved by making it possible for the rights to be sold to a third party.

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There are a number of reasons for their use and these include: ● It is possible for a company to raise equity funding relatively quickly. It is usual for rights issues to succeed as they are often issued at a price 10 per cent below the market price. However, as only existing shareholders are involved, this does not create problems. ● It is much cheaper to obtain additional equity without having to make a new issue, which is often very expensive. ● The administrative procedure is much less complicated in respect of the existing shareholders and the Stock Exchange regulations. (c) There are a number of different forms of debt that can be used to provide funding for organisations that are planning to expand. These include: ● Debentures are usually sold in units of £100 via the stock market. This means that investors can sell their debentures if they require their funds before the date on which the debentures are scheduled to be redeemed. Debenture issues are often secured by means of a floating charge against all present and future assets. This does not represent a major problem to the management of the organisation as they can act within the contractual obligations that are usually specified in the documentation prepared at the time of the debenture issue. ● Debentures will be issued as an alternative to equity and the funds will usually be used to finance growth or a major new project. It is likely that debenture issues will be monitored more closely by external bodies than the other forms of borrowing, which are really a matter between the lender and the borrower. ● Unsecured loan stock will usually pay a higher rate of interest than secured loans and debentures. The higher rate of interest is to compensate the lenders for the added risks. In the event of a collapse of the organisation, the unsecured loans will only be paid out when the secured loans have been paid. Unsecured loan stock will usually be used if the company is unlikely to find it difficult to meet the conditions of the loan as it is possible that the conditions will be more stringent than those imposed by an issue of debentures. It is possible that restrictive covenants may be imposed by the lender and these may restrict the amount of dividends paid or further debt raised while the loan is outstanding. It is also possible that it will be required to achieve specified financial ratios and to provide regular financial statements to the lender. ● Convertible unsecured loan stock can be converted into equity at the request of the holder. If the company is successful, the lender can obtain shares at the time and price specified in the loan agreement. This facility means that the rate of interest is usually lower and so provides the company with a lower cost of borrowing. Lenders can become involved with companies that are perceived to be a high risk as, if they succeed, they can convert the loan to equity. However, if the company is not particularly successful, the lender will be repaid the amount borrowed and the interest on the loan. This is an attractive proposition for companies that expect to flourish but this view is not generally accepted by the financial markets. In general terms, the most suitable debt for an organisation will depend on the debt capacity of the organisation and the risk profile of the project that is being funded by the loan.

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Solution 2
Aim of the question The purpose of this question is to test whether students fully understand some common financing options available to companies and to explain, with reasons, the best method of financing investment opportunities of different companies in given circumstances. This question examines the following syllabus area:
● ●

Types and features of domestic and international long-term finance; Criteria for selecting sources of finance.

Tips ● The key points to recognise about ABC Ltd are that the company is highly profitable, with profit margins around 30 per cent expected to rise to 35 per cent in 1994 with an expected current ratio for 1994 of 1.4. ● It is in a high-technology business that is competitive and risky. ● There are few non-current assets, so secured debt is unavailable unless the directors provide personal guarantees. ● The most obvious method of financing would be a flotation of the company on the stock market. ● A venture capital company could be a possibility although this would almost certainly involve a large dilution of equity. ● A joint venture with companies in each of the countries being exported to is also a possibility. ● DEF is suffering a decline in profitability based on the 2 years’ figures provided. ● Dividends have been increased by more than the increase in earnings. ● The P/E ratio is now 8.3 compared with 11.2 in 1993, suggesting the market is not convinced of DEF’s ability to reposition itself. (a) (i) Equity. The normal form of equity is ‘ordinary shares’. These are permanent capital (unless the directors are empowered, and choose, to arrange for the company to buy them back) and are rewarded by a dividend (out of profits struck after all other legitimate claims, including interest and tax, have been met). They bear the residual uncertainty, therefore, as regards the financial success of the enterprise. (ii) Mortgage debt. This relates to a loan to the company, secured by a charge over particular (usually tangible) assets. Interest is payable (and chargeable against tax) on either a fixed or variable basis, and the lender is given certain rights, for example, to take ownership of the assets mortgaged should the borrower default. (iii) Convertible debt. This starts life as debt, that is, entitled to a predetermined return in the form of interest, but (on terms and within time frames specified) can be exchanged for shares in the company. (iv) Debt with warrants. This is, and may remain, debt but is accompanied by a document that enables the holder to buy other securities (e.g. shares) at a specified time in the future, at a specified price. These documents (the ‘warrants’) can be traded separately from the original debt.

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(v) Leasing. This means that particular assets (typically plant and machinery) used by an enterprise are not actually owned by that enterprise. A separate organisation (usually a subsidiary of a bank) owns the assets and charges the user a predetermined fee, for example, on a monthly or annual basis, for an agreed length of time. The agreement may include a provision for the user to buy the assets at the end of the specified period. (vi) Preference shares. These give all the rights of membership to the company, but the entitlement to a reward is predetermined, for example, 8 per cent per annum of the nominal value, provided that the company has a positive balance on its reserves. They may also have a right to further participation once ordinary shareholders have had a certain dividend, and usually have preference in a winding-up. (b) ABC Ltd The profit before tax was £705,000 in 1993, and is forecast to be £1,138,000 in 1994. Interest at 12 per cent amounts to £21,000 and £18,000, respectively, implying operating profits of £726,000 and £1,156,000. Net assets are forecast to increase from £565,000 at the beginning of 1994 to £740,000 at the end. Add back dividends and taxes payable £660,000 and £938,000. Therefore, operating assets increase from £1,225,000 to £1,678,000, that is, £453,000. Operational cash generation in 1994 is therefore expected to be £1,156,000 minus £453,000, that is, £703,000, applied as follows:
£ Distributions: Interest Tax Dividends Financing: reduced borrowings Operational cash generation 18,000 220,000 440,000 678,000 725,000 703,000 £

In short, it is forecasting a return on assets of over 90 per cent in conditions commensurate with a 12 per cent cost of borrowing. The new venture looks even more profitable than the existing business, given that profits are expected to treble, whereas operating assets are expected to increase by only 125 per cent. The payback will therefore be extremely rapid, which militates against long-term debt. Assuming the objective of the shareholders is to maximise the value of their investment, the shareholders should be advised to: ● restrict their dividends as much as possible, so as to retain funds and control; ● look into the possibility of borrowing money as individuals in order to subscribe for additional equity capital; ● minimise capital requirements, for example, by leasing (or buying on hire purchase) physical assets and/or factoring book debts; ● identify friendly investors, for example, employees, customers, suppliers or potential competitors, who would be prepared to invest limited amounts (i.e. in aggregate, a minority) in the company, or in some form of joint venture; ● seek to borrow money in the company’s name, with a fairly early payback envisaged; ● as a last resort, contact providers of venture capital. They would find this business attractive, but would want equity, would price it so as to achieve their target return (currently in excess of 30 per cent per annum) and might insist on having representation on the board.
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DEF plc It is difficult to advise the directors of DEF plc as to the form in which they wish to raise £250 million, because we are not told what they are projecting in the way of a return thereon, or the margin of error in such a projection. The current-year forecast shows a return on (closing) equity of £118m/£719m, that is, 16.4 per cent. Assuming tax of 33 per cent, this suggests a return before tax of £176m/£777m, that is, 22.65 per cent. Adding in £19m/£210m for borrowings, we can see that the overall return on assets is expected to be £195m/£987m, or just under 20 per cent. If, in the absence of any prospectus, we assume that the additional £250m will achieve a similar return, the additional operating profit would be close to £50m. This should not prove difficult to finance, provided that the directors can communicate the prospect to the appropriate market. Two possibilities might be considered:

Assuming they have the authority under their articles, the directors might consider debt. Currently borrowings amount to £210m, that is, less than 22 per cent of operating assets. Increasing borrowings to £460m and assets to £1,179m would leave the ratio at less than 40 per cent, which does not seem unreasonable. It would, of course, increase the amount of cash pre-empted for interest by around £20m assuming, say, 8 per cent per annum net interest. Alternatively, they might think about a rights issue. Its current market capitalisation is 2.45 £400m, that is, £980m, so we are talking about, approximately, a 25 per cent increase. The most likely approach (again, assuming the authority has been obtained) would be a rights issue, for example, 1-for-3 at around 210p. Recent experience suggests that analysts will concentrate on the arithmetic of the issue and not question the use to which the money will be put. Some boards of directors (especially in a situation like this, where the share price has fallen) choose to have the issue underwritten, that is, they can be sure of raising the capital for the expansion, even if shareholders do not support it.

Alternatively, a hybrid issue might be considered, for example, initially debt, but with a predetermined conversion into equity. The decision would be made on the basis of projected cash flows and the margin of error (e.g. the greater the margin of error, the more appropriate the equity route).

Solution 3
Aim of the question The question tests an understanding of the factors to be considered by a company when deciding on the appropriateness of a stock market listing, in given circumstances. It also requires explanations of various methods by which a listing might be achieved and comparison of the advantages and disadvantages of each, in the circumstances of the company in the question. Part (c) of the question requires an understanding of the functions of financial institutions and the services they might perform in connection with a public offering of shares. This question examines the following syllabus areas:
● ●

Types and features of domestic and international long-term finance; Criteria for selecting sources of finance.
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Tips ● A very common error made by candidates when answering this question was to assume that this company was already quoted. This was presumably because it is a plc. Plc means public limited company, not public listed company; a plc does not have to be listed. ● There was a widespread belief that flotation would bring in new management. Where from was not clear. Shareholders in general are apathetic in the management of the companies in which they invest and rarely have a direct influence on activities and operations. ● Very few candidates managed to successfully compare methods of flotation and in particular to relate them to the circumstances of the question. ● Part (b) of the question was less well answered than might have been expected, with many candidates providing lists of identical services for all three types of institutions. (a) (i) The principal advantage of floating CP plc on the Stock Exchange, from the point of view of the current shareholders, is that they will be able to convert ‘paper wealth’ into real cash. This would not have been impossible before, especially as the company is already designated a plc, but the availability of a wider market will make it that much easier. Beyond that, it might be argued that the advantages are: ● that it is useful to have an external, and hence objective, valuation of the business; ● that expansion, by way of an acquisition financed by a share issue, will be easier; ● that it will be easier to provide employees with tax-effective incentives, e.g. share options (but see sixth disadvantage below). The disadvantages include: ● a liability to taxation on any gains, albeit reduced by indexation and the annual allowance; ● a clear (and usually higher!) liability to such taxes as inheritance tax; ● a reduction in future dividend income and potential for capital gain; ● the cost of the flotation; ● an increase in administration costs, for example, managing the share register, preparation of more glossy accounts, dealing with the Stock Exchange, analysts, journalists, etc.; ● a danger of conflicting objectives, owing to the arrival of stakeholders with shorter time-scales, for example, a focus on share price, not previously relevant; ● a danger that the volatility of past profits would adversely affect market sentiment, thereby reducing the value that could be obtained (in which case, it might be better to wait until that big profit drop falls out of the figures that need to be published). Effects that could come under either heading include a separation of ownership from control. (ii) The choice as to the method by which the flotation might be brought about will be influenced by the extent to which it is intended to raise additional capital (e.g. to finance an acquisition, other forms of expansion, or simply reduce borrowings), as opposed to providing an exit route for existing shareholders. In a ‘placing’ the issuer arranges for a relatively small number of buyers (usually institutional investors) to take the shares. This is usually a cheaper route, suited to the smaller issue, but does not normally lead to a very active market. An ‘offer for sale’ involves an issue of new shares perhaps accompanied by a certain proportion of existing shares being made available. This is the preferred approach for the larger issue and where the creation of a substantial market is desired.

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This can be done on either: 1. a fixed-price basis, that is, the company determines the price, and recognises that demand will be more or less than the amount it wishes to issue; or 2. a tender basis, which amounts to a sealed bid auction in which prospective purchasers bid different prices, and a price is struck at which the required amount can be allocated. Some privatisations have been able to mix the two by distinguishing between institutional and private shareholders. (b) The various parties mentioned could help as follows: Merchant banks. These will normally play the lead role, once the decision has been made to go ahead. They will advise on: ● the appointment of other specialists (e.g. lawyers); ● the content of articles of association, etc., against the requirements of the Stock Exchange; ● the form of any new capital to be made available (equity, preference, loan, hybrid?); ● the number of shares to be issued, and the price; ● arrangements for underwriting; and ● promotion. Stockbrokers. These are likely to provide advice as to which of the various methods of obtaining a listing is best in the circumstances, and may provide preliminary advice (i.e. before the merchant bankers get involved) on some of the items mentioned above. For small issues, they may identify substantial investors. Institutional investors. Very little direct involvement, but they might agree to buy a certain number of shares (especially in a placing), and might also participate as underwriters in an offer for sale. Some issuers conduct roadshows to explain the company and seek feedback from this class of investor as to their attractiveness as an investment.

Solution 4
Aim of the question The scenario in this question concerned a company that is building up an investment portfolio with a view to developing funds for expansion, including overseas acquisitions. The question tests treasurership skills and ability to evaluate action on one particular type of security – a convertible bond. Tips ● Answers provided for part (a) were generally at least satisfactory. Additional points were as follows. ● More than 44 per cent of the portfolio is in UK equities; 62 per cent is in UK and US equities. This is a high proportion for a company that may need liquidity to expand, particularly if expansion is to be achieved by acquisition for cash. ● Shares traded on the AIM are generally high-risk investments, and may also be fairly illiquid – that is, there may not be a ready buyer for the shares at the time Z plc wants to sell.

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● ●

US stocks give rise to possible exchange risks in the short term. However, if expansion is planned in the US, then holding these stocks as medium-term investments may be more acceptable. There has been a high average return over the past twelve months.What are the expectations for the future? Attitude to risk is specific to a company. Is Z plc (i.e. its shareholders) happy to accept higher risk for higher returns? Answers to part (b) of the question were generally very poor. Few candidates understood the meaning of conversion premium and conversion discount and virtually none could provide the correct calculations (or even any calculations for part (b)(ii)). Convertible loan stock is loan stock that, at the option of the holder, may be converted into ordinary shares in the company under specific conditions. A conversion premium measures how much more expensive it would be to buy the convertible loan stock than the corresponding ordinary shares. A conversion discount is the converse and measures how much cheaper it would be to buy the underlying shares. If a company held a convertible that was showing a conversion premium, clearly it would not convert into ordinary shares. If it was showing a conversion discount, conversion would be advantageous. Whether a convertible is standing at a premium or a discount to the underlying shares depends on the state of the market and many other economic and commercial factors.

(a) The conventional wisdom is that equities will show a higher return than government securities in the long term, but will be subject to wider fluctuations. This means that there is a danger that when an investor wishes to liquidate his holding, the prices could be at the bottom of the range. Hence, as one draws near the time when the funds are required for some specific purpose, the advice is to move into the less volatile securities. However, with the expansion still up to two years away, it is perhaps too early to be in such marketable securities as the government debt and 3-month bonds. Over the last 12 months, the return on the specific equities held by Z plc has been greater than that on their respective markets. On the surface this was beneficial, but those who believe that markets are efficient would suggest that this higher return must imply greater uncertainty, reinforcing the point made in the previous paragraph. If this is the case, was it deliberate policy on the part of the Z plc treasury? If the proposed expansion is in the US or countries whose currencies move in line with the dollar, then the investment in US equities could be said to provide something of a hedge against a fall in the dollar/sterling rate. Otherwise, it could be said to have opened up an exchange rate risk. (b) (i) At any point in time, the price of convertible loan stock is likely to be different from the price of the corresponding ordinary shares – mainly on account of the fact that the latter could change significantly before conversion. If the price of the convertible is higher than that of the equivalent number of ordinary shares, it is said to be at a premium. Conversely, if the price of the convertible is lower than that of the equivalent number of ordinary shares, it is said to be at a discount.
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(ii) Using a 7 per cent p.a. discount rate, holding the stock until redemption is worth:
Interest receivable 12 months hence: £3,000 Interest capital 24 months hence: £53,000 Total 1/1.07 (1/1.07)2 £ 2,804 46,292 49,096

If converted this year, 10,000 shares would be received, which at £5.40 is worth £54,000. However, as of today, the stock is at a discount, i.e. worth only £53,250. If these were the only choices, and transaction costs were negligible, one would convert now. There is one other possibility, that is, wait until 12 months hence, receive a dividend with a present value of £2,804 as above, and then convert. If the price of the ordinary shares at that time is more (in present value terms) than £5.69, the 9,000 shares received would be worth more than £51,196, which together with the dividend would exceed today’s £54,000 value. In conclusion, therefore: ● If you think the share price will be more (in present value terms) than £5.69 in a year’s time, wait and convert then. ● If you do not think that the share price will be more (in present value terms) than £5.69 in a year’s time, convert now.

Solution 5
This question examines the following syllabus area:
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Types and features of domestic and international long-term finance; Criteria for selecting sources of finance.

(a) When choosing between alternative forms of finance, the directors of Denetter might consider the following: (i) Cost. If the market is efficient then the cost paid for any individual financing source will be the appropriate cost for that source, taking into account the relative risks of alternative sources. The fact that debt finance is normally cheaper than equity finance does not necessarily mean that debt finance should be chosen. Cost is important as it affects the company’s overall cost of capital and therefore its market value per share. Assuming that financial structure influences the market value of a company, the company should attempt to select the financing combination that minimises its overall cost of capital. (ii) Risk. The effect of financing upon risk can be measured in several ways, including financial gearing, interest cover, cash-flow cover, and the company’s beta coefficient (systematic risk). (iii) Control. The ownership structure of the company’s shares, and hence the control of the company, will differ according to the financing method selected. (iv) Market conditions. If share prices are falling, an equity issue might not succeed or, if interest rates are expected to fall, a fixed-rate debt issue might be unwise. Market conditions can, therefore, influence the financing choice. (v) Speed of raising finance. Some forms of finance can be raised more quickly and easily than others. If the need for funds is urgent, speed of raising finance might outweigh some other considerations.
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(vi) Flexibility. Can the finance be redeemed easily and cheaply, or swapped into another form of commitment (e.g. an interest rate swap)? (b) Pre-emptive rights mean that companies wishing to make a further issue of equity shares for cash must first offer the shares to existing shareholders in proportion to their existing holdings. Their advantages might include: (i) they allow shareholders to maintain a certain percentage holding in a company. This might be particularly important to companies that are controlled by a few large investors, and to institutional investors; (ii) alternative forms of share issue might have to be made at a lower price than a rights issue in order to attract new investors if pre-emptive rights did not exist. Disadvantages might include: (i) they are a form of restrictive practice that is not appropriate to modern stock markets; (ii) companies can raise finance more quickly and more cheaply when pre-emptive rights do not exist, for example, through placements. (c) In a semi-strong market the share price should accurately reflect new relevant information when it becomes publicly available. This would include the effect on Denetter of the expansion scheme and the redemption of the term loan.
The existing market value is 190 pence 32 million shares The new investment has an expected NPV of £1.1m, which will add to market value The proceeds of the issue will add to market value Issue costs of 4% would reduce market value £m 60.8 1.1 15.0 (0.6)

The early redemption of the bank loan will produce a benefit to the present value of cash flows associated with the loan.
Expected present value of outflows before redemption is announced: £m Interest £750,000 per year (£5m PV of repayment in year 5 £5m 15%) 0.621 3.791 2.843 3.105 5.948 Redemption cost now Penalty charge Present value benefit from early redemption Expected total market value (5.000) (0.350) 70.598 76.898

(d) (i) Changes in factors affecting the value of the company’s shares between the setting of the terms of issue and the issue date; (ii) existing shareholder reaction to the issue; (iii) the effect of the extra volume of shares on their marketability; (iv) whether forecast earnings from the new funds are considered realistic by the market.

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Capital Structure and Cost of Capital
LEARNING OUTCOMES
After completing this chapter you should be able to: calculate the cost of equity using the divided growth model; gear and ungear betas; calculate, interpret and use the weighted average cost of capital; appreciate the ideas of diversifiable risk and systematic risk.

4

4.1 Introduction
The topics covered in this chapter are:
● ● ● ● ● ●

calculation of the cost of equity; impact of charging capital structures; weighted average cost of capital; adjusted present value; the capital asset pricing model; arbitrage pricing theory.

In CIMA’s Management Accounting: Official Terminology, financial gearing (called leverage in the US) is defined as follows: The use of debt finance to increase the return on equity by deploying borrowed funds in such a way that the return generated is greater than the cost of servicing the debt. In this chapter we consider the advantages and disadvantages of using debt as a source of finance, and consider the impact of gearing on the cost of capital of a company. The advantage to equity holders of using debt arises from the tax shield on debt, that is, the benefit to shareholders deriving from the treatment of debt for tax purposes as being deductible in arriving at an entity’s taxable profits. High gearing means that debt represents a high proportion of the financing of an entity’s assets, whereby in its capital structure of
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equity plus debt (E D), the element D is high in proportion to the element E; conversely, low gearing is where D is low in relation to E. The main disadvantage of increasing debt is that the additional interest payable reduces the earnings available to shareholders, thereby increasing the risk of their investment and consequently increasing the cost of capital, as new investors will require a higher return on equity to compensate for the increased financial risk. If you are still doubtful as to why increasing debt increases risk, you must appreciate that debt has priority over equity and also that coupon rates of debt must be met. Thus, if an entity hits bad times and profits fall significantly or losses ensue, there may be little if any return for shareholders. Clearly, therefore, the level of an entity’s gearing can affect both earnings per share and dividend policy decisions. You must take care to distinguish between operational gearing and financial gearing, noting that the former represents the ‘relationship of the fixed cost to the total cost of an operating unit’ (CIMA Official Terminology). It is evident, however, that operational and financial gearing have the common feature that an increase in either (i.e. higher fixed cost or higher debt) reduces the earnings available to shareholders and thereby increases their risk. Note also that high operational gearing exposes lenders to the risk that, if an entity makes losses or suffers a serious fall in profits, their loans may not be fully or even partially serviced.

4.2 Measuring gearing
4.2.1 Capital gearing
Capital gearing is concerned with the level of debt in a company’s capital structure and concentrates on the following groups of capital:

Equity (E). This is the portion of the company that is financed by the ordinary shareholders. Prior charge capital (PCC). This is the capital that has to be serviced prior to the equity capital receiving any return. Prior charge capital will be represented by preference share capital plus all long-term liabilities.

There are many alternative forms of the capital gearing ratio. Some of the more common forms are: E PCC E E PCC 100% 100% PCC 100% E PCC 100% E PCC

The preferred form of the calculation for the examination is: E PCC PCC 100%

Using this form of the gearing ratio sets an upper limit to the gearing percentage, which may help with interpretation of the ratio. Wherever possible, market values should be used in preference to book values for the capital gearing ratio. When using market values, care must be taken when calculating the
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market value of equity:

When equity is valued using book values it must include any reserves and retained profits that are attributable to the ordinary shareholders: that is, the book value of equity ordinary share capital reserves.

When market values are used, reserves must be excluded since they are considered to be already incorporated into the market price of the shares: that is, the market value of equity number of shares share price.

Another problem that may be encountered is the bank overdraft. It is difficult to generalise about this item. On the one hand, it may be viewed as a short-term source of capital. On the other hand, it may have become, over time, a source of relatively permanent capital and could then be considered an element of PCC. Each case must be considered on its merits. High gearing exists when a company has a large proportion of prior charge capital in relation to equity and low gearing exists when there is a small proportion of prior charge capital. High gearing increases the financial risk of the equity investor but the reward can be in the form of increased dividends when profits rise. If, however, profits falter, the equity investor can expect to be the first to feel the effect of the reduction in profits. Low gearing or no gearing may not necessarily be in the equity investor’s best interests because the company might then be failing to exploit the benefits which borrowing can bring. Provided that the return generated from borrowed funds is greater than the cost of those funds, capital gearing could be increased. The extent to which it is prudent for a company to increase its capital gearing will depend upon many variables such as the type of industry within which the company operates, the cost of funds in the market, the availability of investment opportunities and the extent to which the company can continue to benefit from the ‘tax shield’. The ordinary share price of highly geared companies will tend to be depressed in times of rising interest rates.

Exercise 4.1
The following is an extract from the balance sheet of Ashton plc at 30 September 2004:
Ordinary shares of 25p each Reserves 7% preference shares of £1 each 15% unsecured loan stock Total long-term funds £ 250,000 350,000 250,000 1,150,000 1,000,000

The ordinary shares are currently quoted at 125p each, the loan stock is trading at £85 per £100 nominal and the preference shares at 65p each. Calculate the gearing ratio for Ashton plc using: (i) book values (ii) market values.
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Solution
Gearing (i) Book values 250,000 400,000 (ii) Market values
Equity (Ve) Preference (Vp) Loan stock (Vd) 1,000,000 125p 250,000 65p 150,000 85% £ 1,250,000 162,500 1,127,500 1,540,000

prior charge capital prior charge capital equity

150,000 600,000

40%

127,500 162,500 1,540,000

18.8%

4.2.2 Interest cover
An important ratio linking gearing with profitability is the interest cover, a measure of safety whereby the higher the rate, the greater the protection for shareholders and lenders, as the company is then less vulnerable in the event of a significant drop in profits. Interest cover profit before interest payable and tax . interest payable

Example 4.A
The profit and loss account of Ateyo plc for the year to 30 June 2005 shows the following figures: £000 100 140 160 118 142 £100,000 £40,000 2.5.

Operating profit Interest payable Profit before tax Corporation tax Profit after tax Interest cover is calculated as

4.2.3 Leverage
The use of debt introduces financial risk to the balance sheet. This financial risk means that the earnings available to the ordinary shareholders become more volatile if the interest charges on debt are fixed. This effect on earnings is similar to the effect of leverage, which considers the relationship between fixed and variable charges and their effect on profits.
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Leverage may be calculated using the following two ratios: Operating leverage Financial leverage contribution (sales less variable costs) profit before interest payable and tax profit before interest payable and tax profit before tax

Their use is best explained by means of an example:
Year 1 £000 1,000 (400) + (200) 400 + (50) +350) Year 2 £000 1,100 (440) + (200) 460 + (50) +410) % Change 10

Sales Variable costs Fixed costs Operating profit Interest payments Profit before tax

15 17.1

For year 1: Operating leverage

£600,000 £400,000

1.5

Operating leverage indicates by how much fixed costs could increase without the company making an operating loss. The figure of 1.5 also indicates that a 10 per cent increase in sales would result in a 15 per cent increase in operating profits (10 1.5). Financial leverage £400,000 £350,000 1.14

Financial leverage indicates by how much interest payments could increase without the company making a pre-tax loss. By multiplying the two leverage measures together, it can be shown that a 10 per cent increase in sales would result in a 17.1 per cent increase in profit before tax, that is, total leverage (1.5 1.14) 1.71, giving an increase in profit before tax of 17.1 per cent (10 1.71). These projected increases are illustrated in the profit and loss figures for year 2 above, which assume an increase in sales of 10 per cent.

4.3 Cost of capital
We call the cut-off rate, which separates viable from non-viable opportunities, the cost of capital and it is one of the fundamental disciplines of the capitalist market economy. Only those enterprises able to offer the prospect of a return in excess of the cost of capital will be able to attract the funds required to grow: those unable to do so will wither to extinction. This discipline is translated into a criterion for the allocation of resources within enterprises. The higher the cost of capital, for instance, the lower will be the investment in equipment, in innovation, in training and in working capital in anticipation of customers’ needs; the higher will be the selling price that optimises the return on a particular product, and so on. In order to understand fully the nature of cost of capital as discussed in this chapter, you will need to know how to calculate some of the basic financial models associated with the concept. It is important that you understand that the cost of capital must be equivalent to the return that investors expect to reward them for the risk taken by investing in a particular security, and effectively the market value in the calculations represents the NPV of the expected future cash flows to the investor discounted at this expected rate of return.
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4.3.1 Cost of equity
Equity may be raised externally through a share issue, or internally through retained profits. Measuring the cost of equity is a very difficult task. The cost of equity must relate to the return that equity investors expect to reward them for the risk taken by investing in the company. However, this return is likely to vary from year to year. It is often thought that retained profits are a free source of finance. This is not true as there is an opportunity cost of the dividend forgone from retaining profits. There are a number of approaches to estimating the cost of equity that we shall now consider. Dividend valuation model We begin this section with the basic form of the dividend valuation model as a method of calculating cost of equity. This model makes the assumption that the market price of a share is related to the future dividend income stream from that share in such a way that the market price is assumed to be the present value of that future dividend income stream. This is known as the fundamental theory of share valuation. If a share pays a constant annual dividend in perpetuity, the ex-dividend share price may be calculated as: P0 d (1 d ke d P0 cost of equity annual dividend market value of equity (ex-dividend) k) (1 d k)
2

d (1 k)3

to infinity

This simplifies to: P0

which may be rearranged to give: ke where ke d P0

This basic model assumes a constant rate of dividends to perpetuity and ignores taxation.
Example 4.B
Assume £1 shares quoted at £2.50, dividend just paid of 20p, then ke 20 250 0.08 or 8%

If a question quoted the share price as cum-div, or stated that the dividend proposed to be paid was 20p, then P0 needs adjustment to ex-dividend, thus: ke 20 250 20 0.087 or 8.7%.

Dividend growth model Equity investors will usually expect dividends to increase over time, rather than remain constant each year in perpetuity. This model still assumes the market price of a share
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is equal to the present value of the dividend income stream from that share. If we assume the dividend increases by a constant annual growth rate ( g), the market price of a share may be expressed as: P0 d0(1 g) (1 k) d0(1 g)2 (1 k)2 d0(1 g)3 (1 k)3 to infinity

This simplifies to: P0 d0(1 ke g) g

which may be rearranged to give: d0(1 g) ke g P0 where ke d0 P0 g cost of equity current dividend market value of equity (ex-dividend) expected constant annual growth rate in dividends

Note that the dividend growth model is sometimes shown as: ke d1 P0 g

where d1 d0(1 g), that is, next year’s dividend is equal to the current dividend uplifted by the growth rate.

Exercise 4.2
The current market price of a share is £2.50. A dividend of 20p has just been paid. Assuming the expected annual growth rate for the dividend is 5 per cent to perpetuity, calculate the cost of equity.

Solution
ke d0(1 g) g P0 20(1.05) 0.05 250 0.084 0.05 0.134 13.4%.

ke

Exercise 4.3
The current market price of a share is £2.00. A dividend of 20p per share has just been paid. Assuming the dividend is expected to decline by 2 per cent each year in perpetuity, calculate the cost of equity.
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Solution
ke d0(1 g) g P0 20(1 0.02) 200 0.098 7.8%. 0.02

0.02

ke

Exercise 4.4
Thompson plc’s shares have gone ex-dividend having just declared a dividend of 20p per share. The market expects the dividend to grow by 5 per cent each year in perpetuity. The company’s cost of equity capital is 13.4 per cent. What is the ex-dividend market price per share?

Solution
P0 d0(1 g) ke g 20(1.05) 0.134 0.05 21 0.084 250p.

P0

Estimating the growth rate An examination question may require you to estimate the growth rate in dividends. There are two possible approaches with which you need to be familiar. You may need to extrapolate growth from historical data, assuming the historical average annual growth rate will continue in perpetuity.
Example 4.C
Year 2000 2001 2002 2003 2004 Dividend £ 15,000 15,500 17,200 18,100 19,000

The historical average annual growth rate may be calculated using the compound interest formula: S 19,000 1 g g g X (1 r)n g)4 1.06

15,000 (1
4

19,000 15,000 1

1.06

0.06 or 6%.

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Alternatively, Gordon’s growth model may be used to estimate the growth in dividends. This approach developed by economist Myron Gordon attempts to derive a future growth rate, rather than the previous approach of extrapolating the historical growth rate. Gordon argued that an increase in the level of investment by a company will give rise to an increase in future dividends. The two key elements in determining future dividend growth will be the rate of reinvestment by the company and the return generated by the investments. Gordon was able to demonstrate that the future dividend growth rate ( g) can be estimated as: g where b bR proportion of earnings retained each year Earnings dividend Earnings R average rate of return on investment Earnings Book value of capital employed There are a number of assumptions required to apply this model:

● ● ● ●

the company must be all equity financed; retained profits are the only source of additional investment; a constant proportion of each year’s earnings is retained for reinvestment; projects financed from retained earnings earn a constant rate of return.

Exercise 4.5
A company retains 60 per cent of its earnings for identified capital investment projects that are estimated to have an average post-tax return of 12 per cent. Estimate the future dividend growth rate for the company.

Solution
g g bR 60% 12 7.2%. 7.2

Capital asset pricing model (CAPM) The dividend valuation model as described above does not explicitly consider risk. Risk here is the risk that actual returns – that is, dividends – will not be the same as expected returns. CAPM, as described later in this chapter, is a technique that enables risk to be incorporated into financial analysis. Using CAPM to calculate the cost of equity: ke where ke Rf cost of equity risk-free rate of return
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[Rm

Rf]

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Rm

expected return from the market portfolio equity beta

Example 4.D
Calculate the cost of equity using the CAPM, assuming an equity beta of 1.4, an expected market return of 16 per cent and a risk-free rate of 10 per cent.

Solution
ke ke Rf 10 10 [Rm [16 8.4 Rf] 10]1.4

18.4%.

4.3.2 Cost of debt
Thus far we have considered dividend valuation models relating to an ungeared company, so the next stage is to consider the effect of introducing debt into the calculation. In Chapter 3 we pointed out the need to distinguish between face value and market value of debt, and between coupon rate and rate of return. Any fixed interest debt, for example, bonds or debentures, when issued will carry a coupon rate, that is, the rate of interest payable on the face or nominal value of the debt. Thus, £100 (face value) of 7 per cent debentures has a coupon rate of 7 per cent. When such debt is issued, the coupon rate will be fixed in accord with interest rates ruling in the market at that particular time for debt of similar nature and maturity. After issue of the debt, its market value will depend on the relationship of the coupon rate to the rate of return required by investors at any particular time. Thus, if the market value of £100 of 7 per cent debentures on a particular day is £90, the rate of return required at that time (gross of tax) is 7/90 100 ≈ 7.78 per cent. Irredeemable debt As the interest on debt is a tax-deductible expense, the relevant cost to a company of using debt finance is the after-tax cost. For irredeemable debt, the cost of debt is given by an interest yield calculation: i(1 P0 t)

kd net where kd net i t P0
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cost of debt (after tax) annual interest rate of corporation tax (assumed immediately recoverable) market value of debt (ex-interest, i.e. immediately after payment).

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Exercise 4.6
Assume 7 per cent debentures quoted at £90 (ex-int), interest just paid, and corporation tax is 30 per cent, calculate the cost of debt:

Solution
kd net 7(1 0.30) 90 0.054 or 5.4%

Notice that if £90 was the cumulative interest market price (i.e. the price includes the pending interest payment), then the cost of debt above would be: 7(1 0.30) kd net 0.059 or 5.9%. 90 7 Redeemable debt The cost of redeemable debt is calculated using an internal rate of return approach. The calculation takes the internal rate of return of the annual net of tax interest payments from year 1 to year n plus the redemption payment in year n minus the original market value of the debt in year zero. In other words, all of the cash flows associated with the debt from today’s market value through to the redemption value (Red) are discounted on a trial-anderror basis to find the internal rate of return.

Exercise 4.7
Calculate the cost of a 7 per cent debenture currently quoted at £90. It will be redeemed at £101 in 5 years’ time. Interest and redemption payments are assumed to be payable at year end and tax of 30 per cent to be immediately recoverable.

Solution
MV (ex-int) 1 t Red Year 0 1 to 5 5 Cash flow 90 7 (0.70) 4.9 101 DF @ 5% 1.000 4.329 0.784 DF @ 10% 1.000 3.791 0.621 PV @ 5% (90.000) 21.212 79.184 10.396 PV @ 10% (90.000) 18.576 62.721) | (8.703)

so by interpolation: kd net kd net 5 5 10.396 10.396 8.703 2.72 7.72%. (10 5)

Convertible debt In the case of convertible loan stock, the redemption payment would become the market value at year n of the ordinary shares into which the debt is to be converted. We can calculate MV in n years’ time using the model: Pn P0 (1 g)n
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Notice that this is the compound formula, previously seen as: S X(1 r)n

If we assume dividend growth of 9.2 per cent per annum and P0 of 250p, then in four years’ time: P4 250 (1.092)4 ≈ 355p

which we can use as the convertible value.

4.3.3 Cost of preference shares
The cost of preference share capital is related to the amount of dividend payable on the share. The dividend is an appropriation from post-tax profits, which means that it is not allowable for tax. The cost can be represented by: kpref where kpref d P0 cost of preference shares annual dividend current ex-div market price d P0

Assuming a dividend of, say, 7p per £1 preference share and a market value of 60p (ex-div), the cost of the preference share would be: 7 60 11.7%.

4.4 Weighted average cost of capital
The weighted average cost of capital (WACC) assumes that when a company raises finance, the cash raised is added into a pool of funds. When a potential investment project is identified, the project is assumed to be financed from the pool, rather than from any specific fund-raising operation. If the mix of equity, debt and preference shares within the pool of funds is assumed to remain constant over time, the discount rate to apply in appraising the project would be the cost of the pool of funds, that is, the weighted average cost of capital. The WACC can be found by calculating the cost of each long-term source of finance weighted by the proportions of finance used. In theory, market values of the securities should be used in the gearing calculations as these give a more accurate measure of the company’s value, although book values are frequently used in practice. Using market values for a firm with equity, debt and preference shares in its capital structure, the WACC would be: k0 keVe kpVp Ve Vp kdVd Vd

where Ve, Vp and Vd denote the market value of equity, preference shares and debt, respectively.
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Note that in the formula sheet the formula for weighted average cost of capital is shown as: k0 ke Ve Ve Vd kd Vd Ve Vd

This assumes that a firm has equity and debt in its capital structure, but no preference shares. Introducing preference shares into the formula would give: k0 ke Ve Ve Vd Vp kd Ve Vd Vd Vp kpref Ve Vp Vd Vp

This text will use the first formula quoted when illustrating the calculation of WACC.

Exercise 4.8
The following is an extract from the balance sheet of Gate plc at 30 September 2004:
Ordinary shares of 25p each Reserves 7% preference shares of £1 each 15% unsecured loan stock Total long-term funds £ 250,000 350,000 250,000 1,150,000 1,000,000

The ordinary shares are currently quoted at 125p each, the loan stock is trading at £85 per £100 nominal and the preference shares at 65p each. The ordinary dividend of 10p has just been paid, and the expected growth rate in the dividend is 10 per cent. Corporation tax is at the rate of 33 per cent. Calculate the weighted average cost of capital for Gate plc.

Solution
Market values of the securities
Equity (Ve) Preference (Vp) Loan stock (Vd) 1,000,000 250,000 150,000 125p 65p 85% £ 1,250,000 162,500 1,127,500 1,540,000

Cost of equity (ke) ke d0(1 g) P0 10(1.10) 125 0.088 g 0.10 0.10 18.8%
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Cost of preference shares (kp) kpref d P0 7 65

10.8%

Cost of loan stock (kd net) kd net i(1 P0 15(1 85 t) 0.30) 12.4%

Weighted average cost of capital (k0) k0 k0 k0 k0 keVe kpVp Ve Vp (0.188 235,000 0.174 kdVd Vd (0.108 162,500) 1,540,000 15,810 (0.124 127,500)

1,250,000) 17,550 1,540,000 17.4%.

4.4.1 Assumptions in the use of WACC
WACC can be used as a cut-off or discounting rate for calculating the NPVs of projected cash flows for new investments, but the following criteria should be met:

the capital structure is reasonably constant; this assumption is necessary because if the capital structure changes, the weightings in the WACC calculation will change, which will lead to a change in k0; the new investment does not carry a significantly different risk profile from that of the existing entity; as k0 is the company’s cost of capital, it will only be suitable for appraising a project if the project shows the same risk profile as the whole company; the new investment is marginal to the entity; the calculations of ke, kp, and kd are based on small investments: in other words, they represent marginal costs of capital. Their use in the WACC calculation means that k0, by implication, is also a marginal cost; all cash flows are level perpetuities; the derivation of the formula for WACC would show that this must be the case, but it is not shown here as it is not a requirement of the syllabus for Management Accounting: Financial Strategy.

4.5 Marginal cost of capital
As discussed above, the use of WACC assumes that the capital structure of an entity will remain unchanged and that any new investment will have a similar risk profile to existing investments.
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If a large project is under consideration, and it would fundamentally affect the capital structure of an entity, these assumptions would mean that WACC is no longer the appropriate technique for investment appraisal. Use of WACC could lead to the acceptance of projects that reduce the entity’s value. The relevant cost of capital is now arguably the incremental cost, i.e. the marginal cost reflecting the changes in the total cost of the capital structure before and after the introduction of the new capital. In theory, the marginal cost of capital is just the difference between the total cost with the existing capital structure and the total cost with the new capital structure once the investment has been undertaken. Consider a company with the following cost of capital:
Source Equity Preference Loan stock After-tax cost, % A 20 10 8 Market value, £m 1B 15 11 14 10 A B 1.00 0.10 0.32 1.42

Weighted average cost of capital

1.42/10

100

14.2%

It has a large investment project under consideration, to be financed by a major issue of funds which will alter the capital structure. The estimated project cost is £1,000,000, to be financed in equal proportions by a new share issue and a new issue of loan stock. The new capital structure will imply a new level of risk for holders of loan stock and equity shares, causing the cost of capital for the company to change. The new cost of capital may be as follows:
Source Equity Preference Loan stock New loan stock After-tax cost, % A 22 10 8 10 Market value, £m 1B 15.5 11.0 14.0 10.5 11.0 A B 1.21 0.10 0.32 0.05 1.68

Weighted average cost of capital 1.68/11 100 15.3% Marginal cost of capital 1.68 1.42 100% 26% 11 10 The total cost of capital has increased by £260,000 as a result of raising £1,000,000 of funds. The incremental cost of capital is therefore 26 per cent. It might be thought that by raising £500,000 of equity with a cost of 22 per cent, and £500,000 of loan stock with a cost of 10 per cent, the marginal cost of capital would be: (0.5 22) (0.5 10) 16%

but this would ignore the change in the cost of original capital. The approach illustrated here is appropriate only if the investment project is large relative to the current size of the entity and undertaking the project causes an identifiable difference in the capital structure. In practice, companies rarely raise funds from a particular source for a particular purpose, which makes this approach difficult to use.
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4.6 The traditional theory of gearing
The traditional theory of financial gearing considers the effect that a change in gearing has on the WACC and on the value of a company. It is based on the following assumptions:

● ● ●

earnings remain constant in perpetuity and all investors have the same expectations about future earnings; taxation is ignored; risk remains constant, no matter how funds are invested; all earnings are paid out in dividends. From Figure 4.1 we note that: Cost of equity increases as level of gearing increases; the introduction of debt brings financial risk. This financial risk will cause the earnings available to the ordinary shareholders to become more volatile. The ordinary shareholders will require higher returns to compensate for the increase in financial risk, which pushes the cost of equity up. Debt is assumed to be a cheaper source of finance than equity, as it ranks above equity for both distribution of earnings and on liquidation. Interest on debt is a tax-deductible expense and the issue costs of debt are normally lower than equity. As gearing level increases, cost of debt remains unchanged up to a certain point in the level of gearing, beyond which it will increase; interest cover will start to fall and there will be fewer assets available to offer as security for further loans. The risk to providers of debt increases, which pushes up the cost of debt. WACC forms a type of U-shape, at first falling as level of debt increases reflecting the low cost of debt, and then tending to increase as rising equity costs (and perhaps rising cost of debt) become more significant.

The traditional view therefore is that WACC will be lowest at a level of gearing that represents an optimal capital structure (point OCS on the graph). This optimal level of gearing is likely to be different for each company within each industry. It can also be shown that the capital structure that minimises WACC will also be that which maximises the value of the firm, Figure 4.2 always provided that we assume earnings to be independent of the capital structure. This can be illustrated as follows.

Figure 4.1 Note: ke
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Traditional theory of gearing cost of debt; ked WACC.

cost of equity; kd

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Figure 4.2

Market value of a firm

Exercise 4.9
Mansel plc is expected to generate annual earnings of £600,000 for the foreseeable future. Ignoring taxation, calculate the total market value of Mansel plc, assuming that its cost of capital (WACC) is either (i) 10 per cent; or (ii) 20 per cent.

Solution
Earnings where ked cost of capital (WACC) ked If ked 10 per cent: 600,000 MV £6,000,000 0.1 If ked = 20 per cent: 600,000 £3,000,000 MV 0.2 MV

4.7 Modigliani and Miller’s theories of gearing
The background to Modigliani and Miller’s (MM’s) 1958 theory, which forms the basis for the ‘net operating income’ view of WACC, is set out as follows. Assuming that the conditions apply of a perfect capital market, two companies which yield identical earnings and have similar risk profiles and production capabilities will have the same value in terms of capitalisation whatever their capital structures may be. MM also assume that taxation and transaction costs can be ignored, and that their assumptions are supported by market intervention through the process of ‘arbitrage’ whereby the actions of investors would equate the values of the two companies in all respects except that of leverage (the use of debt, which is assumed to be risk-free and costs the same to individuals as to companies, to increase the expected return on equity). ‘Arbitraging’ here refers to the switching of funds by an investor as between investments in order to obtain a better return for the same risk level. In the perfect capital market assumed by MM, information is freely available to all investors, who in turn are assumed to act rationally, to have similar expectations as to
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returns and also to be in agreement as to the expected future streams of earning for each company, while all companies can be classified into equivalent risk groups. From this background, MM set out their three propositions.

Proposition I
‘The market value of any firm is independent of its capital structure and is given by capitalising its expected return at the rate appropriate to its class.’ This can also be expressed in terms of a firm’s ‘average cost of capital’, which is the ratio of the expected return to the market value of all its securities; thus, ‘the average cost of capital to any firm is completely independent of its capital structure, and is equal to the capitalisation rate of a pure equity stream of its class’.

Proposition II
This relates to the rate of return on equity in companies whose capital structure includes some debt: ‘The expected yield of a share of stock is equal to the appropriate capitalisation rate for a pure equity stream in the class, plus a premium related to financial risk equal to the debt-toequity ratio times the spread between [the capitalisation rate and the interest rate on debt]’. In simpler terms, these two propositions have the following effects: 1. The total market value of a company is independent of the level of debt in its capital structure. This value can be calculated by capitalising the expected flow of operational earnings (before interest payments) at an appropriate discount rate depending on risk category. 2. As leverage (use of debt) increases, the equity cost of capital to a levered company will also rise in order to exactly offset the advantages accruing from the lower cost of debt relative to equity. Note that debt is cheaper than equity, owing to its carrying a lower risk in that payment of interest on debt and usually repayment of principal (say in a breaking up of the company) takes precedence over equity dividends or repayment.

Proposition III
This provides a rule for optimal investment policy by the firm: ‘The cut-off point for investment in the firm will in all cases be [the average cost of capital] and will be completely unaffected by the type of security used to finance the investment’. So, if the first two propositions hold, the cut-off rate used to evaluate investments will not be affected by the type of funding used to finance them, whatever may be the capital structure. The gain from using debt (at lower cost) is offset by the increased cost of equity (due to increased risk) and WACC therefore remains constant. In order to maximise equity holders’ wealth, the company should therefore use its WACC as a cutoff rate. These arguments are not easy to grasp for students coming fresh to the subject. To help your understanding, here is how Propositions I and II are stated in a standard text on this subject (Fundamentals of Corporate Finance by Brealey, Myers and Marcus):
‘[MM’s] famous “Proposition I” states that a firm cannot change the total value of its securities just by splitting its cash flows into different streams: the firm’s value is determined by its real assets, not by the securities it issues. Thus, capital structure is irrelevant as long as the firm’s investment decisions are taken as given.’ ‘This is MM’s Proposition II: The expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio (D/E), expressed in market values; the rate of increase depends on the
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Figure 4.3

MM’s gearing propositions without tax

spread between rA, the expected rate of return on a portfolio of all the firm’s securities, and rD, the expected return on the debt. Note that rE rA if the firm has no debt.’

The equation for this theory (without tax) is: Vg keg WACCg where Vg value of geared company. Vug value of ungeared company. keg cost of equity in geared company keu cost of equity in ungeared company kd cost of debt (gross of tax).
Example 4.E
X plc is identical in all operating and risk characteristics to Y plc, except that X plc is all equity financed and Y plc is financed by equity valued at £2.1m and debt valued at £0.9m based on market values. The interest paid on Y plc’s debt is £72,000 per annum, and it pays a dividend to shareholders of £378,000 per annum. X plc pays an annual dividend of £450,000.

Vug keu (D/E )(keu WACCug

kd)

Requirements
(i) (ii) (iii) (iv) (v) Identify the value of X plc. Calculate the cost of capital for X plc. Calculate the cost of equity for Y plc. Calculate the cost of debt for Y plc. Calculate the weighted average cost of capital for Y plc.

Solution
(i)

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Vug (ii) keu (iii) keg Vg £2.1m £0.9m £3.0m 15%

Dividend E keu 15%

450 3,000 kd)

0.15

(D/E)(keu

900 (15 2,100

8)

18%

Alternatively, keg Dividend E Interest D kd 378 2,100 72 900 D D E 0.18 18% .

(iv) kd

0.08

8%

(v) WACCg

keg

E D E 0.18 WACCug. 2,100 3,000

0.08 450 3,000

900 3,000 15%

Note from Figure 4.3 that at the higher levels of gearing, there is the apparent paradox of cost of equity falling and cost of debt rising. This is explained by the selling of equity by existing shareholders who are relatively risk-averse to other investors who are prepared to take much higher risks for the possibility of a high return; the effect is to reduce the cost of equity while the cost of debt, now perceived by its holders as being increasingly risky, will rise. In 1963, MM accepted that corporate taxation could indeed have a distorting effect in that as a result of debt interest being deductible before computing taxation, WACC would continuously decrease as additional amounts of debt were incorporated into the company’s capital structure. This is illustrated in Figure 4.4. The equation for this theory (with tax) is: Vg Vug TB

Figure 4.4
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153 CAPITAL STRUCTURE AND COST OF CAPITAL

k eg WACCg or WACCg where Vg Vug TB Veg keg keu kd E D

keu

(1

t) D (keu E TB D E

kd)

WACCug 1

keg

E D E

kd(1

t)

D D E

value of geared company value of ungeared company present value of tax shield Vg D value of equity in a geared company cost of equity in geared company cost of equity in ungeared company cost of debt (gross of tax) market value of equity market value of debt.

For this proposition our assumptions change to allow for the inclusion of the debt tax relief at 33 per cent as follows. The value of Y plc now becomes:

Vg

Vug TB 3,000,000 (900,000 £ 3,297,000

0.33)

The value of equity for Y plc becomes Veg Vg D £3,297,000 £2,397,000

£900,000

The cost of equity for Y plc is now calculated as: keg keu (1 t) D (keu E kd)
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15% 15%

0.67 1.76%

900 (15% 2,397 16.76%.

8%)

The weighted average cost of capital now becomes: WACCg or WACCg keg E D E 2,397 3,297 kd(1 8% t) D D E 900 3,297 13.65%. WACCug 1 TB D E 15% 1 900 0.33 3,297 13.65%

16.76%

0.67

4.7.1 Limitations of MM theory
Apart from MM’s own recognition of a flaw in their basic theory as examined above, other limitations can be briefly mentioned as follows:
● ●

cost of capital is not likely to remain constant in the real world; personal and corporate leverage are seldom equivalent, for companies even of medium size are likely to have a higher credit rating than most individual investors. (This was allowed for in Miller’s and MM’s later work, but knowledge of this is not required for the Financial Strateg y syllabus.); most investors would face less risk if they allow a company with limited liability to borrow on their behalf; very high levels of gearing carry considerable dangers of corporate collapse.

4.8 Cost of capital and adjusted cost of capital
You should clearly understand the two concepts of cost of capital:

Opportunity cost of capital, r, is ‘the expected rate of return offered in capital markets by equivalent-risk assets’, depending on the risk of project cash flows. Use r where there are no significant side-effects from financing. Adjusted cost of capital, r *, is an opportunity cost rate which also reflects the financing side-effects of an investment project. If these are significant, use r * and accept projects having positive APVs (adjusted present values).

4.8.1 Adjusted present value
Cost of capital is the opportunity cost of capital and, as such, is frequently used as the discount rate in investment decisions. This is not entirely correct; the rate to be used in the investment decisions should, in theory, be a specific risk-adjusted discount rate which reflects the business risk of the project. This adjusted rate is the basis of the concept of adjusted present value (APV) which suggests that the net present value (NPV) of a project can be increased or decreased by the side-effects of financing.
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You must be clear as to the difference between NPV and APV. Thus, in using APV you proceed by taking NPV as a first stage (‘base case NPV’), evaluating a project as if it was totally financed by equity, and then introduce APV as a second stage by making adjustments to the base case to allow for the side-effects of the intended method of financing. A simple example will serve to illustrate the basic idea.

Example 4.F
A project has a net present value of £50m (the ‘base case’ NPV). However, as the project is considered socially desirable it qualifies for an immediate tax-free government grant of £10m. This is a special financing arrangement and hence needs to be taken into account: APV NPV side-effect of financing £50m £10m £60m

More complicated examples could be found, for example to show how the tax benefits of debt interest might increase the base case NPV of a project. The issue costs would of course have the effect of decreasing base case NPV. Note that the calculation of APV usually takes the form of first calculating NPV as if the project financing was all by equity, and then incorporating adjustments to allow for the effects of the financing method to be actually used. Bear in mind that difficulties in using APV may arise either in determining the costs involved in the financing method to be used, or in finding a suitable cost of equity for the basic NPV calculation. Nevertheless, APV often has the advantage of being a more positive approach than making an arbitrary adjustment of the company’s cut-off rate. The APV approach also suggests that an adjusted cost of capital can be calculated to use as a discount rate in specific circumstances.

Example 4.G – APV and adjusted cost of capital calculations
A project requires £1m capital investment. The project will save £220,000 per year after taxes. Assume the savings are in perpetuity. The business risk of the venture requires a 20 per cent discount rate. In this case the project’s base case NPV is just positive: Base case NPV 1,000,000 220,000 0.2 £100,000

However, assume this project has one financial side-effect, it expands the firm’s borrowing power by £400,000. The project lasts indefinitely so we treat it as supporting perpetual (i.e. undated) debt. If we assume the borrowing rate is 14 per cent and the net tax shield is 35 per cent, the project supports debt which generates an interest tax shield of: 0.35 0.14 £400,000

which is £19,600 per annum for ever. The PV of the tax shield is: 19,600 0.14 £140,000

The project’s APV is therefore: APV Base case NPV TB £100,000 £140,000 £240,000
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Adjusted discount rate The adjusted discount rate, or adjusted cost of capital, is the rate at which the APV 0; that is, the IRR. To calculate the adjusted discount rate we must first calculate the minimum acceptable annual income (i.e. the annual income that would result in an APV of zero). APV Base case NPV TB Initial investment Annual income/Base case discount rate £1m Annual income/0.2 £140,000 0, we can rearrange the equation to give: 0.2 (£1m £172,000 £140,000)

TB

Assuming APV

Min. annual income

The minimum IRR is therefore: IRR Minimum annual income/initial investment (gross) £172,000/£1m 0.172 or 17.2% This is the adjusted cost of capital – denoted r*. To calculate r* we find the minimum acceptable rate of return – the IRR at which APV The rule is, accept projects which have a positive NPV at the adjusted cost of capital. 0.

The adjusted cost of capital is significant in that it separates out the financial side-effects of an investment project, while the marginal cut-off rate is useful in the case of projects whose financing may create significant variations in gearing, or create a markedly different risk profile from that of the existing company.

4.8.2 Adjusted cost of capital – Modigliani and Miller
Modigliani and Miller demonstrated that the adjusted cost of capital (r *) may be calculated from the formula: r * r(1 T *L) where the opportunity cost of capital the rate of corporation tax the project’s marginal contribution to the firm’s debt capacity as a proportion of the firm’s present value The formula may also be expressed as: kg keu(1 T *L) r T* L where kg keu the average cost of capital in a geared company the cost of equity in an ungeared company.

Example 4.H
A project requires £1m capital investment. The project will save £220,000 per year after taxes in perpetuity, and will expand the firm’s borrowing power by £400,000. The business risk of the venture requires a 20 per cent discount rate. The rate of corporation tax is 35 per cent. Calculate the adjusted cost of capital using Modigliani and Miller’s formula.
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157 CAPITAL STRUCTURE AND COST OF CAPITAL

Solution
r* where r T* L r* 20% 35% 400,000/1,000,000 0.2(1 0.35 0.4) 0.2 0.86 0.172 17.2%. r(1 T *L)

40%

Notice that this is the same figure as calculated using the same raw data in Example 4.G. However, this was because the project was assumed to generate savings in perpetuity, and the level of gearing is assumed to remain the same.

4.9 Risk and reward
Another major topic in finance theory concerns the relationship between risk and reward. The conventional wisdom is that investors (as distinct from gamblers who bet on football matches or horses, and customers of lotteries) are risk averse. Specifically, it is said that the higher the risk they associate with a particular investment, the higher the return they will demand. Figure 4.5 portrays the general relationship. For all practical purposes, ‘risk’ in the context of investment means uncertainty as to outcome. While it is legitimate to seek the truth about the past, any projections of the future need to recognise a margin of error. Although intuition may suggest that additional risk should be rewarded with additional return, we need to be able to define and measure return and risk in order to quantify the additional return required for each additional unit of risk. The measurement of return must be related to a time period. The return from a share over any given time period can be quantified as: r where r P1 P0 d return from the share during the period value of the share at the end of the period value of the share at the beginning of the period dividend received in the period. P1 P0 P0 d

Figure 4.5

Risk and reward
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Figure 4.6

Risk assessment of two shares

This equation can also be written as: d P0 P0 which shows that the return from a share is represented by a capital gain (or loss) plus the dividend (measured as dividend yield). The return from a share could be quoted either as a historical return based on actual data, or as an expected return based on subjective probabilities. Assuming that a dividend of 20p was paid during a period on a share whose price was 80p at the start of the period and 90p at the end, the historical return would be calculated as: r r 90 80 80 20 90 80 80 20 80 0.125 0.25 0.375 or 37.5%. P1 P0

The total return here comprised a capital gain of 12.5 per cent and a dividend yield of 25 per cent. Quantifying an expected return for the next period is more difficult as both the dividend and the share price at the end of the period will need to be estimated. It is usually assumed that any share will have a range of possible returns that are distributed symmetrically about the expected return. The risk of a share is usually expressed as a measure of the dispersion of the possible returns about the expected return. The measure of dispersion that tends to be used is the standard deviation, or the variance. As shown in Figure 4.6 if two shares X and Y offer the same expected return, risk-averse investors would prefer share X as the possible returns are less widely dispersed about the expected return than with share Y. Share Y is a riskier investment than share X.

4.10 Portfolio theory
As long ago as 1952, H M Markowitz explained how in an efficient market a rational riskaverse investor could achieve a more efficient investment by holding a combination (or portfolio) of shares. When shares are held together, the expected return on the portfolio is simply the weighted average of the individual expected returns. The risk of the portfolio, however, depends on the correlation between the expected returns of each pair of shares in the portfolio.
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Figure 4.7

Risk–return profiles for differing correlation coefficients – the two-asset case

The coefficient of correlation provides a measure of the strength of the relationship between the expected returns of two securities. The coefficient of correlation can vary between values of 1 and 1. If the expected returns of two securities are perfectly positively correlated ( 1), this would indicate that the expected returns will move in the same direction in the same proportion at all times. With perfect negative correlation ( 1), the expected returns on the two securities will move in the opposite direction in the same magnitude at all times. A portfolio of shares will not diversify risk if the returns on the shares within the portfolio are highly correlated. If correlation is low, the portfolio will be highly diversified and the risk much less, that is, if the return on a particular share is poor, this will be compensated by a good return from another share. Suppose, for example, that there was a perfect positive correlation between two securities (X and Y) that comprise the market. In other words, high and low returns always move in sympathy. It would pay the investor to place all funds in whichever security yields the higher return at the time. The straight line XY in Figure 4.7 represents the possible combinations of securities X and Y assuming the coefficient of correlation between the two securities is 1. Under this assumption there is a linear relationship between expected return and risk. If, however, there was perfect negative correlation (i.e. a high rate of return on X was always associated with a low return on Y and vice versa) or there was random (zero) correlation between the returns, then it can be shown statistically that overall risk reduction can be achieved by diversification. The triangle XYV in Figure 4.7 shows the full range of possible combinations of securities X and Y for all possible levels of correlation between the two securities. The diagram shows that as long as the correlation between the securities is less than perfect positive ( 1), then the risk of the portfolio as measured by standard deviation would be lower than the weighted average of its constituent elements. The greatest reduction of risk would be where the returns of securities X and Y show perfect negative correlation ( 1). The lines XV and VY contain all combinations of securities X and Y under this assumption, where at point V it is possible to construct a portfolio with zero risk. Portfolios will usually consist of more than two securities and the benefits of diversification are likely to increase as more securities are introduced to the portfolio. Most securities are likely to have a positive correlation with other securities. As long as this positive correlation between securities is less than perfect, the scope for risk reduction and the creation of more efficient portfolios increases.
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Figure 4.8

Efficient frontier of risky investments

Figure 4.9

Determination of an optimum portfolio

An efficient portfolio is one that satisfies two conditions relative to any other combination of financial assets, namely: (i) maximum expected return for its given risk; (ii) minimum risk for its given expected return; where the expected return and risk are measured by the arithmetic mean and standard deviation of the portfolio. At any point in time there will be a number of portfolios that satisfy the conditions as shown in Figure 4.8. Figure 4.8 represents all the securities and so all possible combinations of those securities for a particular market. The most desirable portfolios have been emphasised, lying on the curve XY which is referred to as the efficient frontier. These are the portfolios that offer the highest return for a given level of risk, or the lowest risk for a given level of return. The efficient frontier XY of risky portfolios reveals that to the right and below, alternative investments yield inferior results. To the left, no possibilities exist. Individual investors will have different preferences from this range of efficient portfolios, depending on their attitude to risk and expected return. This personal attitude to risk and expected return could be represented by an indifference curve. An optimum portfolio for an investor can be determined at the point where the individual’s utility indifference curve (calibrating an attitude towards risk and expected return) is tangential to the efficient frontier. The indifference curve for a particular investor is shown in Figure 4.9. The optimum portfolio for this investor is at the tangential point E
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to the efficient frontier. This investor is willing to take relatively high risks to earn high returns. Other investors may be more risk averse. Introducing the possibility that investors can lend and borrow at a risk-free rate of interest leads to the conclusion that there would now be only one portfolio of risky securities that would be of interest to all investors, regardless of their individual attitudes to risk and return. As an alternative to the optimal wholly risky portfolio, investors may opt for: (i) a risk-free selection of short- to medium-term government securities; (ii) a mixed portfolio comprising any combination of risky and risk-free investments. These possibilities are portrayed in Figure 4.10, where M represents the optimal wholly risky portfolio, A denotes the risk-free portfolio and the line AB (which can be infinitely extended) represents the capital market line (CML) showing the boundary of efficient mixed portfolios.

Figure 4.10 The capital market line

Since M denotes a wholly risky portfolio, the line AM represents increasing proportions of portfolio M combined with a reducing balance of lending at the risk-free rate. The line beyond M can only represent opportunities for borrowing at the risk-free rate in order to increase the size, but not the composition, of the optimal portfolio. By ‘leveraging’ (borrowing against) the investment, the investor’s risk would rise but so would the return. Thus, if all investors can borrow or lend at the same rate of interest, Tobin concluded that they all ought to choose the same optimal portfolio, irrespective of their attitude to risk, by first finding the point of tangency (M) and then borrowing or lending to adjust the balance between risk and return. By definition, portfolio M is the market portfolio of all risky securities available on the market, as it is the only wholly risky portfolio that is of interest to investors. The linear relationship between risk and expected returns shown in Figure 4.10 applies to all efficient portfolios. Unfortunately, it does not hold for individual risky investments, since securities with higher standard deviations may have lower returns and vice versa. An objective of portfolio diversification, therefore, is to achieve an overall standard deviation lower than that of its component parts.

4.10.1 Systematic risk and unsystematic risk
Other things being equal, if the standard deviation of an individual security is higher than that for a portfolio in which it is held, then part of the standard deviation must have been
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Figure 4.11 Portfolio risk and diversification

diversified away through correlation with other constituents, leaving only that portion of risk that is correlated with the economy as a whole. The latter portion of risk is inescapable (undiversifiable or systematic) and is the only risk that investors will pay a premium for. There emerged an academic consensus that the two elements of total risk associated with an investment were systematic or market risk (also known as beta, or non-specific risk) and unsystematic or non-market (alpha or specific) risk, which may or may not be correlated with other securities. Systematic risk affects the market as a whole and may be described as a portfolio’s inherent sensitivity to world political and economic events, a particularly good example being the collapse of the European Exchange Rate Mechanism (ERM) and the currency devaluations of 17 September 1992. Unsystematic risk relates to an individual security’s price and is independent of systematic risk. Specific to individual companies, it is caused by factors such as profitability, product innovation, management and, of increasing importance recently, law suits, consequential upon the paucity of published accounting data. Although neither element of risk can be observed directly, Figure 4.11 highlights the empirical fact that up to 95 per cent of unsystematic risk can be diversified away by randomly increasing the number of securities in a portfolio to about 30. When it approaches the composition of the market, virtually all the risk associated with holding that portfolio becomes systematic or market risk. It is not surprising, therefore, that practising fund managers requiring a far simpler model than that offered by Markowitz to enable them to diversify efficiently, as they invested across innumerable securities, sectors and countries, were quick to appreciate the utility of the relationship between the systematic risk of either a stock or a portfolio and their returns. But how to measure such risk and how to choose the efficient portfolio? This is the subject of the next section: the capital asset pricing model (CAPM).

4.11 The capital asset pricing model
In the previous section we saw that risk could be reduced by investing in a portfolio of securities. The total risk involved in any one investment is the sum of the impact of all the risk that might affect the return on a specific investment. The CAPM would argue that investors do not need to suffer the total risk inherent with individual investments as this could be reduced by holding a diversity of investments within a portfolio. The return from
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Figure 4.12 Elements of total risk

Figure 4.13 Risk reduction through diversification

a single investment in an ice-cream company will be subject to changes in the weather – sunny weather producing good returns, cold weather poor returns. By itself the investment could be considered a high risk. If a second investment were made in an umbrella company, which is also subject to weather changes, but in the opposite way, then the return from the portfolio of the two investments will have a much-reduced risk level. This process is known as diversification, and when continued can reduce portfolio risk to a minimum. The CAPM argues that total risk, as measured by standard deviation, can be split into two elements: the risk that can be reduced by diversification, known as specific risk, and the risk that will not be reduced by diversification, known as market risk. Market risk can be broken down further, as shown in Figure 4.12. The risk that can be removed through diversification – specific risk – is that risk that is specific to the individual investment. For example, if you had a single investment of ordinary shares in a company that built houses, the specific risks would include particular planning applications, subsidence problems, non-payment by particular customers, etc. Market risk. Market risk is associated with the economic environment in which all companies operate, so changes in interest rates, exchange rates, prices, taxation, etc., affect all companies and their share prices to a greater or a lesser extent. Because investors can avoid specific risk through diversification, the CAPM would argue that the only risk worthy of consideration is market risk. This market risk is measured as a beta value. Business risk. Business risk is the risk associated with the particular activities undertaken by the enterprise. Financial risk. Financial risk is the risk resulting from the existence of debt in the financing structure of the enterprise. If individual investors wish to hold a single investment, such as the building company ordinary shares, or a poorly diversified portfolio, then the market will not offer a compensation for suffering the specific risk associated with such a limited portfolio. As specific risk can be diversified away, (Figure 4.13), securities will be priced by reference to their market
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risk only. Securities with high market risk will have required returns above the market rate, while those with low market risk will have lower rates of return. In the following section we consider how the market risk, or beta, for a security may be measured.

4.11.1 Measuring beta values
If the price of a selected security increases when the market rises, then statistical measurements are still needed to identify how much of the security price increase occurred because of systematic (market) and unsystematic (specific) risk respectively. In the UK, prior to the introduction of the FT-SE100 share price index, the obvious procedure was to compare movements in an individual share price with movements in the market using the FT All-Share Index. A scatter diagram was plotted over a period of time correlating percentage movements in: (i) market prices as measured by the index (on the horizontal axis); (ii) the selected share price (on the vertical axis). The line of ‘best fit’ for the observations could then be determined by regressing stock prices against the overall market over time using the method of least squares. This linear regression line is known as the share’s ‘characteristic line’. As Figure 4.14 reveals, the intercept of the line on the vertical axis measures the average percentage movement in the share price occurring if there is no movement in the market and is called the alpha of the stock. A positive alpha over the period of observation indicates a share which has outperformed the market. The slope of the regression line in relation to the horizontal axis is the beta factor. It reveals the volatility of share price to market movements in terms of the ratio of expected change in the price of the stock to the market itself. Although alpha varies considerably over time, studies in the 1970s (e.g. Black, Jensen and Scholes, 1972) showed that beta values are more stable, displaying a near straight-line relationship with their returns. While this relationship is less than certain today, beta values are still valuable for portfolio selection. Fund managers can tailor a portfolio to their specific risk return (utility) requirements, aiming to hold securities with beta factors in excess of unity (one) while the market is rising, and less than unity when the market is falling. A beta of 1.15, for example, implies that if the underlying market with a beta factor of one

Figure 4.14 The relationship between security price and market movements – the characteristic line
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were to rise by 10 per cent, then the stock may be expected to rise by 11.5 per cent. The market portfolio has a beta of one because the covariance of the market portfolio with itself is identical to the variance of the market portfolio. Needless to say, a risk-free investment has a beta of zero because its covariance with the market is zero. Whereas the linear relationship between portfolio risk and expected returns (the CML) does not hold for individual risky investments, all the characteristics of beta apply to portfolios, as well as to individual securities. The beta of a portfolio is simply the weighted average of the beta factors of its constituents. Using the seminal capital asset pricing model (CAPM) developed independently by Sharpe (1963), the attraction of this relationship becomes clear if the CML is, therefore, reconstructed to form what Sharpe termed the security market line (SML) by substituting systematic (market) risk for total risk on the horizontal axis. Since beta factors can be calculated, the CAPM provides a usable measure of risk. It also implies that the optimum portfolio is the market portfolio. Because the return on a share depends on whether it follows market prices as a whole, the closer the correlation between a share and the market index, the greater will be its expected return. Finally, the CAPM predicts that shares or portfolios with higher beta values will have higher returns.

4.11.2 The security market line
As Figure 4.15 confirms, the expected risk-rate return of E (R m ) from a balanced market portfolio (M) will correspond to a beta value of one, since the portfolio cannot be more or less risky than the market as a whole. The expected return on risk-free investment (Rf) remains unchanged with a beta value of zero. Portfolio A (or anywhere on the line Rf M) is termed a ‘lending’ portfolio and consists of a mixture of risky and risk-free securities. Portfolio B is a ‘borrowing’ or leveraged portfolio, because beyond (M), additional securities are purchased by borrowing at the risk-free rate of interest. Proceeding one stage further, the Sharpe single index CAPM can now be utilised in order to establish whether individual securities are under- or overpriced (hence its name), since their expected rates of return and beta factors can be compared with the SML. For example, stock (X) might have an expected return of 8 per cent and a beta coefficient of 0.5. Superimposed on Figure 4.15 (see Figure 4.16), this would reveal that the

Figure 4.15

The security market line
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Figure 4.16 The capital asset pricing model

return was too low for the risk involved and that the share was overpriced, since (X) is located below the SML. Consequently, rational shareholders would sell their holdings, eliciting a fall in price, while potential investors would delay purchase until the price had fallen and the increased yield (A) impinged upon the SML. Given a market return of 16 per cent from a balanced portfolio and a risk-free rate of 6 per cent, Figure 4.16 illustrates why the required rate of return with a beta value of 0.5 should be 11 per cent. This may be confirmed by Sharpe’s formula for the expected return of a portfolio or individual security. This comprises a risk-free return, plus a premium for accepting market risk and assumes all correctly priced securities will lie on the SML. Thus Expected return risk-free rate (beta (market rate risk-free rate)) As expressed in CIMA’s formula sheet: Expected return Rf (R m R f)

Example 4.I
Assuming a market return of 16 per cent and a risk-free rate of return of 6 per cent, calculate the required rate of return for a share with a beta value of 0.5.

Solution
Required return: r = Rf + (Rm Rf) 0.06 0.5(0.16 0.11 11% 0.06)

It is also clear from Figure 4.16 why investment in security (Y) is beneficial. Stocks above the line will be in great demand; they will rise in price. Thus, it seems reasonable to conclude that in theoretical equilibrium, all securities or portfolios will lie on the SML and individual investors need not conform to the market portfolio. They need only determine how much systematic risk they wish to assume, leaving market forces to ensure that any security can be expected to yield the appropriate return for its beta.
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4.12 Using the CAPM as an investment tool
Beta ( ) is a measure of responsiveness of the returns for a particular investment when compared to the average market return, as summarised in the Financial Times All-share Index. If the average market return moves up or down by (say) 10 per cent and the returns for a particular investment also move up and down by 10 per cent in parallel with market movements, then that investment is said to have a beta of 1.0 (10% 10%). Such an investment shadows market movements and has identical risk on the market as a whole. If the average market return moves up or down by (say) 20 per cent and the returns for a particular investment move up and down by 15 per cent, then that investment is said to have a beta of 0.75 (15% 20%). Such an investment is less risky than the market because it softens the impact of changes in market returns. The three key variables – Rf, Rm and – can be quantified from data available from the market. The beta for a particular investment is available from the London Business School Risk Analysis Service, which provides betas and other data on all quoted UK company shares. The risk-free rate of interest (Rf) is the expected rate for short-term government securities. The average return to the market (Rm) can be calculated from the Financial Times Actuaries All-share Index. If an investor was considering an investment in a company whose quoted ordinary shares had a beta of 1.12 with the 3-month Treasury bill rate currently at 12 per cent and the average market return being 20 per cent, then the expected return from such an investment would be: Er Rf (Rm Rf) 12%)

12%+1.12 (20% 20.96%

Just as returns for individual securities may be calculated using betas, then a similar approach can be adopted for a portfolio of investments.

Example 4.J
A pension fund manager holds a highly diverse portfolio of investments on behalf of her members and is considering adding the following ordinary share investments to the portfolio: Investment BTR Tesco RTZ British Petroleum Quoted beta 1.14 0.83 1.15 0.83

At first sight these investments seem to represent a broad spread of risk, with betas above and below the average market risk of 1.0. Before any realistic risk measure can be evaluated the proportions of new investment monies allocated to each investment must be considered. If the fund manager were to invest new moneys in the following proportions: Investment BTR Tesco RTZ British Petroleum Proportion (%) 20 25 20 35

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then the risk associated with the new investments should be given by the weighted average beta, as follows: Investment (all ordinary shares) BTR Tesco RTZ British Petroleum Percentage of portfolio 20 25 20 135 100 Beta of investment 1.14 0.83 1.15 0.83 Weighted average 0.228 0.208 0.230 0.291 Beta 0.957

The new investments with an average beta of 0.957 may be described as defensive, as they represent a mini-portfolio with less risk than the market. The portfolio manager may use this information to assess the wisdom of the new investments. For example, if the fund manager wished to hold a portfolio with an average beta of 1.0 and the existing portfolio already had an average beta greater than 1.0, then this selection may be suitable.

4.13 MM, CAPM and geared betas
Students should note that CAPM to an extent follows Modigliani and Miller (MM) theory in that, based on the arbitrage process, two similar assets cannot sell at different prices. Earlier in this chapter it was shown that, by assuming a tax-free world, MM identified the relationship between the required return on the equity of a geared company and that of an ungeared company. This links with the relationship between the equity beta of a geared company and the equity beta of an ungeared company in the same systematic risk class. This relationship is given by:
G U

(

U

D)

D E

equity beta of a geared company; U equity beta of an ungeared company; beta of debt; E market value of equity in geared company; D market value of D debt in geared company; it also assumes a tax-free environment. Although CAPM and MM theory are based on a number of similar assumptions, CAPM is strictly speaking a single-period model, while MM theory is a multi-period model which assumes that the cash flows to an enterprise are constant to perpetuity. Betas have an affinity with MM theory and provide one means of measuring rates of return, with responses to changes in gearing in the manner predicted by MM. where
G

4.13.1 Ungearing beta
Let us now extend the model to show the relationships between companies, both geared G) and ungeared ( U), and the projects of which these companies consist ( A). We shall assume that ke, the expected return on projects, should be related to the return required by investors. We shall use a square balance sheet to illustrate the approach. The square balance sheet shows the financing of a business or project on the left-hand side, while the right-hand side reflects how the financing has been applied by way of net assets. This is illustrated below for an all-equity-financed company, investing in a single project (A): (

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where E market value of equity; U equity beta in ungeared company; A beta of the activity (project beta). Note that, in many textbooks, A is called the asset beta. ‘Activity’ seems a more appropriate term, but A is used in exactly the same way as in other texts. The risk of the equity as measured by beta ( U) will relate to the risk of the activity as measured by beta ( A) so that:
U A

Equation 1
A(R m

Using CAPM, the required rate of return on project (kA) is then calculated as: kA rf Rf ) The beta of the activity is a measure of the activity’s systematic business risk. It can only be measured directly in a quoted all-equity-financed company. For other companies we may have to estimate activity betas by using figures from similar quoted companies, or calculate the activity beta from the betas of the equity and debt. We shall begin by considering a company that has invested in a number of projects. The assets on the right-hand side of our square balance sheet may be analysed into a number of identifiable projects. Each project will have its own beta, and the beta of the company is determined by these projects.

If there is no debt, the company’s equity beta will be the weighted average of the project betas (equals A):
A

wi

i

U

where wi weighting of individual project based on market values; i beta of individual project or activity. If there is debt, this will be modified by the financial risk inherent in raising debt. The left-hand side of our square balance sheet may now be analysed between equity and debt:

The activity beta will now be related to the equity beta and the debt beta, so that the activity beta becomes the weighted average of the equity and debt betas: A weighted average: where G of equity.
A D

D D E

G

E D E

Equation 2 market value

equity beta in geared company; D

market value of debt; E

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With tax, this becomes: D(1 t ) A D D(1 t ) E

G

D(1

E t)

E

where t corporation tax rate. A can be used then to evaluate projects before considering the method of financing, that is, it is the business risk that is important. kA rf
A(R m

Rf )

Remember from Equation 1 that u A, so that: D(1 t) E u D G D(1 t) E D(1 t) E and ku
f u(Rm

Rf)

4.13.2 Geared equity beta
We can now show the relationship between the equity beta in a geared company and the equity beta of an ungeared company in the same systematic-risk class:
A U D

D D E

G

E D E

(ignoring tax)

Rearranging:
U(D GE

E) UD

DD UE

GE DD

Divide through by E:
U U

D E
U

U

D

D E
D)

G

(

U

D Ungearing beta E

Systematic business risk

Systematic financial risk (premium)

This links in with the Modigliani and Miller hypothesis on capital structure (see Section 4.7) where the cost of equity in a geared company (keg) was shown as: keg keu (keu kd) D. E

The effect of the tax shield effect of debt can be introduced to give:
G U

(

U

D)(1

t )D E

from: keg

keu

(1

t )(keu

kd)D E

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Example 4.K
Ashton plc is identical in all operating and risk characteristics to Gate plc, except that Ashton plc is all-equity financed and Gate plc is financed by equity and debt in the proportion 75 : 25 at market valuation. The beta factor of Ashton plc is 0.9. Gate plc’s debt capital is virtually risk-free, and corporation tax is levied at the rate of 33 per cent.

Requirement
Calculate the equity beta of Gate plc and the cost of equity for the company.

Solution

G

U

(

U

D)(1

t)

D E

but debt is assumed risk-free so:
G U U(1

t)

D E 25 75

G

0.9 0.9

(0.9)(0.67) 0.201

G

1.101

Alternatively:
A D

D(1 t) D(1 t) E

G

D(1

E t)

E

As

D

0:
A G

D(1 25(1

E t)

E 75 0.33) 75

0.9
G

G

1.101

The cost of equity may then be calculated as: keg rf 6
G(Rm

Rf) 6)

1.101(12

12.606%

4.14 Use of CAPM in investment appraisal
If we use CAPM as a means of project appraisal, we are in effect substituting an investment project for an investment in a share. The workings of the concept are similar, the purpose being to obtain an appropriate cost of capital for the project.

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We can proceed as follows: 1. Obtain the beta of an industry which relates as closely as possible to our own project, that is, with similar systematic risk characteristics, and use this beta to obtain the cost of capital using the CAPM formula. 2. A more exact method would be to obtain the betas of a few companies within that related industry and proceed as follows: (i) convert those betas to allow for our own company’s gearing level, that is, its relationship of debt to equity, by first ungearing the betas and then converting them back to geared betas which reflect our own company’s gearing ratio; (ii) average these new geared betas, possibly excluding any which seem unduly far from the mean, that is, where their standard deviation seems excessive; (iii) as a further step we could give weights to the new geared betas in relation to the closeness which we judge their companies to be in relation to our project, before averaging them; (iv) having obtained a new average geared beta, we obtain a cost of capital using the CAPM formula. These procedures could provide useful tools to employ, preferably in conjunction with other appropriate methods, in appraising an acquisition as well as a major project.

4.14.1 Limitations of CAP-M
The main limitations of using CAP-M to obtain the cost of capital (discount rate) to a appraise an investment project are:

● ●

CAP-M is a single-period model, so the discount rate calculated may not be appropriate for the whole life of the project. CAP-M assumes only systematic risk needs to be captured as unsystematic risk has been diversified away. CAP-M assumes that risk can be encapsulated in a single figure (beta). Close comparison with a proxy company is difficult as it assumes close similarity of activities and business risk.

4.15 Arbitrage pricing model
The CAPM provides a simple relationship between risk and return, such that the expected return of an asset is equal to the risk-free rate of return plus a risk premium. That risk premium is determined by beta ( ), which represents the asset’s systematic risk relative to the systematic risk of the market. Arbitrage pricing theory (APT), developed in 1976 by S. Ross, attempts to explain the risk–return relationship using several independent factors rather than a single index. APT may be expressed as: E(ke) where E(Ke)
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1 1

2

2

n

n

required return on an asset

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173 CAPITAL STRUCTURE AND COST OF CAPITAL

rf

risk-free rate of return the ‘market price’ for each risk factor, that is, the difference between the actual and expected value of each factor sensitivity of the asset’s returns to changes in the values of each factor

Research undertaken to date suggests that there are a small number of factors, or economic forces, that systematically affect the returns on assets. These are:
● ● ● ● ● ●

inflation or deflation; long-run growth in profitability in the economy; industrial production; term structure of interest rates; default premium on bonds; price of oil.

Each factor must be independent of the other factors. APT assumes that the process of arbitrage would ensure that two assets offering identical returns and risks will sell for the same price. Intuitively, APT appears to improve on CAPM, as return is determined by a number of independent factors. The main practical difficulties are in determining what those factors are, as the model does not specify them, and forecasting their value. There have been few tests of APT, probably because of the difficulties in determining which variables to include in the model and how to weight them.

4.16 Summary
In this chapter we have considered the implications of using debt in the capital structure. The main argument for gearing is that, by introducing debt, the interest payments attract tax relief. Against this, debt also introduces financial risk into a company. These factors call for the financial manager to formulate a policy that will effectively balance out their opposing effects. We examined methods of assessing the costs of equity, preference shares and debt finance and explored the impact that capital structure has on the overall cost of capital for an organisation as measured by the weighted average cost of capital. We also saw that the marginal cost of capital is useful in the case of projects whose financing may create significant variations in gearing, or create a markedly different risk profile from that of the existing company. The impact of changing capital structures on the cost of capital was outlined before investigating the relationship between risk and reward. Portfolio theory helps towards a better understanding of the risk–reward relationship, especially as to the way it affects the investor in shares. Investors are assumed to evaluate portfolios from their expected return and standard deviation. The expected return of a portfolio is the weighted average of the expected returns of the individual securities, whereas the risk or standard deviation is dependent on the correlation of returns between each pair of securities. A key aspect of portfolio theory is the concept derived from Markowitz that an efficient portfolio either offers the highest return for a given level of risk or has the lowest risk for a given level of return. From efficient frontiers and investor indifference curves emerged the capital market line (CML), with the conclusion that, with the opportunity to borrow and
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lend at the risk-free rate of interest, all investors will invest in a portfolio located on the CML. Portfolios on the CML will comprise the market portfolio of wholly risky securities with either lending or borrowing at the risk-free rate of interest. As the number of securities held in the portfolio is increased, the risk relating to individual securities (unsystematic or specific risk) can be eliminated but market (systematic) risk cannot be diversified away. The capital asset pricing model (CAPM) provides a useful decision-making framework for investors, by providing a measure for risk that can be quantified and operationalised by them. Like any economic model it is based on a series of assumptions, but empirical research suggests that the CAPM is both robust and durable for investment decisions in the real world, if investors hold diverse portfolios. You must make sure that you understand and can distinguish between the two key elements of CAPM share evaluation – specific risk and market risk. You must also be aware that significant controversy exists over the effectiveness of the concept, and the problems of using CAPM need to be clearly appreciated.

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Readings

4

In the following article, the author argues that CAPM provides a useful, simple and practically applicable approach to investment appraisal in risky environments.

The usefulness of beta in the investment appraisal process
Alan Gregory, Management Accounting, January 1990. Reproduced with permission.

In a recent article, John Fielding argued that ‘most finance directors cannot be sure that the beta of their company is different from l’ and then went on to draw the conclusions that (a) the cost of equity for most companies was very close to 18 per cent, (b) the company accountant would find it difficult to explain to ‘a sceptical chairman that total risk is unimportant in assessing the riskiness of a project’ and (c) most treasurers or accountants should not spend too much time estimating their precise cost of equity, since ‘an estimate of 18 per cent won’t be too far out’. The purpose of this article is to examine these claims, and to explain why the beta measure potentially offers a very useful input to the investment appraisal process.
Betas in the investment appraisal process

Fielding gives a useful description of the nature of systematic and specific risk. It must be emphasised, however, that studies have shown that investors are not rewarded for taking on specific risk but are rewarded for systematic risk. The theory (the capital asset pricing model or CAPM ) predicts that this will be the case because investors can freely diversify away specific risk but must accept systematic (market) risk as the cost of investing in risky assets. It is this systematic risk that is measured by beta, which can be viewed as an index with a mean value of 1. Practical studies have suggested that there is, indeed, a linear relationship between systematic risk and return, although the relationship is a little flatter than the CAPM predicts (see Figure 1 (left)). We shall return to this point later. Provided that the risk borne per period is constant, it can be argued that the CAPM (a single period model) can be used in the appraisal of capital investment. Broadly, the approach is to estimate a beta for the project, and use this in the CAPM to give a discount rate for use in the calculation of net present value (NPV). In practice, most firms using this approach would calculate a beta (and hence a discount rate) for each division or principal business activity rather than for each individual project, unless that project represented a major new venture.
175
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Figure 1 (Left): Theoretical v empirical risk-return trade-off. (Right): Using the WACC rejects Project A (which has a positive NPV at the correct discount rate) and accepts B (which has a negative NPV at the correct rate)

The most common method of estimating beta in practice is to use companies operating in the same businesses as the division or project in question as proxies; in outline, the beta of a portfolio of proxy companies is calculated (the beta of the portfolio is simply a weighted average of the individual betas) and this is then adjusted for gearing effects. A case study of the practical aspects of this approach is covered in the CIMA course on Advanced Investment Appraisal. Note the contrast of all this with John Fielding’s recommendations. First, weighted average cost of capital (WACC) is not used; given that most businesses cover more than one business activity, each of which may support different levels of gearing, the use of WACC is totally inappropriate and may lead to non-optimal decision making within the firm (see Figure 1 (right)). Secondly, if we are not using WACC, it is not our company’s beta which is of concern but the betas of companies operating in the same business as the division or project being analysed. In general, WACC can only be used where: 1. the company has one main line of business; 2. project cash flows are of approximately the same systematic risk as the company’s existing line of business; 3. gearing is expected to remain constant. A possible example of this type of situation would have been the case of Jaguar (before recent events) appraising new production line investment of a scale not requiring major new finance. (Although given Fielding’s suggested 18 per cent cost of capital, it is worth noting that Jaguar’s beta was 1.34 as measured by London Business School Risk Measurement Service [LBSRMS] in September.) Contrast this with the not untypical case of brewing companies with interests in the hotel and catering trade, who wish to appraise new projects in both business areas. If we exclude those brewers which already have substantial hotel interests, from the LBSRMS data, we find that their typical beta factors are around 0.7. By contrast hoteliers average slightly over 1.0. How important is this difference?
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Let us assume that we are appraising a project with a ten-year life. As at November 1989, ten-year gilt yields are around 10.5 per cent and LBS estimates that the long-run historical market risk premium (i.e. return of the market less the risk-free return) is around 9 per cent for the UK. A perusal of various economic forecasts might lead us to the somewhat crude assumption that the average inflation rate over the ten-year period might be 5 per cent. Thus a suitable discount rate for hotel projects would be given by the CAPM (which predicts that return should be the risk-free rate plus beta times the market risk premium) as 10.5 (1.0 9) 19.5 per cent (this contrasts with an 18 per cent return assumed by Fielding), whereas for brewing projects this discount rate should be only 10.5 (0.7 9) 16.8 per cent. In real terms, using the relationship (1 real rate) (1 money rate)/(1 inflation rate), we obtain real discount rates of 13.8 and 11.2 per cent respectively. Imagine that projects costing £10 m are available in both brewing and hotels, that the projected annual benefits are £1.8 m p.a. for ten years, and that this amount will increase in line with inflation. At the CAPM real discount rate of 13.8 per cent, the hotel project NPV is £0.54 m negative, whereas the brewing project shows a positive NPV of £0.51 m at a real discount rate of 11.2 per cent. (Note that in the case of a real project we would need to be much more rigorous in our estimate of betas, and take account of the impact of gearing. Taxation has also been ignored for simplicity. Nonetheless, there is no reason to suppose that the scale of the difference will change by much.) Compared to the project cost of £10 m, the difference between these NPVs appears significant. Doubtless the news that a 2.6 per cent change in money cost of capital can have a considerable impact will come as no surprise to either the CBI or those of us with mortgages.
Practical issues in using beta

Turning to Fielding’s point concerning the reliability of beta estimates, he notes that, for the majority of companies, beta is not statistically significantly different from 1.0. There are problems with his conclusion on this. For the reasons we discussed above, it is not the beta of our own company we are interested in but the beta of a portfolio of proxy companies. Fortunately, the standard error of a portfolio beta is always lower than the average of the standard errors of the individual betas. As an example, the beta of Blue Arrow plc is 1.36, with a standard error of 0.17, whereas the beta of the agencies sector in general is 1.39 with a standard error of 0.09. Thus we can be more confident in our estimated beta when we have a reasonable number of proxy companies in our portfolio. If we are particularly concerned about this point, we can estimate our betas by using a larger number of data points (for example, LBS tapes are available giving daily share and market returns) although, as Fielding correctly points out, there are a number of pitfalls here that can trap the unwary. Besides the empirical problem referred to above, these include mean reversion and ‘thin trading problems’, which are associated with smaller company shares (shares which are not frequently traded will appear to have betas which understate their ‘true’ systematic risk). The LBSRMS beta estimates do allow for such known problems. It is important that beta remains relatively stable over time if it is to be of any use in estimating a project discount rate. As we know that portfolio betas are more stable than individual company betas, we can again be more confident of our estimates if we are using a reasonable number of companies as proxies. However, we can check the beta to see if it is expected to change. For example, we would anticipate that a utility company like British Telecom would have a low beta; in fact it has a beta of 0.71, in line with expectations.
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If we knew that BT was about to take over BICC (which has a beta of 1.11) and was to finance this with a large increase in debt, we would expect BT’s beta to increase since (a) post takeover, BT would be a portfolio of the old BT and the old BICC and (b) highly geared companies should have higher betas than lowly geared companies, as their equity has a greater degree of systematic risk. It is also worth noting that in contrast to Fielding’s claims that modern portfolio theory ( MPT ) is regarded with suspicion by many analysts and finance directors, in the USA ‘portfolio managers in almost any large American investment institution use modern risk measurement to analyse their portfolio … the investment community spends over $200 m per annum on MPT services alone’ (LBSRMS). Furthermore, the CAPM approach to investment appraisal is now virtually standard fare on any MBA programme in both the US and the UK, and the demand for courses on MPT in the UK would suggest that British practice may be about to follow the American experience.
Alternative and supplementary approaches

This article should not be construed as unqualified support for the CAPM approach to the exclusion of all others. There are more sophisticated MPT-based approaches to risk analysis which may be of use in project appraisal. For example, one US study found four significant variables which drive security returns, which were an index of industrial production, changes in the default risk premium, twists in the yield curve and unanticipated inflation (this contrasts with the single parameter of ‘market risk premium’ in the CAPM). To use this in project appraisal would require estimates of all the parameters (including unanticipated inflation) and four beta estimates, each of which would need to remain relatively stable. There are no readily available data sources which provide such betas. In reality, companies will tend to look at total risk, although it is to be hoped that they will at least look at company-wide diversification effects; when doing so techniques such as sensitivity analysis and scenario modelling are useful inputs to the decision making process and can be recommended as supplementary to the CAPM approach. However, our ‘sceptical chairmen’ must be careful not to give too great an emphasis to total risk. It must be remembered that the market does not reward specific risk, and thus a company that attempts to ‘price’ this risk by building it into the appraisal process will tend to reject projects which ideally should have been accepted; such a company will tend to exhibit below average growth. ‘The market does have its own peculiar way of rewarding these companies;’ it’s known as a takeover bid. Of course, there is an exception to this rule of only pricing systematic risk, and that is where the shareholders are not fully diversified (thus contradicting one of the assumptions of the CAPM); the management of companies controlled by individuals or families would be concerned quite legitimately with total risk.
Conclusion

As we have shown, management should be concerned with the systematic risk of each business activity. In effect, the aim is to value each project as though it is a ‘mini company’ in its own right. Although it is not a perfect method and can usefully be supplemented by other methodologies, the CAPM offers a useful, simple and practically applicable approach to investment appraisal in risky environments, which has theoretical foundations. It would be unfortunate to reject it too readily.
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Discussion questions
1. ‘Betas have a tendency over time to revert to 1, low betas increasing and high betas decreasing.’ Why might this be? 2. Bearing in mind the admitted difficulties of calculating betas, how widespread is their use likely to be in practice? Is this an instance where the enthusiasm of academics is not matched among practitioners? Outline solutions 1. Betas are not easy to estimate in the first place. They are generally calculated over a long period of time (typically 60 months), using a form of regression to obtain a line of best fit. This means observations are included from periods that may no longer be representative of the company’s (or country’s) current economic or financial potential. The variation around the characteristic line can be very great, which also reduces the confidence we can place in the accuracy of beta as a measure of risk. A company’s risk profile may change over time. Smaller companies are generally believed to be riskier than large ones. As they grow, their risk therefore reduces and their beta will move closer to 1. The reverse may also be true. Large companies stagnate unless they constantly develop new markets and products. This dynamism introduces risk into what may have been a relatively safe business. 2. There are three main groups of users of betas: financial analysts, academic researchers and companies themselves. We are not concerned here with the the academic examination of company performance using betas, although, even with this group, their use has been more readily accepted in the USA than elsewhere. ● Analysts. Investment analysts can use beta to design portfolios to match risk preferences of their clients. The method can also be used to monitor the performance of a company or portfolio – but bear in mind that performance is related to what was predicted by theory. Analysts generally have a stronger background in quantitative techniques than company managers and are better able to handle the complicated statistics involved. It would be useful here to review some of the surveys done by the financial press on the performance of fund managers and decide for yourselves whether the use of sophisticated techniques have helped them make improved returns for their clients. ● Companies. Company managers could use beta and the CAPM to establish a cost of equity and subsequently a weighted average cost of capital. The problem here is that beta measures only market risk. Many company managers would argue that they are more concerned with total risk, unless their company is so large and diversified that all specific risk of their projects has been eliminated. It might be useful here for you to recap on the meaning of total, specific and market risk and how all three types of risk are measured.

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Revision Questions

4
Canall plc £m 42 82 (72) ,52) 10 27 115 ,52 180 112 1.3 Sealalot plc £m 76 65 (48) ,93) 30 50 113 ,93 230 – 1.2

Question 1
Crestlee plc is evaluating two projects. The first involves a £4.725 million expenditure on new machinery to expand the company’s existing operations in the textile industry. The second is a diversification into the packaging industry, and will cost £9.275 million. Crestlee’s summarised balance sheet, and those of Canall plc and Sealalot plc, two quoted companies in the packaging industry, are shown below:
Crestlee plc £m 96 95 (70) 121) 15 50 156 121 380 104 1.2

Non-current assets Current assets Less current liabilities Financed by: Ordinary shares1 Reserves Medium and long-term loans2 Ordinary share price (pence) Debenture price (£ ) Equity beta

Notes: 1. Crestlee and Sealalot 50 pence par value, Canall 25 pence par value. 2. Crestlee 12% debentures 1998–2000, Canall 14% debentures 2003, Sealalot medium-term bank loan.

Crestlee proposes to finance the expansion of textile operations with a £4.725 million 11 per cent loan stock issue, and the packaging investment with a £9.275 million rights issue at a discount of 10 per cent on the current market price. Issue costs may be ignored. Crestlee’s managers are proposing to use a discount rate of 15 per cent per year to evaluate each of these projects. The risk-free rate of interest is estimated to be 6 per cent per year and the market return 14 per cent per year. Corporate tax is at a rate of 33 per cent per year.

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Requirements (a) Determine whether 15 per cent per year is an appropriate discount rate to use for each of these projects. Explain your answer and state clearly any assumptions that you make. (19 marks) (b) Crestlee’s marketing director suggests that it is incorrect to use the same discount rate each year for the investment in packaging, as the early stages of the investment are more risky, and should be discounted at a higher rate. Another board member disagrees, saying that more distant cash flows are riskier and should be discounted at a higher rate. Discuss the validity of the views of each of the directors. (6 marks) (Total marks 25)

Question 2
PMS is a private limited company with intentions of obtaining a stock market listing in the near future. The company is wholly equity-financed at present, but the directors are considering a new capital structure prior to its becoming a listed company. PMS operates in an industry where the average asset beta is 1.2. The company’s business risk is estimated to be similar to that of the industry as a whole. The current level of earnings before interest and taxes is £400,000. This earnings level is expected to be maintained for the foreseeable future. The rate of return on riskless assets is at present 10 per cent and the return on the market portfolio is 15 per cent. These rates are post-tax and are expected to remain constant for the foreseeable future. PMS is considering introducing debt into its capital structure by one of the following methods: 1. £500,000 10 per cent debentures at par, secured on land and buildings of the company; 2. £1,000,000 12 per cent unsecured loan stock at par. The rate of corporation tax is expected to remain at 33 per cent, and interest on debt is tax-deductible. Requirements (a) Calculate, for each of the two options: (i) values of equity and total market values, (ii) debt/equity ratios, (iii) cost of equity. (9 marks) (b) List the main problems and costs which might arise for a company experiencing a period of severe financial difficulties. (6 marks) (c) ‘Capital structure can have no influence on the value of the firm.’ Discuss this statement and comment briefly on the practical factors which a company may take into account when determining capital structure. (10 marks) (Total marks 25)

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Question 3
The following is an extract from the balance sheet of Leisure International plc at 30 June 19X2:
£000 5,200 4,850 4,500 15,000 19,550

Ordinary shares of 50 p each Reserves 9% preference shares of £1 each 14% debentures Total long-term funds

The ordinary shares are quoted at 80p. Assume that the market estimate of the next ordinary dividend is 4p, growing thereafter at 12 per cent per annum indefinitely. The preference shares, which are irredeemable, are quoted at 72p and the debentures are quoted at par. Corporation tax is 35 per cent. (a) You are required to use the relevant data above to estimate the company’s weighted average cost of capital (WACC), i.e. the return required by the providers of the three types of capital, using the respective market values as weighting factors. (6 marks) (b) You are required to explain how the capital asset pricing model would be used as an alternative method of estimating the cost of equity, indicating what information would be required and how it would be obtained. (7 marks) (c) Assume that the debentures have recently been issued specifically to fund the company’s expansion programme under which a number of projects are being considered. It has been suggested at a project appraisal meeting that, because these projects are to be financed by the debentures, the cut-off rate for project acceptance should be the after-tax rate on the debentures rather than the WACC. You are required to comment on this suggestion. (6 marks) (d) Assume that instead of raising £5 million of 14 per cent debentures, the company had raised the equivalent amount in preference shares giving the same yield as the existing preference capital. You are required: (i) to demonstrate that the returns offered to investors in the two securities are consistent with investor risk aversion; and (ii) to calculate how Leisure International plc’s equity earnings would have been affected if the preference shares had been issued instead of the loan capital. (6 marks) (Total Marks 25)

Question 4
DEB plc is a listed company that sells fashion clothes over the Internet. Financial markets have criticised the company recently because of the high levels of debt that it has maintained in its balance sheet. The company’s debt consists of $150 million of 8% debentures that are due for repayment by 31 March 2005. Financial markets indicate it would not be possible to issue a new loan under the same conditions. The market value of the debentures is $90 per $100 nominal.
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184 CAPITAL STRUCTURE AND COST OF CAPITAL

REVISION QUESTIONS P9

DEB plc’s draft balance sheet at 31 March 2002 was as follows:
Ordinary shares of $1 Reserves 8% debentures (at nominal value) Non-current assets Net current assets $ million 100 120 120 150 270 200 270 270

Fixed assets consist of $150 million of capitalised development costs and $50 million of land and buildings. The company’s share price has fallen consistently over the past 2 years as follows:
31 March 2000 31 March 2001 31 March 2002 Price per share $20 $8 $4

The company intends to make a 1-for-2 rights issue at an issue price of $2.50 on 30 June 2002. It is assuming that the cum rights price at the issue date will be $4. Immediately thereafter, all the proceeds will be used to redeem debt at its nominal value and thereby reduce its gearing. Requirements (a) Calculate the gearing (that is, debt/equity) of DEB plc at 31 March 2002 using both (i) book values; and (ii) market values. (3 marks) (b) Evaluate (i) the weaknesses; and (ii) the benefits of the two methods used to calculate gearing in requirement (a) above. (6 marks) (c) Calculate the gearing of DEB plc in market value terms, immediately after the rights issue and redemption of debt. (6 marks) (d) Briefly explain the advantages and disadvantages for DEB plc of redeeming part of its debt using an issue of equity shares. (5 marks) (Total marks 20)

Question 5
CAP plc is a listed company that owns and operates a large number of farms throughout the world. A variety of crops are grown. Financing structure The following is an extract from the balance sheet of CAP plc at 30 September 2002.
Ordinary shares of £1 each Reserves 9% irredeemable £1 preference shares 8% loan stock 2003 £ million 200 100 50 250 600

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185 CAPITAL STRUCTURE AND COST OF CAPITAL

The ordinary shares were quoted at £3 per share ex div on 30 September 2002. The beta of CAP plc’s equity shares is 0.8; the annual yield on treasury bills is 5%, and financial markets expect an average annual return of 15% on the market index. The market price per preference share was £0.90 ex div on 30 September 2002. Loan stock interest is paid annually in arrears and is allowable for tax at a corporation tax rate of 30%. The loan stock was priced at £100.57 ex interest per £100 nominal on 30 September 2002. Loan stock is redeemable on 30 September 2003. Assume that taxation is payable at the end of the year in which taxable profits arise. A new project Difficult trading conditions in European farming have caused CAP plc to decide to convert a number of its farms in Southern Europe into camping sites with effect from the 2003 holiday season. Providing the necessary facilities for campers will require major investment, and this will be financed by a new issue of loan stock. The returns on the new campsite business are likely to have a very low correlation with those of the existing farming business. Requirements (a) Using the capital asset pricing model, calculate the required rate of return on equity of CAP plc at 30 September 2002. Ignore any impact from the new campsite project. Briefly explain the implications of a beta of less than 1, such as that for CAP plc. (5 marks) (b) Calculate the weighted average cost of capital of CAP plc at 30 September 2002 (use your calculation in answer to requirement (a) above for the cost of equity). Ignore any impact from the new campsite project. (10 marks) (c) Without further calculations, identify and explain the factors that may change CAP plc’s equity beta during the year ending 30 September 2003. (5 marks) (Total marks 20)

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Solutions to Revision Questions

4

Solution 1
(a) The discount rate should reflect the systematic risk of the individual project being undertaken. Unless the risk of the textile expansion and the diversification into the packaging industry are the same, their cash flows should not be discounted at the same rate. The discount rate to be used should not be the cost of the actual source of funds for a project, but a weighted average of the costs of debt and equity which is weighted by the market values of debt and equity. It is possible to estimate an existing weighted average cost of capital for Crestlee, but the rate cannot be applied to new projects unless the following assumptions are complied with. (i) The project is marginal, that is, it is small relative to the size of the company. Taken together, the two projects are not marginal, but this is not a crucial assumption as long as the costs of debt or equity do not alter because of the size of the financing required. (ii) All cash flows of the project are level perpetuities. This is unrealistic for ‘real world’ projects, but again makes little difference to the validity of the estimated weighted average cost of capital. The remaining two assumptions are of more importance: (iii) The project should be financed in a way that does not alter the company’s existing capital structure. The net present value investment appraisal method cannot handle a significant change in capital structure; if such a change occurs the adjusted present value (APV) method should be used. Crestlee’s existing capital structure using market values is:
30 million ordinary shares at 380 pence £56 million debentures at £104 £m 114 158.24 172.24 % 66 34

If the two investments are considered as a ‘package’:
New finance being raised is £9.275m equity £4.725m debt 14.000m % 66 34

The company’s capital structure does not change as a result of these two investments.
187
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188 CAPITAL STRUCTURE AND COST OF CAPITAL

SOLUTIONS TO REVISION QUESTIONS P9

(iv) The project should have the same level of systematic risk as the company’s existing operations. As the textile investment is an expansion of existing operations, it is reasonable to assume that it has the same systematic risk. The diversification into packaging could have very different risk characteristics. The company’s existing weighted average cost of capital should not be used as a discount rate for the diversification. Textile expansion. The discount rate may be based upon the company’s weighted average cost of capital (given that assumptions (iii) and (iv) are not violated): WACC ke E E D kd(1 Tc) D E D

Using the capital asset pricing model, ke may be estimated by RF ke (RM 6% RF) E (14% 6%)1.2 15.6%

kd is taken as the current cost of loan stock, 11 per cent (alternatively a rate could have been estimated using the redemption yield of the debenture): WACC 15.6% 66 100 11%(1 0.33) 34 100 12.8%

This is the suggested discounted rate for the expansion. Packaging diversification. The systematic risk of diversifying into the packaging industry may be estimated by referring to the systematic risk of companies within that industry. However, the equity beta is influenced by the level of financial risk (gearing). Unless the market-weighted gearing of Canall and Sealalot is the same as Crestlee, it is necessary to ‘ungear’ the equity of these companies (to remove the effect of financial risk) and regear to take account of Crestlee’s financial risk:
Gearing Equity Debt Canall (£m) 72.0 16.8 88.8 % 81 19 Sealalot (£m) 138 113 151 % 91 9

These are both significantly different from Crestlee. Ungearing Canall (assuming debt is risk-free and d 0):
a e

E

E D(1

t)

1.3

72

72 16.8(1

0.33)

1.124

Ungearing Sealalot :
a e

E

E D(1

Tc)

1.2

138

138 13(1

0.33)

1.129

These are very similar. The ungeared equity beta of the packaging industry will be assumed to be 1.125. Regearing for Crestlee’s capital structure: E
e a

D(1 E

t)

1.125

114

58.24(1 114

0.33)

1.51

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189 CAPITAL STRUCTURE AND COST OF CAPITAL

ke is estimated to be: 6% (14% WACC 6%)1.51 18.08% 66 18.08% 11%(1 100 0.33) 34 100 14.4%

Fifteen per cent is not an appropriate discount rate for either of these projects. The less risky textile expansion has an estimated discount rate of 12.8 per cent, and the diversification 14.4 per cent. (b) The marketing director might be correct. If there is initially a high level of systematic risk in the packaging investment before it is certain whether the investment will succeed or fail, it is logical to discount cash flows for this high-risk period at a rate reflecting this risk. Once it has been determined whether the project will be successful, risk may return to a ‘more normal’ level, and the discount rate reduced commensurate with the lower risk. If the project fails there is no risk (the company has a certain failure!). The other board member is incorrect. If the same discount rate is used throughout a project’s life, the discount factor becomes smaller and effectively allows a greater deduction for risk for more distant cash flows. The total risk adjustment is greater the further into the future cash flows are considered. It is not necessary to discount more distant cash flows at a higher rate.

Solution 2
(a) If the rate of return on equities is perceived as comprising 10 per cent pure interest and 5 per cent risk premium, and the beta is put at 1.2, then the theoretical cost of capital (using the capital asset pricing model) is 10% 1.2 5%, i.e. 16%.

The value of the entity, therefore, is £400,000/0.16, that is, £2.5m. Assuming totally equity funding, a 33 per cent tax rate and full distribution of profits (consistent with maintained earnings), £0.825m of this value would be attributable to the tax authorities, and £1.675m to the shareholders. This is illustrated in Figure 1.

Figure 1

All equity

ke

Rf

(Rm

Rf)

e

10
PBIT Tax PAT

(15

10)
400,000 132,000 268,000

1.2

16%

MVfirm

PAT/ke

268,000/0.16

£1,675,000

Of itself, capital structure cannot affect the overall cost of capital or value – only its attribution between the stakeholders. Take the first suggestion, that assets of the firm be secured against a loan of £500,000 (20 per cent of the total value) at 10 per cent, that is,
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190 CAPITAL STRUCTURE AND COST OF CAPITAL

SOLUTIONS TO REVISION QUESTIONS P9

£50,000 per annum. This leaves £350,000 p.a. for tax and dividends. This is worth £2.5 m £0.5 m, that is, £2 million, implying a cost of capital of 17.5 per cent per annum, higher than before because of the higher margin of error associated with the return. If tax takes 33 per cent, that is, £0.66 m, the value of the equity is £1.34 m. This is illustrated in Figure 2.

Figure 2

First option – 10% debentures

Vg

Vug

TB

1.675

(0.5
Vg Vdebt Vequity

0.33)
1,840,000 1,500,000 1,340,000

£1,840,000

D/E keg

500/1,340 kug (kug

37.3% kD)(1

t )D E

0.16

(0.06)(0.67)500 1,340

17.5%

Likewise, if £1m (40 per cent of the total value) was borrowed at 12 per cent p.a., £280,000 p.a. would be available for tax and dividends, with a value of £2.5 m £1 m, that is, £1.5 m, implying a cost of capital of 18.7 per cent p.a. Again assuming tax takes 33 per cent, that is, £0.495 m, the value of the equity is £1.005 m. This is illustrated in Figure 3.

Figure 3

Second option – unsecured loan stock

Vg

Vug

TB

1.675

0.33
Vg Vdebt Vequity

£2,005,000
2,005,000 1,000,000 1,005,000

DE keg

1,000 1,005 99.5% kug (kug kD)(1 t )D E

0.16

(0.04)(0.67)1,000 1,005

18.67%.

Summary
Option 1 (i) Value (£m) of: Equity Debt Total Entity (ii) Ratio: debt/equity (iii) Cost of equity (%, p.a.)
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Option 2 1.005 1.000 2.005 99.5 18.7

1.340 0.500 1.840 37.3 17.5

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191 CAPITAL STRUCTURE AND COST OF CAPITAL

(b) There is an old saying that nothing stands still – what is not expanding is shrinking. Likewise, in many situations, either a vicious or virtuous circle is obtaining at any point in time: the gardens which have seen no rain are the ones which are not permitted to benefit from hosepipes. So it is with businesses, for when one gets into difficulty: ● suppliers are less keen to trade, demanding higher prices or faster payment; ● the best employees are the first to find jobs elsewhere; ● customers may go to other suppliers, out of fear (no doubt encouraged by competitors!) that continuity is uncertain, for example, spares will not be available; ● short-termist pressures (e.g. the need to keep up reported profits even if it means cutting back on intangibles like research, marketing and training) threaten long-term financial health; ● bankers are less willing to provide finance, other than at substantial premium rates of interest; ● there could be legal and professional costs of reconstruction, administration, etc., if things get that far. (c) Intuitively, the Modigliani and Miller theory that capital structure is irrelevant is valid: the value of a firm as an entity is independent of its capital structure. That does not mean, however, that it is irrelevant from a practical financial management point of view. For while the principal financial objective of a private-sector enterprise is to maximise the net present value of protected cash flows, there is a secondary objective which nevertheless has great importance: the maximisation of the proportion of entity value which is attributable to the shareholders. It is in pursuit of this objective that corporate treasurers consider a range of possible capital structures. The key factors which enter such considerations are: ● the variability and unpredictability of projected cash flows (the greater these are, the less likely that borrowings are appropriate); ● the variability and unpredictability of interest rates (as various ‘large ticket’ suppliers found in 1991/92, with high interest rates depressing demand and increasing outgoings); ● the bias introduced by the different taxation treatment of loans as distinct from profits; ● the anticipated rate of growth of the business, and the implication, therefore, in terms of retentions, and the growth in the proportion of cash flows earmarked for taxation; ● the concerns of incumbent management, e.g. degree of control, threat of being taken over; ● the transaction costs of issue and redemption (note greater popularity of companies buying back their own shares); ● the international aspects and hence currency risks: neutrality means matching currencies of capital to currencies of projected cash flows.

Solution 3
This question examines the following syllabus areas: Tips ● In answering part (a), some candidates made the (minor) error of treating the dividend given in the question as the current dividend instead of the next expected dividend. ● In part (b), saying that the return on the market portfolio ‘could be obtained from the financial press’ is rather an over-simplification. ● Not many candidates were aware of the exact external source of information on ‘beta’, or the practicalities of the company undertaking the calculations.
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SOLUTIONS TO REVISION QUESTIONS P9

In part (c), the basic point to be made was that debt always has an implicit as well as an explicit cost because it makes equity riskier and the net interest rate can never be the appropriate cut-off rate for risky projects. Many candidates correctly presented the ‘pool of funds’ argument without pointing out that the project might be in a different risk category from the company’s normal activities, thus invalidating the use of the current weighted average cost of capital. In part (d), not many candidates were able to work out that, allowing for the differing tax effects, debt resulted in higher expected equity earnings.

(a) Market value of securities
Equity (Ve) Preference (Vp) Debentures (Vd) Total 10.4 million 80 p 4.5 million 72 p 5.0 million 100 p £ million 8.32 3.24 15.00 16.56

Cost of equity (ke) ke d0(1 g) g P0 4 0.12 80 17%

Cost of preference shares (kpref) d P0 9 12.5% 72 Cost of loan stock (kd) kpref kd net i[1 P0 14(1 t]

kd

k0

0.35) 9.1% 100 keVe kpVp kdVd Ve Vp Vd (0.17 8,320,000) (0.125 3,240,000) 16,560,000 1,414,000 405,000 455,000 16,560,000 13.73%.

(0.091

5,000,000)

(b) The above calculations were based on explicit forecasts of dividends. In practice these are not available, and outsiders looking in have to resort to other approaches. The capital asset pricing model (CAPM) is one such approach and involves the following steps: (i) identification of the: so-called market-risk premium, that is, the excess of equity yields over bond yields for a particular period of time;
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193 CAPITAL STRUCTURE AND COST OF CAPITAL

beta of the share price over the same period, that is, its volatility relative to the market. There are consultants who will provide this information for a fee; (ii) presumption that, if investors had foreseen the particular volatility of the share, they would have expected a return that amounted to the bond rate plus the risk premium factored by the beta; (iii) presumption that this will be replicated in the future; (iv) calculation, therefore, of the cost of equity capital as the cost of debt, plus a premium based on the equity market average factored by the beta. The practical problems are associated with which of the past (and very different) time frames you are going to say is the model for the future. The market is often described in terms of random walks, that is, prices are discontinuous. As the financial services advertisements show, the return on investment depends more than anything on where you measure from. (c) The linking of particular branches of funds with particular parts of the business is frequently debated. The capital structure determines how the overall risk is shared as between investors. The evaluation of an individual project should concentrate on its projected cash flows and the perceived margin of error therein. Others point to particularly large projects, where it is only natural to consider the financing at the same time. So, it depends to an extent on the business. It also depends on how the margin of error in cash-flow forecasts is dealt with. If it is allowed for by depressing the forecast cash flows, then the cost of debentures is going to approximate to the pure cost of capital. It should be borne in mind, however, that the cost of capital appropriate to decision-making is the opportunity cost: were interest rates to rise, for instance, the historical cost of the debentures would be too low a figure. (d) (i) As shown in (a) above, the yield on the preference shares is 12.5 per cent. This is higher than the 9.1 per cent on the debentures, because the latter have a prior call on the assets of the business. (ii) The net payment on the debentures is 14 per cent of £5 million less 35 per cent, that is, £455,000. To give a 12.5 per cent yield, the company would have to issue the preference shares at a discount. The net payment would be 9.1 per cent of £5 million, that is, £625,000.

Solution 4
Requirement (a) (i) Book values Debt equity (ii) Market values Debt equity 135 400 33.75% 150 120 125%

Requirement (b) (i) Weaknesses The market values based gearing of DEB plc will have increased as the share price has fallen over the past 2 years, reflecting industry and market changes. The book value will
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194 CAPITAL STRUCTURE AND COST OF CAPITAL

SOLUTIONS TO REVISION QUESTIONS P9

have largely failed to recognise such changes and thus would be much the same as 2 years ago, other than changes in retained profit and any new capital. In general, book values tend to give poor measures of gearing as they include balance sheet values which may be inappropriate as: ● fixed assets may not have been revalued and thus represent historic costs rather than current market values; ● development costs may be subject to significant subjectivity as to the amount capitalised; ● debt appears to be stated at nominal value rather than market value; ● values are normally out of date reflecting only the position at the last balance sheet date. (ii) Benefits Notwithstanding these problems, restrictive covenants on debt are normally in terms of book values and thus the book gearing calculation may have relevance in this context. Market value measures of gearing have the following advantages: ● the reflect the going concern value of the business and thus its future earnings potential to repay debt; ● values reflect up-to-the-minute market movements; ● debt values reflect changes in corporate risk and industry risk since issue; ● comparison between companies is easier – with care!

Requirement (c) Proceeds raised Ex rights price $2.5 [$2.5 50 million (2 3 $4)] $125 million $3.5

Value of equity after rights issue $3.5 150 million $525 million

Value of debt after rights issue ($150 million Gearing $125 million) 4.29%. 0.90 $22.5 million

22.5 million 525 million

Requirement (d) Advantages The issuing of new equity will reduce debt and thus partly address the concerns of financial markets. This may be important in developing relationships with the loan creditors for refinancing the remaining debt in 3 years, or for new finance. In the short term, it may also be important in helping prevent a breach of restrictive covenants based upon book gearing. Disadvantages The gearing was not particularly excessive at 33.75% in market value terms even prior to the repayment. The high book value measure of gearing may thus be misleading.
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195 CAPITAL STRUCTURE AND COST OF CAPITAL

The yield in the market on this type of debt is greater than the nominal rate paid to the debenture holders. In redeeming the loan, the company is thus paying off a cheap source of finance. If it needed further borrowing, this may be expensive. Paying off most of the debt ($125 million of the $150 million) appears excessive in appeasing the concerns of financial markets. The traditional model of gearing would leave the impact on the weighted average cost of capital (WACC) uncertain depending on whether the company was already beyond the minimum point on the WACC curve. If the redemption had the effect of lowering WACC, then the repayment may have been worthwhile. In terms of the timing of the issue, the efficient markets hypothesis would state that, in semi-strong form, it is irrelevant as we cannot predict future share prices. Historic share price falls are no guide to future prices.

Solution 5
Requirement (a) Required return on equity 5% 0.8 (15% 5%) 13%

The beta is a measure of the extent to which historic movements in CAP’s share price have correlated with average market returns (e.g. as summarised in the FT All Share Index). A beta of less than 1 means that the share price is less volatile than the market. Thus, at 0.8, it means that if the market index rises by 10% then on average the share price of CAP would be expected to increase by 8%. This argument does not however mean that the required rate of return on CAP’s shares also moves in direct proportion to the required return on the market as this is also affected by the risk free rate. Requirement (b) Cost of preference shares 9 90 10%

Cost of debt 20 (1 1 0.3) Kd 250 250 1.0057

Simplifying: 1 Kd Kd 14 250 1.0057 250 5%
Market values Equity (200 £3) Preference (50 0.9) Loan stock (250 1.0057) Total Value £m 600.00 45.00 251.42 896.42 Proportion 0.669 0.050 0.281 1.000
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196 CAPITAL STRUCTURE AND COST OF CAPITAL

SOLUTIONS TO REVISION QUESTIONS P9 Cost % 13 10 5

Cost of capital Equity Preference Loan stock Total

Proportion 0.669 0.050 0.281 1.000

Average 8.697 0.500 11.405 10.602

Thus, the weighted average cost of capital is 10.602%. Requirement (c) There are three major factors occurring during 2003 which may impact upon the beta of CAP plc.
● ● ●

The opening of a new business venture in campsites; The financing of the new venture with a new issue of bonds; The refinancing of the existing debt which is redeemable in 2003.

The new business venture The new business venture is significantly different from the existing business. This is indicated by the low correlation of the returns of the two businesses. The low correlation may diversify the unsystematic risk of the business, but its impact on the beta of the company is uncertain. This will depend on the correlation of the returns on the campsite project with the market portfolio – not their correlation with existing company returns. Ignoring the impact of debt financing, this new equity beta will be the weighted average of the existing beta and the beta of the new project. Financing for the new project The new debt finance will increase financial gearing and thus increase the variability of equity returns on the project and for the company as a whole. If the equity returns become more variable in relation to the market index, then this will increase the equity beta, although the total risk to debt and equity will be unaffected. Refinancing existing debt The impact of refinancing on the beta will depend on the type of financing used to redeem the existing debt – if any. If there is like-for-like replacement with new debt, then there will be a minimal impact on the beta, although the terms of the replacement debt instruments may differ. If however, the debt is redeemed – totally or partially – with new equity then this will reduce gearing, reduce the volatility of equity returns and thus lower the beta. Other factors Betas are based on historic returns and may not be stable over time. Past betas are, thus, not necessarily a good guide to the future, as they are affected by random events in relation to the company and the market. Even without the significant operational and financial changes in CAP plc in 2003, the beta would thus be likely to change anyway through normal ongoing events in the farming industry. The direction of change would, however, be indeterminant. Summary The new beta will be the weighted average of the beta on the existing farming business and the beta of the new leisure business. Both of these may change over time.
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Business Valuations

5

LEARNING OUTCOMES
After completing this chapter you should be able to: calculate values of organisations of different types; identify and calculate the value of intangible assets.

5.1 Introduction
The topics covered in this chapter are:
● ● ● ●

Valuation bases for assets, earnings, and cash flows; The strengths and weaknesses of each valuation method; Recognition of the interests of different stakeholder groups; Forms of intellectual property and methods of valuation.

Valuation models fall broadly into four variants based respectively on assets, earnings, dividends and discounted cash flows, typically using the capital asset pricing model to calculate a discount rate. Each method has its advantages and disadvantages and are not all appropriate in all circumstances. It is often unwise to depend on any one method and calculating a range of values using different appropriate types of valuation can provide valuable benchmarks for the project or company valuation being considered. Frequently, the compulsory case study question in the Management Accounting: Financial Strategy examination will give information on a company and request the candidate to calculate a range of values for that company. Part of the test is not only to be able to use the various methods to calculate values but to understand the circumstances in which each is most appropriate. For example, asset based valuations have very limited relevance for companies which are going concerns especially if they have substantial intangible assets. In each of the following sections, the various valuation methods are explained together with the circumstances in which they might be most appropriate.

197

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198 BUSINESS VALUATIONS

STUDY MATERIAL P9

5.2. Asset-based valuations
Using an asset-based valuation, the value of a company is equal to the net assets attributable to the equity shares. Intangible assets are only included if they have a realisable value. Net assets attributable to equity non-current assets current assets current liabilities non-current liabilities preference shares

5.2.1 Choice of valuation base
The valuation can be used on various factors, for example:

Book value. This method suffers from being largely a function of depreciation policy, for example, some assets may be written down prematurely and others carried at values well above their real worth. Original costs may of little use if assets are very old, or if asset replacement has been irregular over time. Net present value. The real value of assets retained in a business is the net present value of the future cash flows to be derived from them. Replacement value. This method recognises the additional store of worth to be derived from the future use of the asset. Break-up value. Individual assets are valued at the best price obtainable, which will depend partly on the second-hand market and partly on the urgency of realising the asset.

5.2.2 Merits of asset-based valuations
The main strengths of asset-based valuations are:
● ●

the valuations are fairly readily available; they provide a minimum value of the business.

The main weaknesses of asset-based valuations are:
● ●

future profitability expectations are ignored; balance sheet valuations depend on accounting conventions, which may lead to valuations that are very different from market valuations; it is difficult to allow for the value of intangible assets such as intellectual property rights.

5.3 Earnings-based valuations
5.3.1 P/E ratio valuation
Earnings-based valuations assume that the value of a business is equal to the present value of the future earnings that will be generated by the business. This method is based on two elements, the price/earnings (P/E) ratio and the post-tax earnings per share (EPS) of a business, which when combined give the market price per share (MPS). Thus: P/E ratio
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Current market price per share Post-tax earnings per share

MANAGEMENT ACCOUNTING – FINANCIAL STRATEGY

199 BUSINESS VALUATIONS

so that: MPS P/E EPS

MPS is influenced by market or non-specific risk. When markets are at relatively low levels, MPS and P/E ratio are liable to considerably undervalue the real worth of an individual share. It is very useful in evaluating MPS to relate the figure for a particular company to that for the nearest equivalent industry and to those for comparable companies within the industry sector. As a general guide, one might chart the relative movements in MPS for the last 3 or 5 years for the industry sector and comparable companies, taking care to note the effects of any significant events (e.g. mergers or acquisitions) occurring during the period. Another pointer is to check the P/E ratio on the basis of taking the median points of high and low values for the middle day of each quarter, comparing figures for the last 1 or 2 years, and taking care to note any significant trend or event over the period and endeavouring to weight the data accordingly.

5.3.2 Earnings yield valuation
Another important evaluation ratio is the earnings yield (EY), which can be expressed as: Earnings yield ( EY ) Earnings per share Market price per share 100

Again, some deeper analysis is desirable, for example examining the trend of MPS over a number of quarters in the light of any events such as profits warnings and acquisitions (or rumours thereof ), and the likely effect that they have had on earnings. The stability of EY is often as important as its growth, bearing in mind that in a general way the market is absorbing new information to try to assess a sustainable level of EPS on which to base growth for the future. Clearly, effective growth is dependent on a stable base, and the trend of EY over time is to an extent a reflection of this factor. A prospective acquirer would, of course, be concerned to assess the worth of a prospective biddee on the basis of its becoming part of the acquiring company, and the valuation will especially need to take into account the expectations of the biddee’s shareholders. A further point relates to the acquirer’s intentions regarding the biddee. If, for example, the latter company is to be partially demerged, that is, certain parts disposed of to other companies in which they would provide a better fit, then the MPS valuation may well be greater than if the whole biddee company was to be retained. Nevertheless, any such break-up considerations will need to take into account all the stakeholders, including employees, suppliers and customers of the biddee, as any serious demotivation will take away from the goodwill value of the acquisition and quite possibly damage that of the acquiring company itself.

5.4 Dividend-based valuations
In Chapter 1 you were introduced to the dividend decision as one of the key policy decisions many organisations have to make. The announcement of dividends is widely believed to have ‘signalling’ properties; in other words, the company is giving a signal to the market about its future prospects. How such signals are built into the share price depends on how they are interpreted by share
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purchasers. However, the dividend-valuation model provides a formula (or formulae – there can be variations on the basic model) that allows an estimate of cost of equity or share price to be calculated. You should revisit Chapter 4 for examples of the use of dividend valuation models to calculate the cost of equity.

5.4.1 Dividend yield
The dividend yield method of valuation assumes that the value of a business is equal to the present value of the future dividends payable by the business. Dividend yield assumes that the amount of the dividend remains constant each year. Dividend per share Dividend yield 100 Market price per share Thus: Market price per share Dividend per share Dividend yield 100

5.4.2 Dividend growth model
The dividend growth model assumes that the annual dividend payable by a business will grow at a constant annual growth rate. The equation for obtaining a market value, based on a shareholder’s expected rate of return (ke), the projected growth rate (g) and the company’s dividend (d0) is given below: g) d0(1 P0 (ke g) So, for example, if the company’s current dividend is 20 pence per share, its cost of equity is 18 per cent and it is expecting growth in earnings and dividends of 9 per cent per annum, we would estimate a share valuation of: P0 20 (1.09) (0.18 0.09) 242 pence

5.4.3. Problems of dividend-based valuations
Problems of using dividend models include:
● ●

the difficulties associated with MPS mentioned earlier; investors tend to have very different expectations from each other (Modigliani and Miller’s theories can hardly cope with the present-day wide difference in attitude between institutional and individual investors); most investors look for a return based on two components: dividend and capital appreciation leading to capital gain on sale of the shares; the mechanistic aspect of all such models. It should be noted that d0 is, of course, much dependent on EPS, and the factors mentioned above in regard to earnings-based valuations must be taken into account. dividend-based valuations are suitable for valuing small shareholdings rather than for valuing a controlling interest.

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A profits warning will not of itself necessarily cause a reduction in d0, but is a strong pointer to the need for a possible negative weighting for g. Also, events such as a current or forthcoming acquisition will affect d1 (i.e. d0(1 g)) as well as g. Again, one is looking to measure d0 and g in terms of their stability as a base, which also means that movements in capital structure such as rights issues need also to be taken into account.

5.4.4 Capital asset pricing model
The concept of the capital asset pricing model (CAPM) as described in Chapter 4 should be well understood. This is an important method of evaluating the standing in the market of a particular share or industry sector. To obtain a market value using CAPM, the formula combines with the dividend valuation model as follows: P0 where d0 P0 E(R1) d0 E(R1) dividend to perpetuity; share value at year 0; expected return for share, noting that the CAPM formula is usually taken to relate to a period of one year. Rf
1

E(R1)

(Rm

Rf) 30p; Rm 8%) 16%; Rf 16.8% 8%;
1

Assume, for example: d0 E(R1) and: P0 30p 0.168 £1.79 8% 1.1 (16%

1.1. Then:

5.5 Cash-based valuations
Cash-based valuations assume that the value of a business is equal to the present value of future cash flows to be generated by the business.

5.5.1 Discounted cash flow
Under this method, a value for the equity of the business is derived by estimating the future annual after-tax cash flows of the business, and discounting these cash flows at an appropriate cost of capital. The advantages of this method of valuation are:
● ●

it can be used to place a maximum value on the business; it considers the time value of money.
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The disadvantages of this method are:
● ●

it is difficult to forecast cash flows accurately; it is difficult to determine an appropriate discount rate.

5.5.2 Shareholder value analysis
Shareholder value analysis (SVA) is used to indicate the amount of economic value created in a period. It is based on the assumption that the value of a business is equal to the present value of its future cash flows discounted at an appropriate cost of capital. SVA was covered in Chapter 1, and should be reviewed in relation to business valuation.

5.6 Business valuations and efficient markets
Study of the efficient markets hypothesis (EMH) and share price volatility was covered in Chapter 2. However, it is necessary to review some of those issues in connection with business valuations. In particular, it is worth recalling the three forms of the EMH:

Weak form. This says that the current share price reflects all the information which could be gleaned from a study of past share prices. If this holds, then no investor can earn aboveaverage returns by developing trading rules based on historical price or return information. This form of the hypothesis can be related to the activities of chartists, analysts who believe future prices can be charted and a pattern identified which can be used to predict future prices. Semi-strong form. This says that the current share price also reflects all other published information. If this holds, then no investor can be expected to earn above-average returns from trading rules based on any publicly available information. This form of the hypothesis can be related to fundamental analysis, in which estimated future prices are based on the analysis of all known information. Strong form. This says that the current share price incorporates all information, including nonpublished information. This would include insider information and views held by the directors of the company. If this holds, then no investor can earn above-average returns using any information whether publicly available or not. A useful summary of the hypothesis is as follows:

● ●

the weak form of efficiency is where share prices reflect all historical information; the semi-strong form of efficiency is where share prices reflect all publicly available information; the strong form of efficiency is where share prices reflect all information (public and internal) and is the perfect information environment.

The CAPM, which depends for its validity on markets being at least semi-strong form efficient, was covered in Chapter 4 of this Study System, which dealt with cost of capital and capital structures. If we are to accept that the CAPM can be used to determine a cost of capital, then we must also accept some level of market efficiency. Generally, studies have shown the semi-strong form of the EMH to hold, although the presence of inside information cannot be ignored. A (contentious) point to consider is whether inside information, far from being a ‘bad thing’ (not to mention illegal in many countries), actually contributes to an informationally efficient market, and therefore should be encouraged.
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Of course, these topics are predominantly concerned with the valuation of large, listed companies. Although the underlying principles apply to a whole range of organisations, including those in the public sector, the absence of a market price removes a valuable benchmark.

5.7 Intellectual capital
The following section is based mainly on IFAC’s Study 7, The Measurement and Management of Intellectual Capital: An Introduction (1998).

5.7.1 Forms of intellectual capital
A broad perspective on what the intellectual capital of the firm might mean could be: Intellectual adj. Of or pertaining to the intellect; Engaging, or requiring the use of, the intellect. Capital noun Wealth in any form, employed in or available for the production of more wealth. As it is applied today, the term intellectual capital has many complex connotations and is often used synonymously with intellectual property, intellectual assets and knowledge assets. Intellectual capital can be thought of as the total stock of capital or knowledge-based equity that the company possesses. As such, intellectual capital can be both the end result of a knowledge transformation process or the knowledge itself that is transformed into intellectual property or intellectual assets of the firm. Intellectual property is legally defined and assigns property rights to such things as patents, trademarks and copyrights. These assets are the only form of intellectual capital that is regularly recognised for accounting purposes. However, accounting conventions based upon historical costs often understate their value:
● ●

● ●

Patents are recorded at their registration cost but not their potential value in use. Trademarks, copyrights and other intellectual property rights are recorded at registration cost rather than their potential market value. Franchises are recorded at contract cost rather than the market value. Goodwill is recorded only when a business is sold (acquired). It is defined as the market price of the business as a whole, less fair market value of other assets acquired.

Definitions of intellectual assets and knowledge-based assets are typically less concrete and apply to a potentially broader range of intangible assets than those captured under the umbrella of intellectual property. The Society of Management Accountants of Canada defines intellectual assets as follows: In balance sheet terms, intellectual assets are those knowledge-based items, which the company owns, which will produce a future stream of benefits for the company. This can include technology, management and consulting processes, as well as extending to patented intellectual property. Within this knowledge view of the firm, the organisation is seen as an institution for integrating knowledge, the critical input in production, and the primary source of value is knowledge; all human productivity is knowledge dependent, and machines are simply embodiments of knowledge. According to one expert on knowledge and intellectual capital
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management, this emerging view of the firm may require a fundamental shift in the way we think about organisations: ‘Managers often have an unconscious and tacit mindset that is coloured by the values and the common sense of the industrial age. To see another world, they need to try to use a conscious mindset such as the knowledge perspective.’ Some of the major points of departure between an industrial management perspective and a knowledge management perspective are as follows:

The knowledge view of the organisation sees people as revenue generators whose primary task is to convert knowledge into intangible structures, whereas within the industrial paradigm, people at times are viewed more simply as costs or factors of production. The purpose of learning within the knowledge organisation is to create new assets or processes instead of simply applying new tools or techniques. Within the knowledge organisation, production flows are idea-driven and sometimes chaotic, as opposed to sequential and machine driven. The law of diminishing returns is replaced with increasing returns to knowledge, and economies of scale in the industrial paradigm are replaced with economies of scope in the knowledge paradigm. The power base of management rests with their relative level of knowledge as opposed to their hierarchical position within the organisation. Information flows via collegial networks versus via the organisational hierarchy.

In his review of the emerging knowledge-based theory of the firm, Grant identified several characteristics of knowledge that have implication for the overall management of the organisation:

First, he distinguishes between explicit knowledge – that which can be observed – and tacit knowledge – that which is subjective and revealed through its application. Explicit knowledge often has the characteristics of a public good that can be easily transferred, often at zero marginal cost. (An example of explicit knowledge is the information contained on a web page. The marginal cost of one more person accessing a web page is virtually zero.) Tacit knowledge, however, can be acquired only through practice. It is not easily transferred within the organisation, and its transferral is slow, costly and uncertain. Second, transferring tacit knowledge within the organisation will require certain organisational structures and cultures. Once firms are viewed as institutions for integrating knowledge, hierarchical structures and hierarchical coordination fails. The transfer or integration of tacit knowledge requires network lines of communication and team-based structures. When managers know only a fraction of what their subordinates know and tacit knowledge cannot be transferred upwards, then coordination by hierarchy is inefficient. Third, knowledge is a resource that is subject to unique and complex measurement problems resulting from the inability to define or identify ownership. Direct claims on the ownership of knowledge are often difficult to prove, except in the case of patents and copyrights where owners are protected by law. Fourth, Grant called into question the current shareholder structure of many firms based on the unique ownership characteristics of knowledge. He concluded: ‘If the primary resource of the firm is knowledge, if knowledge is owned by employees, if most of this knowledge can only be exercised by the individuals who possess it – then the theoretical foundations of the shareholder value approach are challenged.’

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Finally, the knowledge-based view of the firm provides insights into the current trends in corporate management and design, such as delayering, empowerment, team building, the use of cross-functional teams in new product development, and building strategic allegiances. Each of these practices has been shown to facilitate the communication, integration and transformation of knowledge within the firm.

5.7.2 The components of intellectual capital
One model of intellectual capital management – The Value Platform – separates intellectual capital into three main components that interrelate to form value:
● ● ●

human capital; customer (relational) capital; organisational (structural) capital.

Figure 5.1 shows the forms of intellectual capital falling into each of these categories. Within this system of classification, the intellectual capital of the firm has the following properties:
● ●

It can be fixed, as in the case of a patent, or flexible, as in the case of human capabilities. It can be both the input and the output of a value-creation process. That is, intellectual capital is ‘knowledge that can be converted into value’ or the end product of a knowledge transformation process. It is created through the interplay of human, structural and customer capital – corporate value does not arise directly from any one of its intellectual capital factors, but only

Figure 5.1

Elements of intellectual capital
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Figure 5.2

Intellectual capital

from the interaction between them all. Just as importantly, no matter how strong an organisation is in one or two of these factors, if the third is weak (or worse, misdirected), that organisation has no potential to turn its intellectual capital into corporate value. While these characteristics imply that the management of intellectual capital will be unique in each organisation, it is assumed that human capital acts as the building block for the organisational (structural) capital of the firm, and both human capital and organisational (structural) capital interact to create customer capital. At the centre of the three forms of intellectual capital lies the financial capital or value created by the interaction of the three components. As can be seen in Figure 5.2, it is at the intersection of the classes of intellectual capital that value is created. This interaction is dynamic, continuous and expansive. Indeed, the more the circles overlap, the greater the value produced. The intellectual capital management framework described here offers new ways of seeing the organisation and its core competences. However, many of the management concepts and methods it proposes parallel well-established management accounting practices. Human capital Human capital refers to the know-how, capabilities, skills and expertise of the human members of the organisation. It is the knowledge that each individual has and generates. Some of the key functions tied to human capital management are drawn from the traditional practices of human-resource management, and include:
● ●

building an inventory of employee competences; scanning the environment and determining competences which need to be developed or acquired to meet strategic objectives; developing a system to deliver the needed knowledge, skill or intellectual upgrade as needed; developing an evaluation and reward system tied to the acquisition and application of competence that aligns with the organisation’s strategic objectives.

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Organisational (structural) capital Organisational capital includes the organisational capabilities developed to meet market requirements, such as patents. Clearly, every patent, trademark, management tool, improvement technique, IT system and R&D effort that has been or will be implemented to improve the effectiveness and profitability of the firm can fall within the category of organisational (structural) capital. While it is impossible to prescribe an all-encompassing framework for managing this type of capital, value-chain analysis offers a systematic approach to the subject. The objective of value-chain analysis is to identify the elements of organisational processes and activities and link them to the creation of value by the firm. Processes are structured and measured sets of activities, designed to produce a specific output for a particular customer or market. Identifying the firm’s value-creating process – the way in which knowledge is created, integrated, transformed and utilised – will require a horizontal view of the organisation and the cross-functional relationships that exist within it. A model is first established using process analysis and the activities within each process are subsequently analysed. In this way, management can begin to assess the flows of information, flows of knowledge and characteristics of knowledge transformation between functional departments, within divisions and throughout the organisation. The end product of the knowledge-management process can then be identified and valued as: 1. a patent, consulting process or trademark; 2. an improvement in organisational efficiency, measured by cost savings, profits, revenue growth, or return on investment; 3. improved innovative capabilities of the firm, measured by a variety of individual and team-based performance indicators. Customer capital Customer (relational) capital includes connections outside the organisation, such as customer loyalty, goodwill and supplier relations. It is the perception of value obtained by a customer from doing business with a supplier of goods and/or services. Various techniques and analysis tools have been developed to better understand the value of customers and their perceptions. Some of these are described below:

Market-perceived quality profiles. These are developed through customer questionnaires for the purpose of: – identifying what quality really means to the consumer; – indicating which competitors are best on each aspect of quality; – developing overall quality-performance measures based on the definition of quality that customers actually use in making their purchasing decision. Market-perceived price profiles. These are derived in the same way as market-perceived quality profiles, but instead of asking customers to list factors affecting their perception of quality, the organisation asks them to list factors affecting their perception of the product’s cost. Customers are then asked to weight these factors and rate their perception of competitors’ performance on each price attribute. Customer value maps. Organisations use these to illustrate how customers decide among competing suppliers and products. They contain information on which companies might be expected to gain market share, and why. Won/lost analysis. This technique allows an organisation to thoroughly analyse the reasons for either winning or losing a competitive bid. If it has won a bid, it can determine which
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product and service attributes were met, and what the relative price/quality conditions were. This approach also offers a method for examining the factors contributing to changes in market share, that is, what the quality–price relationships were, vis-à-vis the competitors. What/who matrix. These allow organisations to track responsibility for the actions that will ensure success in providing customer value. This matrix shows, for each quality attribute, those business processes that influence an organisation’s performance and that of its competitors. It shows who owns the process that has the greatest impact on the organisation’s performance vis-à-vis that of a specific competitor. The business process owner (in the organisation) is then responsible for coordinating the processes and function required to improve customer value performance.

5.7.3 Valuing intellectual capital
Intellectual capital can affect and be affected by the unique culture of the organisation and the distinct processes and relationships that evolve within it. This propensity for complexity suggests that a rigorous approach to managing, measuring and reporting on the intellectual capital within the firm would require a number of evaluation measures. Some possible measures are shown in Table 5.1. The universal intellectual capital report Table 5.1 represents only some of the measures that can be used to evaluate the intellectual capital of the firm. Skandia AFS, a pioneer company in the area of intellectual capital management and reporting, has developed an intellectual capital report on the basis of no fewer than 164 different indicators. These indicators can be consolidated into five main categories according to the primary focus that they take: financial focus, customer focus, process focus, renewal and development focus and human focus. Using this framework, 111 intellectual capital measures have been developed, forming the basis of the universal intellectual capital report.

Financial focus. Indicators that take a financial focus are represented in money values or percentages. They include standard calculations of return on investment and other common financial ratios. However, calculated returns to employees and returns to customers are used to gain a picture of the profitability of the human resources and clientele of the firm. Examples of measures that take a financial focus include: – revenues per employee; – value added per customer; – profits per employee; – revenue from new customers/total revenues; – value added per employee; – value added per IT employee. Customer focus. The customer focus specifically assesses the value of the customer capital of the firm. It uses financial, percentage and numerical indicators to paint a picture of such things as composition of market share, customer service, demographic characteristics of various customer groups, and the overhead and other support costs required. Examples of customer capital indicators include: – market share; – customers per employee;

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Table 5.1

Measures for managing intellectual capital

Human capital indicators ● Reputation of company employees with headhunters ● Years of experience in profession ● Rookie ratio (percentage of employees with less than 2 years’ experience) ● Employee satisfaction ● Proportion of employees making new idea suggestions (proportion implemented) ● Value added per employee ● Value added per salary dollar Organisational capital indicators ● Number of patents ● Income per R&D expense ● Cost of patent maintenance ● Project life cycle cost per dollar of sales ● Number of individual computer links to the database ● Number of times the database has been consulted ● Contributions to the database ● Upgrades of the database ● Volume of information systems use and connections ● Cost of information systems per sales dollar ● Ratio of new ideas generated to new ideas implemented ● Number of new product introductions ● New product introductions per employee ● Number of multifunctional project teams ● Proportion of income from new product introductions ● Five-year trend of product life cycle ● Average length of time for product design and development ● Value of new ideas (money saved, money earned) Customer (relational) capital indicators ● Growth in business volume ● Proportion of sales by repeat customers ● Brand loyalty ● Customer satisfaction ● Customer complaints ● Product returns as proportion of sales ● Number of supplier/customer alliances and their value ● Proportion of customer’s (supplier’s) business that your product (service) represents (in money terms)

– satisfied customer index; – annual sales per customer; – customers lost; – average duration of customer relationship; – revenue-generating staff; – average time from customer contact to sales response; – IT investment per salesperson; – support expense per customer. Process focus. Measures that take a process focus emphasise the effective use of technology within the firm. Primarily they include ratios of administrative costs; information technology use and spending per employee; efficiency measures based on time, workload and error ratios; and effectiveness measures designed to monitor quality and quality-management

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systems. More specifically, process measures include: – administrative expense to total revenue; – cost of administrative error to management revenues; – processing time, outpayments; – contracts filed without error; – PCs and laptops per employee; – network capability per employee; – IT expense per employee; – change in IT inventory; – IT capacity per employee; – corporate quality performance (e.g. ISO 9000). Renewal and development focus. The renewal and development focus utilises measurements that capture the innovative capabilities of the firm. These focus on the effectiveness of investment in training, research and development outcomes, and the return on technological infrastructure spending. The following indicators are seen to capture these elements: – training expense per employee; – training expense to administrative expense; – competence development expense per employee; – share of training hours; – business development expense to administrative expense; – R&D expense to administrative expense; – R&D invested in basic research; – R&D invested in product design; – R&D resources to total resources; – IT expense on training to total IT expense; – educational investment per customer; – value of electronic data interchange (EDI) system; – upgrades to EDI system. Human focus. Measurements that take a human focus are intended to reflect the human capital of the firm and the renewal and development of those resources. They include a number of calculated indices of employee competence and measures of the elan and potential creativity of the workforce, as well as indicators of the rate at which the human resources of the firm must be replaced. The measures include: – IT literacy of staff; – leadership index; – motivation index; – number of employees; – number of managers; – average age of managers; – annual turnover of full-time permanent employees; – percentage of company managers with advanced degrees in business, science and engineering, and liberal arts; – time in training each year.

What is evident from the diversity and extent of intellectual capital indicators is that each organisation must decide for itself which of these measures are most suited to their needs, budget constraints and available management resources.
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5.7.4 Comparative indicators
Three broad indicators have been developed to facilitate comparisons of intellectual capital stocks between firms:
● ● ●

market-to-book values; Tobin’s q; calculated intangible value.

Market-to-book values This is the most widely known indicator of intellectual capital. The contention is that the value of a firm’s intellectual capital will be represented by the difference between the book value of the firm and its market value. If a company’s market value is £10bn and its book value £5bn, then the residual £5bn represents the value of the firm’s intangible (or intellectual) assets. The principal benefit of this method is its simplicity. However, as with most other measures, the more simple the calculation the less likely it is to capture the complexities of the real world. In this case, simply subtracting book value from market value tends to ignore exogenous factors that can influence market value, such as deregulation, supply conditions and general market nervousness, as well as the various other types of information that determine investors’ perception of the income-generating potential of the firm, such as industrial policies in foreign markets, media and political influences, rumour, etc. In addition, the current accounting model does not attempt to value a firm in its entirety. Instead it records each of its severable assets at an amount appropriate to the national or international accounting standard under which the accounts have been prepared (e.g. historical cost, modified historical cost, replacement value, etc.). The market, however, values a company in its entirety as a going concern with strategic intent. It may be argued that the differences between these two forms of valuation can be defined as the value of intellectual capital. This value will then be subject to variations arising from the book value of the severable assets, their current market price, and various imperfections that may exist in the market valuations. However, it must be recognised that, if we define intellectual capital this way, then we are talking about an aggregate, including the difference between severable assets and the market valuation of the firm. Calculations of intellectual capital that use the difference between market and book values can also suffer from inaccuracy because book values can be affected if firms choose, or are required, to adopt tax depreciation rates for accounting purposes, and the tax rates reflect factors other than an approximation of the diminution in value of an asset. Thomas Stewart has written:
To encourage companies to invest in new equipment, [US tax] rules deliberately permit companies to depreciate assets faster than the rate at which they really wear out; and companies can (within limits) fiddle with depreciation methods to make profits look better or worse than they are. Because the right side of a balance sheet (liabilities plus shareholders’ equity) must equal the assets on the left, any understatement of assets results in a corresponding undervaluation of book value.

Tobin’s q Another way of getting around the depreciation rate problem when comparing the intellectual capital between firms is to use Tobin’s q. This was developed initially by James Tobin as a method of predicting investment behaviour. It uses the value of the replacement costs of a company’s assets to predict the investment decisions of a firm, independent of interest rates. The q is the ratio of the market value of the firm (share price number of shares) to
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the replacement cost of its assets. If the replacement cost of a company’s assets is lower than its market value, then a company is getting monopoly rents, or higher-than-normal returns on its investments. A high value of q indicates that the company will likely purchase more of those assets. Technology and human-capital assets are typically associated with high q-values. As a measure of intellectual capital, Tobin’s q identifies a company’s ability to get unusually high profits because it has something that no one else has. However, Tobin’s q is subject to the same exogenous variables that influence market price as the market-to-book value. Both methods are best suited to making comparisons of the value of intangible assets of firms within the same industry, serving the same markets, and having similar types of hard assets. In addition, these ratios are useful for comparing the changes in the value of intellectual capital over a number of years. When both the Tobin’s q and the market-to-book ratio of a company are falling over time, it is a good indicator that the intangible assets of the firm are depreciating. This may provide a signal to investors that a particular company is not managing its intangible assets effectively and may cause them to adjust their investment portfolios towards companies with climbing or stable values of q. By making intra-industry comparisons between a firm’s primary competitors, these indicators can act as performance benchmarks and can be used to improve the internal management or corporate strategy of the firm. Calculated intangible value A third measure, calculated intangible value (CIV) has been developed by NCI Research to calculate the fair market value of the intangible assets of the firm. The CIV involves taking the excess return on hard assets and using this figure as a basis for determining the proportion of return attributable to intangible assets. Merck & Co., a pharmaceutical company, can be used as an example in illustrating how the CIV works: 1. Calculate average pre-tax earnings for three years. For Merck: $3.694bn. 2. Go to the balance sheet and calculate the average year-end tangible assets over three years: US$12.952bn. 3. Divide earnings by assets to get the return on assets (ROA): 29 per cent. 4. For the same 3 years, find the industry’s return on assets. For pharmaceuticals, the number in this example was 10 per cent. If a company’s ROA is below average, then stop: NCI’s method will not work. 5. Calculate the ‘excess return’. Multiply the industry-average ROA by the company’s average tangible assets: this shows what the average drug company would earn from that amount of tangible assets. Now subtract that from the company’s pre-tax earnings. For Merck, excess earnings are: 3.694bn (0.10 12.952bn) $2.39bn

This figure shows how much more Merck earns from its assets than the average drug-maker would! 6. Calculate the 3-year average income tax rate and multiply this by the excess return. Subtract the result from the excess return to show the after-tax premium attributable to intangible assets. For Merck (average tax rate 31 per cent) the figure was $1.65bn. 7. Calculate the net present value (NPV) of the premium. This is done by dividing the premium by an appropriate discount factor such as the company’s cost of capital. Using an arbitrarily chosen 15 per cent yields, for Merck, $11bn. This is the CIV or Merck’s intangible assets – the one that does not appear on the balance sheet.
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While the CIV offers the potential to make inter- and intra-industry comparisons on the basis of audited financial results, two problems remain. First, the CIV uses average industry ROA as a basis for determining excess returns. By nature, average values suffer from ‘outlier’ problems and could result in excessively high or low ROA. Second, the company’s cost of capital will dictate the NPV of intangible assets. However, in order for the CIV to be comparable within and between industries, the industry average cost of capital should be used as a proxy for the discount rate in the NPV calculation. Again, the problem of averages emerges, and one must be careful in choosing an average that has been adjusted for outliers, such as excessively high or low values.

5.8 The impact of changing capital structure
The influence of capital structure on the value of the firm was introduced in Chapter 4. You will recall that, according to Modigliani and Miller, capital structure can have no influence on the value of the firm, other than by:

the benefit of the tax shield on debt interest payments (which increases the value and is fairly easy to quantify); the probability of financial distress and bankruptcy (which decreases the value but is very difficult to quantify).

Although the Modigliani and Miller theories have been criticised for oversimplifying the issue and ignoring many market imperfections (that is, real-life complexities), there is some sound logic in their propositions. Assume, for example, that you buy a house next door to a friend. The house is identical in every way, but you have had to buy yours with a substantial bank mortgage, while your friend has bought his with a legacy from a grandparent. You both decide to work overseas and rent out your houses for 2 years. Will your method of financing your asset have any influence over the rental income you can expect, or on the capital value of your house in 2 years’ time? Of course not! This is obviously an oversimplified example, but it serves to demonstrate that the value of an asset depends on the cash flows that it can generate in the marketplace, not on how the asset is financed. What can influence the value, of course, are factors such as your marketing ability (do you know how to set up a website?) and your attitude to risk (would you take a tenant who would pay more but who has a poor credit record?). This is a different matter altogether.

5.9 Recognition of the interests of different stakeholder groups in company valuations
There are three main sets of circumstances when a company may need to recognise priorities of the various groups of shareholder in determining a valuation. These are liquidation, re-financing and merger or acquisition.

5.9.1 Liquidation
The priorities of various stakeholders in the liquidation of a company is, in the UK, determined by company law. This is beyond the scope of the Financial Strategy syllabus and candidates will have covered the topic elsewhere in their studies. However, subject to the legal constraints companies may be able to influence stakeholder priorities by negotiating with the various groups especially in a voluntary liquidation.
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5.9.2 Re-financing
There are occasions when companies need to obtain new financing or re-finance existing debt. The groups of stakeholder who may be most interested in these circumstances are the managers, shareholders or owners, and providers of finance. Creditors may also have an interest if there is any suggestion that they may not be paid out in full as part of the re-financing negotiations.

5.9.3 Mergers and acquisitions
It is evident that numerous parties other than the bidder and biddee will be affected by an acquisition. A variety of stakeholders in the company will be involved in some way, for example: employees, suppliers, customers, environmental and health agencies, the government (through taxation and grants) and indeed, any person or institution whose activities may be directly affected by the company’s operations. Failure to discuss takeover plans with some of these stakeholder groups, especially employee representatives and government, can lead to prolonged and expensive confrontations. The interests of the local community needs to be recognised also as localised protests can often lead to serious delay in proceedings with what might otherwise be a financially and commercially sound proposal.

5.10 Summary
In this chapter, we have discussed various methods of valuing businesses and determining share prices. The strengths and weaknesses of each method have also been explained. Particular emphasis has been given to valuing businesses where traditional methods have little relevance, for example, those businesses that own substantial intellectual capital and few, if any, tangible assets, or those which have a poor trading history but good future prospects. This is a topic of growing relevance, given the increasing volatility of share prices in general and stock-market valuation of internet companies. It is recognised that the intellectual capital of a firm plays a significant role in creating competitive advantage, and thus managers and other stakeholders in organisations are asking, with increasing frequency, that its value be measured and reported for planning, control, reporting and evaluation purposes. However, at this point, there is still a great deal of room for experimentation in quantifying and reporting on the intellectual capital of the firm. Given the potential for both complexity and diversity, developing intellectual capital measures and reporting practices that are comparable between firms remains one of the key challenges to the accounting profession.

References
Grant, R. M. (1996), Toward a Knowledge-based Theory of the Firm, Strategic Management Journal, 17 (Winter special issue). International Federation of Accountants (1998), The Measurement and Management of Intellectual Capital: An Introduction.

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Readings

5

The launch of companies providing internet services provides a good example of the limitations of traditional valuation models. The ‘value’ of these companies, as measured by share price or market capitalisation, bears little relation to the value that would be placed on them using any of the methods described in this chapter. The following article explains some of the issues, and considers the use of shareholder value analysis as a method of valuation.

Shared visions
Christine Parkinson and Patrick Barber, CIMA Insider, March 2001. Reproduced with permission.

Shareholder value analysis (SVA) emerged as a valuation technique in the 1980s largely from the work of Alfred Rappaport.1 It is not, however, particularly new, and the underlying principles and procedures have been around a long time. CIMA’s Official Terminology2 explains that shareholder value is: ‘Total return to shareholders in terms of both dividends and share price growth, calculated as the present value of future free cash flows of the business discounted at the weighted average cost of capital of the business less the market value of debt’. Put simply, SVA combines the notion that the key objective for a company is to maximise shareholder wealth, with the use of the net present value (NPV) approach to valuing cash flows. What is, perhaps, new is the creation of shareholder value as the explicit focus of corporate strategy. This was largely a phenomenon of the 1990s and was driven in part by the leadership of large institutional investors. Long term, the returns on a company’s shares are determined by its investment ‘fundamentals’ – earnings growth and dividend yields. In the short term, however, these fundamentals are often overwhelmed by speculation (which appears to have been the case in the past few years). This trend would not have surprised the economist John Maynard Keynes, who wrote in the 1930s that the powerful role of speculation in the markets was based on ‘the conventional valuation of stocks based on the mass psychology of a large number of ignorant individuals’.3 Many of the approaches to shareholder value analysis used or discussed today are based on the conceptual framework provided by Rappaport. He used a discounted cash flow (DCF)-based approach to determine shareholder value and identified seven key ‘drivers’ of value. These are: growth in turnover; operating margin; capital expenditure; change in working capital; the effective tax rate; cost of capital; and the competitive advantage period (CAP). At McKinsey and Co., Tom Copeland, Tim Koller and Jack Murrin4 follow a more theoretical approach and suggest three value drivers: return on invested capital; free cash
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flow; and economic profit. Free cash flow is the total after-tax cash flow generated by a company and available to all providers of the company’s capital – shareholders and creditors. Free cash flow is generally not affected by the company’s capital structure, even though this structure may affect the company’s weighted average cost of capital (WACC) and, therefore, its value. Economic profit, or economic value added (EVA) as it is sometimes referred to, is the net operating profit after tax less capital charges, where capital charges are the invested capital multiplied by the WACC. For example, assume a company has after-tax operating profits of £10m, capital employed of £50 million and a cost of capital of 12 per cent. Its economic profit is therefore: £10m (£50m 12 per cent) £4m. Richard Pike and Bill Neale5 claim that most companies find a high correlation between EVA and shareholder returns. Although Copeland, Koller and Mullin use different value drivers, the aim is similar – to emphasise the importance of shareholder value. They also recognise that their approach is not new, at least as far as their basic methodology is concerned: ‘Valuation is an age-old methodology in finance with its intellectual origins in the present value method of capital budgeting and on the valuation approach [of] Miller and Modigliani.’ Serious students may wish to read the seminal work by Miller and Modigliani,6 which forms the basis for many topics in the Financial Strategy syllabus. Copeland, Koller and Mullin’s book is a useful reference for many Financial Strategy topics, including the approach to international investment (or capital budgeting) and the problems surrounding the choice and calculation of the discount rate. It also looks at the different approaches to valuation used in the US, Germany and Japan. (The UK tends to follow the US approach.) The book attempts to demonstrate the link between maximising shareholder wealth – sometimes a disputed objective – and other economic and social goods, such as gross domestic product per capita. The authors make a claim that might be used as a justification for the whole topic: ‘Shareholder wealth creation does not come at the expense of other stakeholders … winning companies, when compared with their competitors, have greater productivity, greater increases in shareholder wealth and higher employment. Shareholder wealth maximisation may be an explicitly stated goal … or it may be implicitly the result of other correct decisions … either way, it cannot be ignored. Managers must measure and manage the value of their companies.’ Luis Serven7 recognises that what matters most to shareholders is what happens to the value of their shareholding, but criticises many of the short-term measures used to boost share price: dividend increases, share repurchases, and other headline-grabbing tactics. However, the impact of these measures will dissipate as investors digest the actual performance of a company over time. Serven proposes a value management system (VMS) as the number one management issue to ensure long-term value creation. He proposes five critical components of such a system: strategic assessment; long-term planning; operational planning; performance measurement and management; and incentive compensation. He also discusses three ‘value killers’: the fire-fighting trap; management that lacks incentive; and (somewhat predictably since he is recommending it) the absence of a value management system. A recent real-life example of a company attempting to create shareholder value from restructuring is that of Whitbread. The company announced in October 2000 that it had ‘completed a strategic review and has concluded that shareholder value will be enhanced by increased focus on growth sectors of the UK leisure markets, unlocking the full value in
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Diagram 1 Shareholder value analysis framework © Pearson Reprinted with permission.

pubs and bars and returning a substantial part of that value directly to shareholders’. (Whitbread’s document to shareholders, 19 October 2000.) The company’s share price rose by 48p (11 per cent) to 479p after the news. At that date, published brokers’ estimates of the company’s pre-tax profits for the year to 28 February 2001 showed a large variation from £340m to £443.3m. Of these brokers, 25 per cent recommended that the shares should be bought, 60 per cent recommended they should be held and 15 per cent said they should be sold. The share price by 21 November 2000 was 533p. Whether this is long-term value creation or a quick fix remains to be seen. It might be useful to look up the share price of Whitbread now to see how it has moved and, perhaps, review brokers’ comments. (Share price movements and comments can be accessed on the Financial Times website: www.marketprices.ft.com) So how do we square the circle? Are the positive views of Rappaport and Copeland et al. incompatible with the rather less enthusiastic views of other writers? Not really – we are looking at two sides of the same coin. The theoretical arguments are conceptually sound and support the DCF approach to valuation. There is no serious support for the view that short-term fixes are relevant to the long-term valuation of a company. Diagram 1 illustrates how the variables that contribute to shareholder value are linked. The relationships are best explained by an example. Baxter plc is listed on the London International Stock Exchange. Its pre-tax operating cash flow for the last financial year was £76.5m. The company declared dividend payments of £26m. Its summary balance sheet as at 31 December 2000 was as follows:
Fixed assets (NBV) Net current assets Financed by: Ordinary shares (25 pence par) Reserves 9 per cent bank loan £m 57.50 144.50 102.00 25.00 32.00 145.00 102.00

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Other financial information is as follows: the current share price is 676p, debt is trading at par; equity beta is 0.9; the risk-free rate is 6 per cent per year, and the return on the market is 12 per cent per year (These figures are post-tax and are not expected to change in the foreseeable future.) The company pays tax at 30 per cent per year. The company’s directors have announced the following decisions together with the estimated effects on cash flow for the current financial year.
● ● ●

Sale of fixed assets: net receipts £3.4m. Purchase of new machinery and investment in working capital: £5.6m. Introduction of improved production methods: net improvement to operating cash flows of £4m per year before tax. Restructuring of regional offices: one-off redundancy payments of £1.75m before tax relief. Ignore the effect on tax of the changes in fixed and current assets. Assume the following for the next five years:

● ● ● ●

All figures are in real terms – so they exclude inflation. Post-tax operating cash flows will remain at year-1 levels. There will be no movement in fixed assets, other than as noted above. There will be no changes in dividend policy or capital structure.

Calculate the worth of Baxter plc based on the NPV of estimated future cash flows, using a fifteen-year time horizon, discounted at an appropriate cost of capital. There are four stages to the calculations: 1. Estimate post-tax cash flows for the coming year. 2. Estimate a discount rate, using the CAPM, as this is implied by the information given in the question. 3. Estimate cash flows for years 2 to 15. 4. Discount these cash flows and sum them to arrive at a NPV. Clearly these are oversimplifications, but they serve to demonstrate the principles involved in SVA. Stage 1
Present value of operating cash flows for year 1 Pre-tax OCFs for last year Less debt interest Plus annual productivity savings Recurrent pre-tax cash flows Tax at 30 per cent Recurrent post-tax cash flows Current year only effects: Sale of assets Investment in capital and working capital Redundancy payments after tax relief £1.75m 0.7 Total cash flows year 1 £m 76.50 (4.05) (24.00 76.45 (22.94) 53.51 3.40 (5.60) (1.22) (1.22) 50.09)

Stage 2 Cost of equity 6% 0.9(12% 6%) Value of equity 100m shares 676p Value of debt £45m
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WACC using market values

676 676 45 10.69%

11.4% 0.39%

45 676 11.08% 45

0.9 (1

0.3)

Stage 3 For simplicity assume a discount rate of 11 per cent.
Recurrent cash flows £53.52 7.191 DCFs for year 1: (3.42) 0.901 Net present value Less debt Shareholder value £ 384.86 3 3(3.08) 381.78) 345.00) 336.78)

This would suggest a share price of 337 pence, significantly below the quoted price. The key things to note about these calculations are: 1. Although using present values of future cash flows is theoretically the correct technique, it relies heavily on estimates of both cash flow and the discount rate. The subjectivity involved in making these estimates is one reason why share prices might suggest a very different market value, or capitalisation, and why share prices may fluctuate regularly and substantially. 2. The time horizon is arbitrary. Fifteen years is a long time to assume no changes in policies, and more detailed forecasts would be used in practice. An estimate could be made of a terminal value based on the worth of the company at the end of fifteen years. 3. Dividend payments are not deducted from the cash flows. This is because we are looking at the total value of the cash flows to shareholders. If we were doing a cash budgeting exercise for the coming year, we would of course deduct dividend payments. 4. The difference between the quoted share price and the calculated share price could stem from one of two things, broadly speaking, and assuming the markets are at least semistrong efficient: (i) The market has information that is different from that of the directors and estimates higher cash flows and/or a lower discount rate and/or uses a different time horizon (note the Whitbread example, where the market did appear to concur with the directors). (ii) The price includes speculation about activities such as takeover. This approach is simply the application of DCF techniques to the valuation of a company’s shares. Of course, the value for small lots of shares will be different from the value for the entire share capital, as a bidder will almost inevitably have to pay a premium for acquiring the entire share capital. And the price of small lots might also be affected at times by market-wide movements or sentiment, or by speculation about, for example, a takeover bid. Few people can have failed to observe the recent volatility of internet shares and this has led to some seasoned analysts questioning whether the SVA approach is relevant to new economy companies. There appears to be a consensus that, as David Skyrme and Debra Amidon8 assert, ‘knowledge management is becoming a core competence that companies must develop in order to succeed in tomorrow’s dynamic global economy’. The movement away from traditional companies with their heavy investment in tangible fixed assets has meant, according to Thomas Stewart9 that ‘knowledge has become the most important factor in economic life. It is the chief ingredient of what we buy and sell, the raw material with which we work. Intellectual capital – not natural resources, machinery or even
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financial capital – has become the one indispensable asset of corporations.’ The perceived difficulty of capturing the value of this intellectual capital (an intangible asset that is not shown on the balance sheet) has to be examined. It is difficult to state with certainty the cause and extent of any divergence between share price and the intrinsic value referred to by Keynes. Internet stocks highlight this difficulty. There may be an issue of thin trading, where a small change in the supply/demand equation for a share results in a relatively large movement in the share price, which is further compounded by the growing (and unregulated) use of bulletin boards on the internet where share tips and gossip encourages speculative behaviour. The emergence of strategies such as ‘pump and dump’ (the hyping of a share to encourage others to buy at inflated prices before realising your profit), and other momentum-based strategies, make it difficult to assess to what extent any short-term deviation between price and value is caused by uninformed traders, as opposed to an inherent weaknesses in SVA. Despite these sector specific problems, it can be argued that SVA is still a useful tool. But it needs to be supplemented by an awareness that knowledge-based companies have the potential to achieve high rates of growth by adapting and responding more speedily to the business environment than traditional businesses. This flexibility to determine the direction of their growth (referred to in the literature as ‘real options’) is measured through the valuation of future growth options.10 For example: market valuation of company value from existing business value of future growth opportunities. The ‘value from existing business’ element can be found using the SVA approach. It is likely that it is the second component which forms a large part of a new economy company’s value (as mentioned earlier, their scope for growth is high) and the difficulty of assessing this area is the subject of much current research. As Mills11 states: ‘Internet businesses are also often of the type where one opportunity leads to another, thereby making the projection of revenues and costs difficult. As a result, qualitative analysis may be as important as quantitative analysis in assessing the value of internet businesses, simply because investors in such businesses may be regarded as placing bets rather than making investments.’ Indeed, this may explain why analysts can justify such different valuations for the same company. Internet bookshop Amazon’s decision to develop the infrastructure to sell books over the internet allowed the company to move into the sale of CDs, toys, videos, electronic goods and an auction site. What else might the company move into? Unfortunately the decision points, probabilities and associated cash flows attached to the real options approach are extremely subjective. Some people have moved away from attempting to measure the value of the real options by reverting to a number of proxy measures designed to determine value, which may include number of visits to a website, the ‘stickiness’ (how long the user views the page) of the site, and its marketing spend. This view is countered by Maboussin and Hiler12 who argue that free cash-flow analysis is still relevant and that it is the lower investment in fixed assets which allows seemingly high valuations for internet businesses to be justified. As Boo.com and Clickmango demonstrated, cash is still king. The basic SVA approach, relying as it does on discounted cash flows, is really nothing new. By depending upon an accurate determination of the discount rate, it is possible that analysts are working with the same forecasts, but are choosing to discount them at different rates to arrive at company valuations. If companies are using SVA as a means of giving more information to the market, then we can only conclude that they do not have total confidence in the notion that the markets are semi-strong efficient.
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Companies may believe that there is no other avenue for this information to be reflected in share prices, and that a formal analysis enables this ‘new’ information to improve the market perception of them. With the uncertainty surrounding the valuation of new economy shares, then SVA undoubtedly has its place – at least it is grounded in something tangible by highlighting the importance of cash to the business. It is when one moves into the valuation of real options that subjective assumptions can alter dramatically the view of what a company is worth. The valuation of real options is a complicated topic because it can involve using SVA as a starting block, and then incorporating both the possible choices that the company may face, and the benefits which might possibly follow. It warrants deeper exploration.
References

1. A. Rappaport, Creating Shareholder Value: The New Standard for Business Performance, Macmillan, 1986. 2. CIMA, Management Accounting: Official Terminology, 2000 edn, CIMA Publishing. 3. J. Bogle, ‘Distortions in value creation’, Directors and Boards, winter 1999. 4. T. Copeland, T. Koller and J. Murrin, Valuation: Measuring and Managing the Value of Companies, 2nd edn, John Wiley, 1994. 5. R. Pike and Bill Neale, Corporate Finance and Investment, 3rd edn, Prentice Hall, 2000. 6. M. Miller, and F. Modigliani, ‘Dividend policy, growth and the valuation of shares’, Journal of Business, October 1961. 7. L. Serven, ‘Shareholder value’, Executive Excellence, December 1999. 8. D. Skyrme and D. Amidon, ‘New measures of success’, The Journal of Business Strategy, 19(1), 1998. 9. T. Stewart, Intellectual Capital: the New Wealth of Organisations, London: Nicholas Brealy, 1997. 10. A. Jägle, ‘Shareholder value, real options, and innovation in technology-intensive companies’, R&D Management, Vol. 29 No. 3, 1999. 11. R. Mills, ‘Valuing internet businesses. What is the intrinsic value of a share?’, Henley Manager Update, Vol. 11 No. 3, spring 2000. 12. M. Maboussin, and R. Hiler, ‘Cash flow.com: cash economics in the new economy, frontiers of finance’, CSFB Equity Research, Vol. 9, 1999.

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Revision Questions

5
1996 127 78 1995 122 77

Question 1
PDQ plc is a medium-sized listed company. The results to 31 December 1999 have just been announced. Earnings per share (EPS) and declared dividends per share (DPS) for the last 5 years are shown below:
EPS (pence) DPS (pence) 1999 140 82 1998 136 81 1997 131 79

Dividends are paid on 31 December each year, and the dividend shown as declared in a particular year would have been or will be paid on 31 December the following year. lf the current dividend policy is maintained, the directors of PDQ plc estimate that annual growth in earnings and dividends will be no better than the average growth in earnings over the past four years. PDQ plc is reluctant to take on debt at the present time to finance growth. The company is therefore considering a change in its dividend policy and total investment programme to allow 50 per cent of its earnings to be retained for identified capital investment projects, which are estimated to have an average post-tax return of 15 per cent. The market risk premium is expected to be 4 per cent over the risk-free rate of 6 per cent. The company’s beta is currently quoted at 1.5 and is not expected to change for the foreseeable future. Requirements (a) Calculate the share price which might be expected by the market: (i) if the company does not announce a change in dividend policy, (ii) if the company does announce a change in dividend policy, using whatever model(s) you think appropriate. (8 marks) (b) (i) Comment on the limitations of the model(s) you have used in your answer to part (a); (ii) Discuss the reasons why the share price might react differently from the market’s expectations. (12 marks) Note: Dividend valuation model: Earnings growth model: Capital asset pricing model: P0 P0 Erj D1 Ke E0(1 Rf g b) (1 Ke br Bj(Rm Rf) (Total marks
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br)

20)
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Question 2
The following financial data relate to RG plc:
Year 1995 1996 1997 1998 1999 Earnings per share (pence) 42 46 51 55 62 Net dividend per share (pence) 17 18 20 22 25 Share price (pence) 252 184 255 275 372

A firm of market analysts which specialises in the industry in which RG plc operates has recently re-evaluated the company’s future prospects. The analysts estimate that RG plc’s earnings and dividends will grow at 25 per cent for the next 2 years. Thereafter, earnings are likely to increase at a lower annual rate of 10 per cent. If this reduction in earnings growth occurs, the analysts consider that the dividend payout ratio will be increased to 50 per cent. RG plc is all equity-financed and has one million ordinary shares in issue. The tax rate of 33 per cent is not expected to change in the foreseeable future. Requirements (a) Calculate the estimated share price and P/E ratio which the analysts now expect for RG plc, using the dividend valuation model, and comment briefly on the method of valuation you have just used. Assume a constant post-tax cost of capital of 18 per cent. (10 marks) (b) Comment on whether the dividend policy being considered by the analysts would be appropriate for the company in the following two sets of circumstances: (i) the company’s shareholders are mainly financial institutions; and (ii) the company’s shareholders are mainly small private investors. (8 marks) (c) Describe briefly three other dividend policies which RG plc could consider. (7 marks) (Total marks 25)

Question 3
One theoretical method of valuing a company’s shares is to calculate the present value of future dividends using a discount rate that reflects the risk of the business. In respect of large, listed companies, current evidence suggests that this is far too simplistic a view of how company values and share prices are determined. Requirement Comment on the reasons why share prices may be substantially different from the level suggested by theory. Include brief comments on the relevance of P/E ratios and net asset values in share price determination. (5 marks)

Question 4
XYZ plc is a software house. It has been trading for 10 years and has shown strong yearon-year improvement in turnover and profits. Turnover for the last financial year was
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£48.5m and profits after tax were £9.4m. Growth in turnover and profits has averaged 15 and 12 per cent, respectively, over the 10-year trading period. Fifty-five per cent of XYZ plc is owned by the four founding shareholders, who are still directors and senior managers of the company. Employees, friends and relatives of the founders own the remaining 45 per cent. The company currently is all equity-financed, a ten-year loan of £1m, taken out when the company was formed, having just been repaid. The controlling shareholders are now considering flotation to allow them and their employees to realise some of the gains their shareholdings have earned. The average P/E ratio for established listed companies in the computer industry is currently 18.4. This has ranged between 17.5 and 21.5 over the past 12 months. The average post-tax cost of capital for the industry, according to a recent study, is 14 per cent. Requirement Calculate market capitalisation estimates for XYZ plc using two suitable evaluation methods, and comment briefly on your answer. (8 marks)

Question 5
MediCons plc provides a range of services to the medical and healthcare industry. These services include providing locum (temporary) cover for healthcare professionals (mainly doctors and nurses), emergency call-out and consultancy/advisory services to governmentfunded health organisations. The company also operates a research division that has been successful in recent years in attracting funding from various sources. Some of the employees in this division are considered to be leading experts in their field and are very highly paid. A consortium of doctors and redundant health-service managers started the company in 1989. It is still owned by the same people, but has since grown into an organisation employing over 100 fulltime staff throughout the UK. In addition, the company uses specialist staff employed in state-run organisations on a part-time contract basis. The owners of the company are now interested in either obtaining a stock-market quotation, or selling the company if the price adequately reflects what they believe to be the true worth of the business. Summary financial statistics for MediCons plc and a competitor company, which is listed on the UK Stock Exchange, are shown below. The competitor company is broadly similar to MediCons plc but uses a higher proportion of part-time to full-time staff and has no research capability.
Shares in issue (m) Earnings per share (pence) Dividend per share (pence) Net asset value (£m) Debt ratio (outstanding debt as % of total financing) Share price (pence) Beta coefficient Forecasts: Growth rate in earnings and dividends (% per annum) After-tax cash flow for 2000/2001 (£m) MediCons plc Last year-end: 31.3.2000 10 75 55 60 10 n/a n/a 8 9.2 Competitor Last year-end: 31.3.2000 20 60 50 75 20 980 1.25 7 n/a

Notes 1. The expected post-tax return on the market for the next 12 months is 12 per cent and the post-tax risk-free rate is 5 per cent.
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2. The treasurer of the company has provided the forecast growth rate for MediCons plc. The forecast for the competitor is based on published information. 3. The net assets of MediCons plc are the net book values of land, buildings, equipment and vehicles plus net working capital. 4. Sixty per cent of the shares in the competitor company are owned by the directors and their relatives or associates. 5. MediCons plc uses a ‘rule-of-thumb’ discount rate of 15 per cent to evaluate its investments. 6. Assume that growth rates in earnings and dividends are constant per annum. 7. The post-tax cost of debt for MediCons plc and its competitor is 7 per cent. Requirement Assume that you are an independent consultant retained by MediCons plc to advise on the valuation of the company and on the relative advantages of a public flotation versus outright sale. Prepare a report for the directors that provides a range of share prices at which shares in MediCons plc might be issued. Use whatever information is available and relevant and recommend a course of action. Explain the methods of valuation that you have used and comment on their suitability for providing an appropriate valuation of the company. In the report you should also comment on the difficulties of valuing companies in a service industry and of incorporating a valuation for intellectual capital. (25 marks) Note: Approximately one-third of the marks are available for appropriate calculations, and two-thirds for discussion.

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Solutions to Revision Questions

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Solution 1
(a) The required return on equity by PDQ’s shareholders using the CAPM is: 6% 1.5(10% 6%) 12%

Average growth over the past four years is 3.5 per cent and the average payout ratio is 60 per cent. (i) Using the dividend valuation model and assuming constant growth, the share price would be: D1 Ke g 82 1.035 12 3.5 998p

(ii) Using the earnings growth model and assuming the retention ratio is constant and the return on the investments perpetual: P0 E0(1 b)(1 Ke br br) expected return on

where b investment proportion (retentions ratio) and r investments. 140 50% 12 [1 (50% 15%)] (50% 15%) 1,672p

(b) (i) The assumptions underlying these models are fairly unrealistic: for example the DVM assumes dividends are the only determinant of share value; they ignore the possibility of outside finance and offer little guidance in determination of the cost of equity. In its commonest form it assumes constant growth. EGM, sometimes called free cash-flow model, allows for growth assuming permanent retention and a constant growth rate. Neither model can be used when growth is greater than the cost of equity, although the model can be adapted for temporary periods of supernormal growth. It is also not unreasonable to expect that the increased rate of return of 15 per cent will only apply to additional retention. (ii) The market will therefore make its own assessment of the company’s prospects. The increase in the retention ratio means that in the short term the dividend payment
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will fall. This may be interpreted by the market as a bad signal about the future, despite reassurances to the contrary by the directors. For example, when National Westminster Bank announced pre-tax profits in 1994 of £989 billion, up from £367 billion in 1993, the share price fell because the market did not like its small dividend increase. The announcement will be made in a dynamic market, and there are other influences on share price other than dividends and investment forecasts. For all these reasons the share price may not rise to anything like the level suggested by the calculations.

Solution 2
(a) The formula for the dividend valuation model is P0 D1/(Ke g), where Ke cost of equity, D1 dividend at end of year 1, that is, D0 growth, and g growth rate. In this question, however, we have two different growth rates. The appropriate course of action is to evaluate the first 2 years’ dividends, and apply the formula at the end of the period. On the basis of the information given, the following projections can be made:
Year 2000 2001 2002 DPS (p) 31.3 39.1 53.3 Discount factors 0.847 0.718 0.609 Discounted DPS (p) 26.5 28.1 32.5 87.1

Thereafter, the perpetuity value, assuming 10 per cent constant annual growth, is: D1 53.3 110% 58.63

Therefore, P0 from the end of 2002 is: 58.63 0.18 0.10 733 pence

This must be discounted back to the present, using the 3-year discount factor for 18 per cent:
Discounted value: 733 0.609 Plus: dividends for 2000–2002 Share price if market shares view of analysts pence 446.40 587.10 533.50

This represents a P/E ratio of 533.5/62, that is, 8.6. (b) On the basis of the policy suggested by the analysts, the company’s dividends would be a function of reported profits, albeit a different ‘cover’ from 2002 onwards. This is consistent with the company law philosophy (dividends may only be paid out of profits) and the fundamental accounting concept (profit is what you could afford to distribute and still be as well off as you were), but is obviously backward-looking. In practice, of course, profits are likely to be volatile, and a conflict arises between the benefits of maintaining dividend cover, and maintaining dividend growth. Recent years have shown how some boards have gone for prudence, and reduced dividends; others have demonstrated confidence in the future by holding or even increasing dividends. Financial
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management logic looks forwards, to make dividends an inverse function of opportunities to invest for a satisfactory return – providing a point of contact with the Modigliani and Miller theory that dividend policy is irrelevant to the value of the firm, provided that investment decisions are made in accordance with sound wealth-maximising principles. It is at this point, however, that differences emerge between the two categories of investor mentioned: (i) Financial institutions, for example pension funds, are in a favourable tax situation, in that they can reclaim the advance corporation tax imputed to their dividends. This makes a given stream of dividend income worth more to them than it is to a tax-paying individual shareholder, and explains the massive shift in the balance of ownership, despite privatisation. From a cash flow point of view, they also prefer dividends to capital gains, in that they avoid the transaction costs of obtaining the funds to meet their liabilities. It is likely, therefore, that institutions would press for a higher payout – as they did in 1991–92 when companies were reporting lower profits. (ii) Some individuals might be below the tax-paying threshold, or have invested in personal equity plans, and would therefore be in a similar position to the institutions. Most, however, will have to bear the imputed tax, or find themselves called upon to pay a further 15 percentage points of tax to bring the imputed amount up to their marginal rate. This category would, other things being equal, prefer capital gains, because of the relief available to compensate for inflation, and the annual exemption. They have been able to reinforce the shift mentioned above by moving into ISAs and National Savings. There is thus no dividend policy which satisfies all classes of shareholder. Understandably, therefore, there is growing support for tailoring it to a particular category, that is, seeking a homogeneous ‘clientele’. (c) There is a range of possible dividend policies, including: ● paying out all of its profits other than the amount needed to compensate for inflation (or, alternatively, the specific price increases associated with its assets) and accepting the need to make the case for attracting funds for real (or, respectively, operational) expansion; ● making a decision each year in accordance with current sentiment in the market, that is, based on what other companies are doing, what analysts are expecting; ● making a decision each year on the basis of perceived investment opportunities, judged against the contemporary perception of the cost of capital.

Solution 3
Since the future is unknown, a valuation based on the discounting of future cash flows will vary according to the assumptions made by the valuer as regards the cash flows, the margin of error, risk aversion and the cost of capital. The theory referred to in the question is rooted in the presumption that the market is so efficient that share prices are fair as between buyers and sellers, that is, they equate with the present value of future cash flows. It is not possible to prove this, objectively, since:
● ●

no such valuations are ever published; the value of a company does not entirely manifest itself in the form of cash unless it ceases to exist; by the time any valuation could be verified, it would be too late.
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Indeed, it is easily disproved by way of the null hypothesis, that is, were it to be valid:

it would be impossible for directors and managers to influence future cash flows, and strategic financial management would not exist – but it does; prices would only change significantly when cash flowed, but this is demonstrably untrue. It is not uncommon for the price of a particular share to rise or fall by 20 per cent or more in one day, usually as a consequence of a statement on current profitability.

Price/earnings ratios are the result of dividing last night’s share price by last year’s earnings per share, and therefore vary from day to day to exactly the same extent as share prices. They, not share prices, are the dependent variable. Many ‘start-up’ businesses, for example, are characterised by losses – but their share prices are never negative. The strongest observable correlation shown by share prices is with short-term accounting profit forecasts issued by the directors of the company. Net asset values have no direct connection with share values or prices. Where a company’s assets are primarily intangible, as with the drug companies (the pace of innovation, the reputation in the market place, etc.) the share prices are currently anything up to 50 times their net assets per share. Some companies – for example, those which have grown by acquisition – have net liabilities but, again, their share prices are never negative. The value to a buyer or holder of a share is the present value of its projected disposal price plus projected dividends in the interim. It is important to remember that the transfer of shares between shareholders has no effect on the cash flows of the company.

Solution 4
Last year’s earnings having been £9.4m, applying the industry average P/E ratio of 18.4 would suggest a market capitalisation of around £173m. The corresponding earnings yield of around 5.4 per cent per annum, if the cost of capital is really 14 per cent per annum, implies a compound growth rate of around 8 per cent per annum. In perpetuity, that seems a high figure, so we may choose to revisit our assumptions. That industry P/E ratio is around 15 per cent below its recent peak, so we might put an equivalent tolerance, that is, 15 per cent, producing a range of around £150m to £200m.

Solution 5
Report To: The directors of MediCons plc From: Independent consultant Date: Re: Valuation of company 1. Introduction and terms of reference Thank you for inviting me to provide advisory services in respect of estimating a valuation for your company. I have reviewed all the internal information made available to me and published information relevant to the exercise. I understand that you are considering two options: a flotation on a UK stock exchange or outright sale to another company. It is beyond the scope of this assignment to approach specific buyers for the company but I discuss later in this report the advantages and disadvantages of flotation at this time, as compared with an outright sale.
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2. Estimated values Using the information available, three methods of valuation can be considered: P/E ratios, dividend valuation and net asset value. The first two of these methods require use of a competitor company as proxy for certain information. The third method, net asset value, is not relevant here but is discussed briefly in section 2.3 of the report. A fourth method, net cash flow or shareholder value analysis, may arguably be superior, but I do not at present have sufficient information and the method has its limitations for valuing an entire company. 2.1 P/E ratios
EPS (pence) Share price (pence) No. of shares (million) P/E ratio (share price EPS) Market value (£m) (no. of shares share price) MediCons plc 75 n/a 10 n/a n/a Competitor 60 980 20 16.3 196

P/E ratios are available only for listed companies. However, we can use the P/E of a competitor to provide a rough estimate of the growth rating the market might award to a new market entrant in the same industry. The P/E for your closest competitor is 16.3. This is above the overall average for commercial and industrial companies and reflects the higher than average growth prospects for the medical and health industry. It is, of course, always possible that a share price reflects takeover speculation but, given that directors and connected persons own 60 per cent of the competitor company, this is unlikely here. Your own estimate suggests that your company might be growing faster than your competitor (8 per cent per annum compared with 7 per cent). All forecasts are, of course, unreliable. However, listed companies may have more opportunities for growth. A range of 17–19 as the P/E ratio the market might award MediCons plc is probably not over-optimistic. This would imply a market valuation of approximately £135 million on last year’s earnings. 2.2 Dividend valuation The dividend valuation model suggests that a company can be valued by reference to its dividend payment. The value is the sum of the stream of future discounted dividend payments plus the value of the shares when they are sold. If the lifespan of the company is considered infinite then we can use a ‘shortcut’ formula: P0 D1 ke g

where P0 is the equity value of the company, D1 is the next year’s dividend, ke is the cost of equity and g is estimated growth (assumed here to be constant). This method requires an estimate of cost of capital. You say that you use a discount rate of 15 per cent to evaluate investments but that this is ‘rule of thumb’. I have, therefore, estimated a cost of equity using your competitor company’s weighted average cost of capital (WACC). A full explanation of the capital asset pricing model and beta is beyond the scope of this report. In summary it provides a useful benchmark for the calculation of a company’s cost of capital that reflects certain types of risk that the company might face. The formula for ke is: Rf (Rm Rf)
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The ke

of the competitor is 1.25, giving a cost of equity of: 0.05 (0.12 0.05)1.25 0.1375, or 13.75%

The competitor’s debt to equity ratio is 20:80. The WACC (or k0) is therefore: (13.75% 80%) (7% 20%) 12.4% Assuming that the risk levels of MediCons plc and the competitor are broadly the same, we can use the competitor’s WACC and MediCons plc’s debt ratio to calculate a cost of equity for MediCons plc, using the formula: ke k0 (k0 kd) D E 7%) 10 90

12.4%

((12.4%

)

13%

All rates in the question are given post-tax. If this had not been the case, the formula would have had to be adjusted to allow for tax. The estimated valuation of MediCons plc using the dividend valuation model is therefore: £5.5m 1.08 0.13 0.08 £118.8m

This method has technical limitations and poses practical difficulties, but is a useful benchmark and as such is commonly used by security analysts. If we apply the same formula to your competitor company the value of that company would be: £10m 0.1375 1.07 0.07 £158.5m

2.3 Asset value This method of valuation has little relevance to any company, except in specific circumstances, such as a liquidation or disposal of parts of a business. In the case of a company which has a substantial amount of its value in human or intellectual capital, it has no relevance whatsoever, unless the company includes such capital in its accounts. This is not the case with MediCons plc. Within accounting guidelines, companies may include ‘brands’ and similar intangibles in the balance sheet, and thus net asset value. The argument for doing this is to make the market aware of the true value of a company that has substantial investments in such intangibles. Arguably, if markets are medium-strongform efficient, then the value of brands is already included in the market price (of quoted companies). If the market is less efficient, placing a value on ‘brands’ in the balance sheet might add to market efficiency and allow more accurate asset pricing. The problem, however, is to value the brands accurately for balance-sheet purposes. 2.4 Shareholder value analysis An alternative method of valuation is discounted net cash flows, or shareholder value analysis. This method involves identifying value drivers within the organisation, such as sales, working capital requirements and discount rate. It would be possible to do this
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3.

4.

for MediCons plc, but would require a much more detailed exercise than has been possible so far. To date you have provided a net cash flow forecast for only one year ahead. There is also a technical problem in the time horizon. The forecast would need to be made for a strategic planning period of between 5 and 10 years. Even then, there is a requirement to determine a terminal value at the end of the planning period. The costs and effort involved in determining all the necessary forecast figures may not justify the benefits. Advantages of flotation versus sale A major problem would be in finding a purchaser and agreeing a price, although establishing an issue price is also problematic, as noted above. Once listed, the market will provide a more accurate valuation of the company than had been previously possible. This clearly allows the realisation of paper profits. Outright sale would also have this advantage, but future gains arising from listed-company benefits would be lost to the original owners. This would also be true if you plan to sell your entire shareholding on flotation. I am assuming that you would not do this because of the adverse signals that this would send to the market and, as a consequence, the effect on the issue price and take-up of shares. A further advantage of a flotation would be that employee share schemes would be more accessible. This is also true of an outright sale, but the employees would not be guaranteed to keep their jobs if the buyer pursued a rationalisation programme. In the circumstances here – where many employees are highly qualified experts and probably in high demand – job security will not be an issue. Indeed, given that the company’s value might be so influenced by these employees, fear of losing them to a competitor might have an adverse effect on company valuation. A disadvantage of flotation is the relatively high cost involved, compared with a private sale, but this would still be a small proportion of the total proceeds. Also, control will be lost by the original owners but this is probably not an issue. Summary and recommendation We have two benchmark valuations that might be considered: £135 million using an estimated P/E ratio and £119 million using the dividend valuation model. The comparative figures for your competitor are £196 million and £158.5 million, respectively. The differences between the two figures for MediCons plc could arise from many factors, but it is the market valuation which is the most important, assuming that the market is informationally efficient. I would, therefore, suggest a minimum value of £135 million for MediCons plc, based on the following key factors: ● the market value of the competitor is unlikely to include any speculative element and is therefore unlikely to be ‘overpriced’; ● growth prospects for MediCons plc are forecast to be higher than those for the competitor; ● the value of the intellectual capital involved in MediCons plc is almost certainly higher than that for the competitor; ● MediCons plc has been valuing its investments using a discount rate of 15 per cent. This is probably too high and may have resulted in some worthwhile investments being rejected. If this is changed for the future it should have a positive effect on the company’s valuation. I would also recommend a flotation as it allows you to continue to participate in future growth of the company, assuming you choose to retain a shareholding. Signed: Consultant
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Mergers, Acquisitions and Buyouts

6

LEARNING OUTCOMES
Identify and evaluate the financial and strategic implications of proposals for mergers, acquisitions, demergers and divestments; Compare and recommend alternative forms of consideration for, and terms of, acquisitions; Calculate post-merger or post-acquisition values of companies; Identify and evaluate post-merger or post-acquisition value enhancement strategies; Evaluate exit strategies.

6.1 Introduction
The topics covered in this chapter are:
● ● ● ● ●

the reasons for merger or acquisition; forms of consideration and terms for acquisitions; the post-merger or post-acquisition integration process; types of exit strategy and their implications; defences against takeover.

6.2 Terminology and types of merger
6.2.1 Terminology
The term ‘merger’ is usually used to describe the fusing together of two or more companies, whether the fusion is voluntary or enforced. Strictly, if one company acquires a majority shareholding in another, the second is said to have been ‘taken over’ by the first. If the two firms join together to submerge their separate identities into a new company, the process is described as a merger.
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In fact, the term ‘merger’ is often used even when a takeover has actually occurred, because of the cultural impact on the acquired company – no one likes to be ‘taken over’! The development of accounting standards tends nowadays to restrict business combinations mainly to acquisitions, and balance sheets are required to give much more information as to the effect of the new assets acquired.

6.2.2 Types of merger
Acquisitions can be classified to reflect the nature of the enlarged group: (a) Horizontal integration results when two firms in the same line of business combine. The current trend in bank and building society mergers is a good example of this type of integration. (b) Vertical integration results from the acquisition of one company by another which is at a different level in the ‘chain of supply’ – as an example, breweries have moved heavily into the distribution of their product via public houses. Note, however, that the Monopolies and Mergers Commission (now the Competition Commission) acted to limit such activity when they felt the situation was not in the public interest. (c) A conglomerate results when two companies in unrelated businesses combine. Hanson is a conglomerate. Maybe its 1996 demerger is an indication of the demise of this type of structure. (d) Synergy – where NPVAB NPVA NPVB (or 2 2 5!). Companies merge where the net present value of the combined enterprise is deemed to be greater than the net present value of the individual firms.

6.3 The reasons for merger or acquisition
The main reason companies should merge is in order to maximise shareholder value. This suggests that a merger would take place only if the value of the combined entity is more than the value of the individual firms. If this were not the case, both companies would remain independent. The following reasons have been suggested as to why companies merge or acquire.

Increased market share – power. In a market with limited product differentiation price may be the main competitive weapon. In such a case, large market share may enable a company to drive prices – for example, reducing prices in the short term to eliminate competition before increasing prices later. Such a motive may create problems with the Competition Commission. Economies of scale. These result when expansion of the scale of productive capacity of a firm (or industry) causes total production costs to increase less than proportionately with output. It is clear that a merger which resulted in horizontal or vertical integration could give such economies since, at the very least, duplication would be avoided. But how could a conglomerate merger give economies? Possibly through central facilities such as offices, accounting departments and computer departments being rationalised. (Indeed, both sets of management are unlikely to be needed in their entirety.) Combining complementary needs. Many small firms have a unique product but lack the engineering and sales organisations necessary to produce and market it on a large scale. A natural

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course of action would be to merge with a larger company. Both companies gain something – the small firm gets ‘instant’ engineering and marketing departments, and the large firm gains the revenue and other benefits which a unique product can bring. Also if, as is likely, the resources which each firm requires are complementary, the merger may well produce further opportunities that neither would see in isolation. Improving efficiency. A classic takeover target would be a firm operating in a potentially lucrative market but which, owing to poor management or inefficient operations, does not fully exploit its opportunities. Of course, being taken over would not be the only way of improving such a poor performer, but such a company’s managers may be unwilling to give themselves the sack! A lack of profitable investment opportunities – surplus cash. A business may be generating a substantial volume of cash, but sees few profitable investment opportunities. If it does not wish to simply pay out the surplus cash as dividends (because of its long-term dividend policy, perhaps), it could use it to acquire other companies. A reason for doing so is that firms with excess cash are usually regarded as ideal targets for acquisition – a case of buy or be bought. Tax relief. A company may be unable to claim tax relief because it does not generate sufficient profits. It may therefore wish to merge with another firm which does generate such profits. Reduced competition is often one benefit of merger activity – provided that it does not fall foul of the Competition Commission. Asset-stripping. Very popular in the early 1970s, this was the result of a firm’s accounts not showing the true value of properties so that a predator would acquire it and realise the easily separable assets, perhaps closing down or disposing of some of its operations. The following reasons are of questionable validity

Diversification, to reduce risk. While acquiring a company in a different line of activity may diversify away risk for the companies involved, this is surely irrelevant to the shareholders. They could have performed exactly the same diversification simply by holding shares in both companies. The only real diversification produced is in the risk attaching to the managers’ and employees’ jobs, and this is likely to make them more complacent than before – to the detriment of shareholders’ future returns. Shares of the target company are undervalued. This may well be the case, although it would conflict with the efficient markets theory. However, the shareholders of the company planning the takeover would derive as much benefit (at a lower administrative cost) from buying such undervalued shares themselves. This also presupposes that the acquiror company’s management are better at valuing shares than professional investors in the market place.

6.4 Defences against takeover
6.4.1 Before the bid
Any quoted company needs to be aware of the possibility of a bid at all times. There are a number of ongoing points a board could follow to protect the company:

Communicating effectively with shareholders. This includes having a public relations officer specialising in financial matters liaising constantly with the company stockbrokers, keeping analysts fully informed, and speaking to journalists.
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Poison pills. For example, shareholders are issued rights to buy loan stock or preference shares which, in the event of a takeover, they have the right to convert into the acquiring firm’s equity shares or to enforce repurchase by the acquiror. Shark repellent – super-majority. The Articles of Association are changed to require a very high percentage of shares to approve an acquisition or merger – say 80 per cent. High asset values. Fixed assets are revalued to current values to ensure that shareholders are aware of true asset value per share. The right shareholders. Managing the shareholder base to ensure that the ‘right’ shareholders are on board. This would be difficult with a large, listed company.

6.4.2 After the bid

Rejection letter. Having received the bidder’s offer document, the target must issue any reply to shareholders within fourteen days. Profit forecast. Poor past profit performance can be compensated for by promising high future profits. However, the board may lose credibility in the short term if the forecast is too optimistic and in the long term if they fail to achieve the forecast. Wellcome brought forward their financial results when under attack from Glaxo. They were presumably not good enough, however – they were eventually taken over. Note that profit forecasts have to be endorsed by the company’s financial advisers. Attacking 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. If another company has already made a bid, then a new, more acceptable bidder could present itself as a ‘white knight’ to the board of the target. Competition Commission. The target company could seek government intervention by bringing in the CC. For this to be effective it would have to be proved that the takeover was against the public interest. The company could also appeal to the European Commission. The impact of regulation on takeover activity is discussed further in the following section.

In practice, directors do not operate purely on behalf of shareholders – they will, for example, take account of employees’ needs and, perhaps more importantly, their own.

6.5 Methods of payment for an acquisition
There are two main methods of financing an acquisition: cash and share exchange.

6.5.1 Cash
This method is likely to be suitable only for relatively small acquisitions, unless the bidding company has an accumulation of cash from operations or disinvestments. There are two potential advantages of a cash bid:

the shareholders in the acquired company are bought out completely, and have no further participation in the future profits of the combined firm – the shareholders in the acquirer retain control. the value of the bid is known and the process is simple – this might persuade the target company’s shareholders to sell.

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A disadvantage from the acquired company’s point of view is that there might be tax implications that might influence their decision. This is a fairly insignificant consideration these days.

6.5.2 Share exchange
Large acquisitions almost always involve an exchange of shares, in whole or in part. The advantage of this method of financing is that the acquirer does not part with cash and does not increase financial risk by raising new debt. It is also possible that the acquirer can ‘bootstrap’ earnings per share if it has a higher P/E ratio than the acquired company. The disadvantage of a share exchange is that the acquirer’s shareholders share future gains with the acquired company. How the estimated gains are split between the two parties is a matter for negotiation. The following is a simple example of how post-merger gains might be divided.
Example 6.A
The cost of merger: cash Market price per share Number of shares Market value of company Company A 7,500p 100,000 £7,500,000 Company B 1,500p 60,000 £900,000

If company A intends to pay £1.2m cash for company B, what is the cost premium if (a) the share price does not anticipate merger; (b) the share price includes a ‘speculation’ element of £2 per share? (a) The share price accurately reflects the true value of the company (in theory). Therefore, the cost to the bidder is simply £1,200,000 £900,000, that is, £300,000. The company is paying £300,000 for the identified benefits of merger. (b) The cost is £300,000 (60,000 £2), or £420,000. The company is therefore really worth only £13 60,000, or £780,000.

The cost of merger: share exchange Suppose company A offers 16,000 shares (£1.2m/7,500p) instead of £1.2m cash. The cost appears to be £300,000 as before, but because company B’s shareholders will own part of company A, they will benefit from any future gains of the merged enterprise. Their share will be (16,000/(16,000 100,000)), or 13.8 per cent. Further, suppose that the benefits of the merger have been identified by company A to have a present value of £400,000 (i.e. company A thinks that company B is really worth £900,000 £400,000, or £1.3m). Therefore, the combined firm of A and B is worth £7.5m £1.3m, or £8.8m. What is the true cost of merger to the acquirer’s shareholders? Estimate of post-acquisition prices
Proportion of ownership in merged company Market value: £8.8m proportion of ownership Number of shares currently in issue Price per share Company A 86.2% £7.586m 100,000 759p Company B 13.8% £1.214m 60,000 202p

What we are attempting to do here is to value the shares in the company before the merger is completed, based on estimates of what the company will be worth after the merger.
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The valuation of each company also recognises the split of the expected benefits which will accrue to the combined form once the merger has taken place. The true cost can now be calculated:
60,000 shares in company B @ 202p Less current market value Benefits being paid to company B’s shareholders £ 1,212,000 2,900,000 2,312,000

6.5.3 Other types of finance
Other types of finance could be used – for example, raising new debt. This would have the same advantages as a cash acquisition: the shareholders in the acquired company are bought out. The disadvantage to the acquirer could be an increase in gearing (and therefore risk). This is a separate issue: sources of finance and the effect on capital structure were covered in Chapters 3 and 4. The disadvantage to the target company’s shareholders is that loan stock might be infrequently traded, and this will affect the company’s ability to liquidate the investment should they need to. Also, the lack of marketability might adversely affect the value of the security.

6.5.4 Earn-out arrangements
The purchase consideration is sometimes structured so that there is an initial amount paid at the time of acquisition, and the balance deferred. Some of the deferred balance will usually only become payable if the target company achieves specified performance targets. Earn-out arrangement: A procedure whereby owner/managers selling an organisation receive a portion of their consideration linked to the financial performance of the business during a specified period after the sale. The arrangement gives a measure of security to the new owners, who pass some of the financial risk associated with the purchase of a new enterprise to the sellers. (Official Terminology, 2000)

6.6 The post-merger or post-acquisition integration process
6.6.1 Impact on ratios or performance measures
Following the completion of an acquisition the purchaser will need to examine thoroughly the financial and management accounting records of each business unit of the acquired company. Thus, the directors of the acquirer will be particularly interested in the financial condition of those units which they might plan to dispose of. From a strategic point of view these are likely to be of more use to another company with whom they would form a better fit. However, it is still essential that financially and operationally they should be in as good shape as possible to ensure that a good price can be obtained for them. Let us assume that one such acquired company unit is their Wodgits subsidiary. The acquirer itself may not have a unit close enough to Wodgits’ business to make ready financial comparisons, so a search must be made for a competitor against which to measure some
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key financial ratios. A small plc called Bigwodge, whose core business is similar to Wodgits, would seem suitable, so by using all published and any other information reasonably available, the following analysis could be constructed:
Return on capital employed (ROCE) Asset turnover (AT) Net profit as percentage of sales (NP) Current ratio (CR) Stock turnover (based on sales) (ST) Debtor days ( DD) Creditor days ( based on sales) (CD) Wodgets 14.9% 1.3 times 11.5% 1.5 times 5.4 times 54 49 Bigwodge plc 25.0% 1.8 times 13.9% 2.2 times 6.4 times 43 37

To refresh your memory concerning ratios, we will assume possible values of the ratio elements to support the calculations as follows:
Ratio ROCE AT NP CR ST DD CD Formula Profit before interest and tax Capital employed (net assets) Revenue Capital employed Profit before interest and tax Revenue Current assets Current liabilities Sales Stock Receivables 365 Revenue Creditors 365 Revenue Wodgits £000 860 0.149 5,770 7,500 5,770 860 7,500 2,700 1,800 7,500 1,400 1.3 0.115 1.5 5.4 54 49 Bigwodge plc £000 2,220 0.25 8,900 16,000 8,900 2,220 16,000 5,500 2,500 16,000 2,500 1.8 0.139 2.2 6.4 43 37

1,100 365 7,500 1,000 365 7,500

1,900 365 16,000 1,600 365 16,000

As the acquirer’s management accountant, how would you advise the directors on the basis of the above comparisons? Your report could address return on capital employed and concern about liquidity. Return on capital employed (ROCE) Wodgits’ inadequate ROCE seems to be mainly due to a low rate of asset turnover, which we must carefully investigate. We know that land and buildings account for £2.5m of Wodgits’ fixed asset total of £4.87m and it is important to establish how much of this property value represents redundant assets. As to plant and machinery, it may be that this is substantially new or revalued, in which case the assets may be of good value and the faults may lie mainly in under-capacity working or production inefficiencies. Much more serious, however, would be a situation where the plant is old and requiring heavy maintenance, and would be hard put to cope with increased volume of throughput. If the first of these plant scenarios is correct, then Wodgits may well fetch a reasonable price, as a bidder, possible Bigwodge themselves, would be obtaining good assets to add to their own evidently successful performance in their sector. If the second scenario applies, then we might find it difficult to obtain net asset value for the assets remaining after sale of the redundant properties.
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Current ratio Wodgits’ current ratio and stock turnover are fairly good but before we put the unit up for sale, we would improve our prospects for a reasonable price by taking early action in regard to both receivables and creditors. Both are too high and we should aim to tighten up credit control and also bring creditors down to the more acceptable level which Bigwodge indicates is appropriate for the industry sector. Conclusions Assuming that we can find that, say, £1.5m of land and buildings are redundant and can be separately sold, and that the plant scenario is favourable or can be made so, then it would not seem to be too difficult to make the remainder of Wodgits a saleable proposition. Thus if we can assume no debt interest, and taxation of 33 per cent, then after-tax profits could be £576,000 (£860,000 0.67), and as Bigwodge’s current P/E is 18, we might achieve for Wodgits a P/E of 9 or 10 which suggests a price of between £5.2 and £5.8m, which is comfortably above an asset value of £4.3m (£5.8m £1.5m assets sold).

6.6.2 Acquirer’s post-acquisition share price
A very important aspect for an acquirer is the post-acquisition effect on its earnings per share (EPS), and the impact on the share price and P/E ratio arising from the market’s perceived views on the acquisition. Let us first consider EPS. Assume that the new company starts with a prospective EPS of 13.1 pence based on combined profits of acquirer and acquired of £8.4m, and 64m shares in issue, and if these earnings could be maintained in year 1 (post-acquisition) they would appear not to be diluted. However, if the acquirer is expected from its previous performances to attain 10 per cent per annum growth in normal (money) terms, then for year 1 EPS of 13.1 pence 1.1 would be 14.4 pence, and arguably if this is not attained then dilution will seem to have taken place. A serious threat to an acquirer’s EPS is the ‘getting to know you’ costs and also the ‘reverse synergy’ effects of 2 2 3, which sadly seems to be the fate of numerous acquisitions. A major question is whether the present value of the combined earnings, including assumed longer-term profit improvements, really takes into account all the downside costs of putting two different organisations together, each with its own management style. We come back to the assessment made above of the key financial performance ratios of Wodgits, and would suggest that this analysis should be performed for each business unit. If the core business is similar to that of a business unit of the acquirer, then the ratios of that acquired company unit should be compared with those of the relevant unit of the acquirer. As stated above, for those acquired company units not comparable with the acquirer’s units, then comparison should be made with another company in the appropriate industry sector.

6.6.3 Example of share valuation, its effects and reasons for acquisition
This example looks at aspects of share valuation and its effects on the acquirer and the acquired.
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Example 6.B
Oscar Wills is the chief executive of OW plc. The company has been trading for 5 years and is quoted on the stock market. Oscar is ambitious and aims to make his company market leader within 5 years. He makes an offer to acquire Wilde plc, an older quoted company of similar size to OW but with a profit record that has been erratic in recent years. Wills is of the opinion that Wilde lacks marketing strength and feels that he could make the company much more profitable. A summary of the financial data before the bid is as follows: OW 40m £4m 20 Wilde 44m £4.4m 10

Number of shares in issue Earnings available to ordinary shareholders P/E ratio

Oscar Wills’ estimated financial data, post-acquisition Estimated market capitalisation Estimated share price Estimated EPS Estimated equivalent value of one old Wilde share £167.7m 262p 13.1p 143p

The offer is six OW shares for eleven Wilde shares. The offer is not expected to result in any immediate savings or increases in operational cash flows.

Requirements
(a) What reasoning did Oscar Wills use to calculate his estimate of post-acquisition values? Would you agree with his calculations? If not, give your own estimates of the post-acquisition share price, assuming the takeover goes ahead. (b) If Wilde’s shareholders rejected the bid, what is the maximum price OW would pay, without reducing its shareholders’ wealth, assuming Mr Wills’ estimates of post-bid market value is correct? (c) Give reasons why OW would wish to make the acquisition and comment on likely post-acquisition effects on the P/E ratio. (d) Discuss other post-acquisition impacts that the directors of OW plc should consider.

Solution
(a) Pre-acquisition Earnings (£m) Number of shares (m) EPS (p) P/E ratio Share price (p) MV (£m) Post-acquisition Proportion of new company owned by: Wills (40/64) Wilde (24/64) Market value (prop. £167.7m) Number of shares pre-acquisition (m) Post-acquisition price per existing share (p) OW 4 40 10 20 200 80 Wilde 4.4 44 10 10 100 44 OW Wilde

8.4 64 13.1 20 262 167.7 (on Wills’ estimate)

62.5% 104.8 40 262 37.5% 62.9 44 143

Oscar Wills has applied his own pre-acquisition P/E ratio to the combined earnings of the new group. The difference between the combined market values pre-acquisition (£124m) and the estimated market value post-acquisition (£167.7m) is £43.7m. This is Wilde’s pre-acquisition earnings multiplied by the difference between the company’s pre-acquisition P/E and the combined post-acquisition P/E (20 10 10). EPS for Oscar Wills appears to have increased from 10p to 13.1p because of this ‘bootstrapping’ effect.
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In the absence of any immediate commercial benefits, or the disclosure of new information during the bid, there is no reason why the market value of the combined group should be any different from the total of the two individual companys’ market values – that is, £124m. This would suggest the following post-acquisition prices per existing share: Wills: £124m Wilde: £124m 62.5% 37.5% £77.5m or 194p per existing share compared with 200p per share now £46.5m or 106p per existing share compared with 100p per share now

There is a transfer of wealth from Wills’ shareholders to Wilde’s, because the terms of the offer are slightly more generous than the ratio of the old share prices. The pre-acquisition prices suggest 1-for-2, not 6-for-11. (b) Estimated value of combined firm (per OW) Value of OW before merger Maximum price £168m £80m £88m

This is £44m over the existing value of Wilde’s shares. It can be reconciled by multiplying the historic earnings by the difference between Wilde’s P/E and OW’s P/E – i.e. £4.4m (20 10). (c) OW plc may have had the following among their reasons for making a bid for Wilde plc: ● Expectation of growth. OW is an ambitious company and it sees in Wilde a means of growing faster and more cheaply than by internal expansion, especially as Wilde seems to be a ‘slumbering heavyweight’ relative to OW. ● Management and technical staff. Wilde’s results may be erratic, but OW is aware that in terms of size and quality of main products Wilde is a significant player in its market sector. It is reasonable to assume therefore that Wilde may be suffering from poor administrative as well as marketing management, which could considerably undervalue the earning potential of its products. By means of more aggressive marketing and improved administration, OW believes that dramatic profit improvements are possible. Also Wilde may possess strong technical expertise which OW might find difficult and expensive to obtain by internal development. ● Market share. If Wilde is in the same industry sector as OW, this could well be a main reason for the bid, in which case OW’s shareholders might have less reason to be concerned over the price. Thus if the acquisition led to OW’s market share rising fairly quickly to make the new company second or third in its sector, and not excessively far below the leader, it could begin to wield significantly greater influence in that sector. ● Synergy savings. Wilde may have a number of ‘dogs’ (Boston Consulting Group term for bad failure) among its business units, which OW may be much less prepared to pour resources into, even though some may be the Wilde chairman’s ‘pets’. However, if this aspect is known to the market, then the synergy savings may well attract a higher bidder. ● Risk reduction. From the comparative P/E ratios it seems evident that Wilde is regarded by the market as being much riskier than OW, and this could well be due to Wilde being an acquirer of struggling companies, bought at cheap prices, possibly even in sectors only remotely related to Wilde’s core business. Such companies often turn out to be disasters, taking up disproportionate amounts of the acquirer’s valuable management time. At OW, Mr Wills does not believe in keeping a ‘kennelful of dogs’! and the profit improvement suggested is likely to come not only from more aggressive marketing but from a concentration of resources on key products, thereby reducing risk in the new company. Next, the acquirer needs to be concerned at the post-acquisition effects on its P/E ratio. On the basis of the preacquisition estimates, Mr Wills looked to maintain OW’s own P/E ratio of 20 (262p 13.1p), but on the more realistic basis of assuming a value of 194p per share – which assumes that OW inherits the greater risks of Wilde’s current operations – then, as shown above, for the new company the market capitalisations should be simply added together, making £124m and the P/E ratio becomes 194p 13.1p 14.8. However, we must now consider the possibility of downside costs in year 1; thus even assuming that OW has taken several steps to improve Wilde’s operations and perhaps made some significant asset sales, an upset to earnings caused by ‘teething troubles’ could do more than offset the effect of the improvements. Thus, EPS of, say, 13.5p for year 1 (instead of 14.4p, showing 10 per cent expected growth), which one would expect to yield a P/E ratio of approximately 15.2 (13.5p 13.1p 14.8), might well fall back to about 13, or even 12. Downside factors often seem to the market to be more significant than improvements. Clearly then, at the time of making its bid, it would have been most unwise for OW to pay excessively for ‘synergy savings’ and not to give due regard to possible adverse post-acquisition impacts. (d) Further post-acquisition aspects ● Position audit. As an initial move, OW will need to do much more than analyse key financial factors of each of Wilde’s units. OW’s management will need to get a proper understanding of the main ‘stakeholders’ of each Wilde unit, for example, staff, customers and suppliers, and an appreciation of the products or services provided. In company planning, this wide-ranging survey is of the nature of a ‘position audit’, which should help considerably in speeding up the ‘getting to know you’ aspect which is so important if the full benefits of the acquisition are to be obtained.
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Improving efficiency. It is better for OW to approach Wilde more as a management consultant rather than to demand immediate changes without adequate explanation. Administrative savings mainly involve people, and OW must try to ensure that the logic of its proposals is clearly explained to Wilde’s management and staff, and as far as possible their cooperation gained. Redundancies need to be worked out fairly but firmly with an emphasis on voluntary redundancy as far as possible; the main purpose must be to reduce the resentment of those who are losing their jobs and to provide as much help as possible by way of counselling or assistance in job-seeking. In these situations uncertainty should be avoided, as it tends to demotivate the entire workforce, and rumour is liable to feed greedily on rumour. Even if Mr Wills is convinced that Wilde’s marketing needs to be more aggressive, he should first of all make himself fully aware of the nature of Wilde’s marketing policies and of their customers and competitors. If Wilde is substantially in the same market sector as OW, there may be certain valuable niches occupied by Wilde which OW would do well to retain. Profit improvement. The financial analysis of Wilde’s units suggested above will help to pinpoint the areas where profit improvements can be obtained, but it is essential that a comprehensive action plan is then prepared, as far as possible in co-operation with Wilde’s management, and reasonable time allowed for the phasing-in of significant changes. It is not helpful to go ‘stomping around’ offices and factories, thereby emphasising the perceived incompetencies of Wilde personnel. It may be that many faults, especially of inadequate systems, may already be recognised by Wilde staff and, faced with the necessity of correcting them, they may be quite willing to join in making appropriate changes. Sadly, it is often the case that obstinate managers may be standing in the way of improvement, and in this situation OW is in a good position to take quick but fair and firm action, possibly by grasping the nettle of making major changes in Wilde’s organisation structure if this is seen to be necessary for a more profitable operation. Asset sales. Here it is often the reluctance of top management to dispose of redundant assets and ‘dog’ units, even though it is recognised that keeping them represents a serious waste of management time and scarce resources. OW will need to make it quite clear as to which activities are to be retained, which merged with OW units and which disposed of, but in all cases the logic of each move should be clearly explained to the Wilde management and staff affected. This assumes, of course, that OW has thought through what it intends to do, which again is a good reason for first carrying out a position audit before taking action on Wilde‘s operations. Effective communication. Finally, a qualitative factor of the utmost importance, as by effective communication we mean that OW must do all possible to ensure that Wilde is on the same ‘wavelength’ as itself. New reporting systems and procedures should only be introduced after proper consultation, in which OW will need to make clear their purposes and ensure that changes will not cause serious disruption to Wilde’s operations. This is especially true in seeking computer system compatibility, which will call not only for careful planning but an acceptance by OW that in this, as with other system changes, a sufficient period of parallel running may be an essential procedure. There should be reasonable opportunities for Wilde staff to have contact with those of OW and vice versa, especially through participation in training procedures and conferences; also Wilde staff should be encouraged to feel that promotional prospects throughout the new company will be open to them. All the points made in this section concerning redundancies, changes and reorganisation created by the acquisition of Wilde apply equally to the need for OW to keep its own staff properly informed, otherwise demotivation may also affect OW with consequent damage to its own profitability whatever happens with Wilde. Perhaps, in the end, the most effective post-acquisition strategy that OW can apply to Wilde and itself is to provide an atmosphere in which both sides are able to talk freely with each other, seeking co-operation wherever possible, and even though some of OW’s actions – improving profitability and making asset sales – may be very hurtful to Wilde, at least things can probably be made somewhat more acceptable if the justification for them is properly explained to all concerned, and that includes any of OW’s own staff who may also be affected.

Example 6.C
This example involves discussion of the significance of each of six different reasons for proceeding with the acquisition. You are required to evaluate net assets and price/earnings ratio as alternative methods of valuation, with discussion as to the most appropriate basis to be used in this case. The whole question has to be answered on the basis of given data in respect of the acquired company, in which a firm of venture capitalists has a significant interest in terms of long-term loan capital. The prospective acquirer is a public company. G Limited operates in the gaming and betting industry. The company was established 7 years ago, and the two founder directors still provide the necessary technical and marketing skills. They own 60 per cent of the issued share capital, the balance plus the long-term loan capital having been subscribed by a firm of venture capitalists.
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Extracts from the annual reports of G Limited are given opposite, together with supplementary information. You are acting as financial adviser to a public company, H plc, in the hotel business. H plc is considering a takeover bid for the shares of G Limited.

Requirements
(a) Discuss the extent to which each of the following six reasons might apply to the proposed acquisition of G Limited by H plc. Support your answers with appropriate analysis of the data provided. (i) Access to innovation (ii) Growth in earnings per share (iii) Achievement of operating economies (iv) Reduction of risk through diversification (v) Access to liquid funds (vi) Improved asset backing for borrowing.

Data relating to G Limited – extracts from annual reports Year ended 30 June Tangible assets At cost Less: depreciation Development costs At cost Less: written off Current assets Inventory Trade receivables Other receivables Cash Current liabilities Trade creditors Taxation Other Net current assets Total assets less current liabilities Long-term loans Net assets Share capital (shares of 25p each) Profit and loss account Revenue Operating profit Loan interest Taxation Profit retained Remuneration of founding directors 2000 £000 224 354 170 254 176 378 30 97 12 321 140 31 12 24 67 73 321 160 161 100 361 161 860 55 (20) 3(9) 326 325 1999 £000 174 334 140 189 109 380 40 64 8 314 126 28 6 17 51 75 295 160 135 100 335 135 684 68 (14) 3(6) 348 320 1998 £000 133 323 110 129 53 76 31 48 9 35 93 21 – 11 32 61 247 160 387 100 3 (13) 387 1 547 3 16 (12) 1–1 334 320 1997 £000 113 313 100 72 23 49 25 42 7 36 80 17 – 39 26 54 203 120 383 100 3 (17) 383 1 421 3 38 (8) 1–1 330 320 1996 £000 58 38 50 32 37 25 22 30 6 19 77 11 – 38 19 58 133 180 153 100 3 (47) 353 1 281 (39) (6) 1–1 (45) 318 1995 £000 44 34 40 12 32 10 12 15 5 32 34 8 – 38 16 18 68 50 18 20 (2) 18 ( 175 1 (3) 1–1 33 (2) 315

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Supplementary information
The directors now forecast that profits after tax for the next 4 years will be as follows: Year ended 30 June 2001 2002 2003 2004 £000 29 42 55 68

(b) Assuming that a bid is to be made, calculate alternative values for the total equity of G Limited, based on: (i) net assets; (ii) P/E ratio based on earnings; and discuss which basis should be used, having regard to the interests of the founder directors of G Limited and of the venture capitalist. For listed companies in the gaming and betting industry, the range of P/E ratios is currently between 10 and 15, which suggests that for an unlisted company, P/E ratios between 6 and 9 would be appropriate.

Solution
(a) (i) Access to innovation. To comment upon this fully would require detailed profit and loss account information. However, the development costs capitalised on the balance sheet give an indication of considerable increase in development as opposed to research expenditure which has been undertaken, assuming that this does not reflect changes in accounting policy. Against this, the high rate of write-off suggests that the life of developed products may well be short. As innovation depends on people, H plc should identify and take steps to retain key staff in the event of a takeover. (ii) Growth in earnings per share. The impact of the acquisition on the earnings per share of H plc will depend upon the price paid and whether the price included shares of H plc. The past profit performance of G Limited and forecast earnings are certainly erratic and lower in relation to turnover. This may be due to poor management, in which case the firm could be turned around and earnings improved or it could be uncontrollable factors in which case earnings might be low and volatile in the future. The counter-view would be to suggest that if the rapid growth of the past 3 years can be maintained, then there must be opportunities for boosting earnings even if the profit forecasts do not reflect this. (iii) Achievement of operating economies. The achievement of such economies depends upon integration of similar businesses. Given that hotels and gaming and betting are closely linked there may be scope for such economies if gambling operations already occur or are planned at the hotels of H plc. (iv) Reduction of risk through diversification. G Limited has volatile earnings and is more likely to increase the risk profile of H plc than reduce it. (v) Access to liquid funds. Although there is no ready cash in G Limited the company has had a satisfactory liquidity position for several years with liquidity ratios of between 4.1 (1996) and 2.1 (2000). However, it should be noted that the position has worsened slightly over recent years. It is probable that since the hotel industry typically has fairly low liquidity, acquiring G Limited will improve the liquidity position of the group as compared with H plc. (vi) Improved asset backing for borrowings. Tangible fixed assets at cost less depreciation have increased more than fourfold during the period 1995–2000. Obviously comments which can be made are limited due to a lack of categorisation of assets and detail of movements. However, the low depreciation charge suggests that there is land and buildings or long leasehold property among the assets. Such assets provide good security for borrowing, and as assets are at cost the borrowing capacity may well be higher as it will reflect market values. (b) (i) The net asset value per the books is £161,000. This is a historical cost valuation and includes £78,000 of an intangible asset. However, as fixed assets are fairly new there should be little need for adjustment. Stock turnover is high and therefore this valuation is probably accurate. However, debtors have grown 52 per cent in the last year against a 26 per cent growth in sales and therefore their collectability should be investigated. A net asset valuation would also require an assessment of goodwill, which in a fast-growing company like this may well be significant. Valuations may therefore range from a conservative £83,000 (net assets less development costs) to an upper figure which depends on the value of goodwill. (ii) P/E ratios range from 6 to 9 (0.6 10 and 0.6 15) for unlisted companies such as G Limited. The company has only been established 7 years and has demonstrated considerable earnings growth in the period despite difficulties in 1998. The appropriate earnings figure for a P/E ratio approach could be 2000 if the outlook was good or an average of 2000 and 1999 (to include earlier years with results affected by startup would probably be unreasonable). No adjustment has been made for directors’ remuneration as the amount

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seems reasonable or even low for active participation. This gives earnings of £26,000 or £37,000 respectively. On this basis the best value would be: £37,000 and the worst: £26,000 6 £156,000 9 £333,000

Given earnings volatility, an offer at the lower end of this range is justified. The founder directors’ interests would probably be best served by service contracts and a moderate payout for the shares. The venture capitalist will probably be a willing vendor given the erratic performance of the investment and therefore an offer at the lower end of the range (given by the net asset approach) may well be successful.

6.7 Reasons why mergers and acquisitions fail

The fit/lack of fit syndrome. There may be a good fit of products or services, but a serious lack of fit in terms of management styles or corporate structure. Lack of industrial or commercial fit. Failure can result from a horizontal or vertical takeover where the biddee (the acquired company) turns out not to have the product range or industrial position that the acquirer anticipated. Usually in the case where a customer or supplier is acquired, the acquirer knows a lot about the acquired company; even so, there may be aspects of the acquired company’s operations which may cause unexpected problems for the acquirer, such that, even in these cases, a prospective acquisition should be planned very carefully and not be based solely on experience gained from a direct relationship with the acquired company. Lack of goal congruence. This may apply not only to the acquired company but, more dangerously, to the acquirer, whereby disputes over the treatment of the acquired company might well take away the benefits of an otherwise excellent acquisition. ‘Cheap’ purchases. The ‘turn around’ costs of an acquisition purchased at what seems to be a bargain price may well turn out to be a high multiple of that price. In these situations, the amount of resources in terms of cash and management time could well also damage the acquirer’s core business. In preparing a bid, a would-be acquirer should always take into account the likely total cost of an acquisition, including the input of its own resources, before deciding on making an offer or setting an offer price. Paying too much. The fact that a high premium is paid for an acquisition does not necessarily mean that it will fail. Failure would result only if the price paid is beyond that which the acquirer considers acceptable to increase satisfactorily the long-term wealth of its shareholders. Failure to integrate effectively. An acquirer needs to have a workable and clear plan of the extent to which the acquired company is to be integrated, and the amount of autonomy to be granted. At best, the plan should be negotiated with the acquired company’s management and staff, but its essential requirements should be fairly but firmly carried out. The plan must address such problems as differences in management styles, incompatibilities in data information systems, and continued opposition to the acquisition by some of the acquired company’s staff. Failure to plan can – and often does – lead to failure of an acquisition, as it leads to drift and demotivation, not only within the acquired company’s organisation but also within the acquirer itself. Every aspect of a prospective acquisition, as it will affect the would-be acquirer, should be weighed up before embarking on a bid. Problems of integration have a much better chance of being resolved before bidding action is taken than they do after the event, when many more complications can ensue.

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Even if a product fit is satisfactory, the would-be acquirer should be satisfied that the aspects of its own operation affected by the bid will be properly adaptable to the new activities. Running the rule carefully over one’s own operations may yield vital information as to areas which may need adaptation before a bid can be contemplated, and provide vital clues to appropriate areas for search when a bid has actually been launched. One factor of special importance is a clear assessment of the flexibility of one’s own information systems. Inability to manage change. Several of the above points stress the need for an acquirer to plan effectively before and after an acquisition if failure is to be avoided. But this in itself calls for the ability to accept change – perhaps even radical change – from established routines and practices. Indeed, many acquisitions fail mainly because the acquirer is unable – or unwilling – reasonably to adjust its own activities to help ensure a smooth takeover. One such situation is where the acquired company has a demonstrably better data information system than the acquirer, which it might be greatly in the acquirer’s interest to adopt.

6.8 Management buyouts
Management buyout : A transaction in which the executive managers of a business join with financing institutions to buy the business from the entity which currently owns it. (Official Terminology, 2000) There are a number of situations in which a management buyout (MBO) might be considered:

● ● ●

the management of the division may feel isolated from the main decision-making process of the group; the group may wish to dispose of a loss making subsidiary; the parent company may need to raise cash to find on acquisition; the group may want to focus on its designated core activities.

Members of the buyout team may possess detailed and confidential knowledge of other parts of the vendor’s business and the vendor will therefore require satisfactory warranties over such aspects which it will not be able to control. More seriously, key members of the MBO team may have skills vital to the vendor’s operation, especially in regard to information services and networking. A vendor may be reluctant to allow key players to end their contracts of service to take part in an MBO, because losing vital operational skills can hardly be compensated by forms of warranty.

6.8.1 Financing MBOs
Financiers tend to favour established businesses with reliable cash flows (to pay down the debt) and a clear exit route. They like definitive plans, but say they prefer them brief and to the point. The emphasis should be on the competences of the team, and the market opportunity to be exploited, with detailed financial numbers (majoring on cash flow) put into an appendix. How services previously supplied by group departments, or fellow subsidiaries, will be replaced is likely to be a key item. Managers will be required to invest some of their own money and this will take the form of shares with special features, for example, a high
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proportion of any disposal value. Capital structures are inevitably complex, with several levels of risk/reward:

Secured loans are usually obtained from a bank, with a first charge on the assets taken over by the venture. The provider of senior debt will require a first-ranking security over all the assets involved in the MBO venture and, usually, over the capital of the MBO as evidenced by shares in the new company. Security will also involve undertakings from the MBO team regarding the provision of financial information and the setting of restrictions on the MBO’s capacity to raise other debt finance and to dispose of assets. Junior debt is usually called mezzanine finance, which is an intermediate stage between senior debt and equity finance in relation to both risk and return. The return on mezzanine finance can comprise a mixture of debt interest and the ability to convert part of the debt into equity, perhaps by the conversion of warrants. By this means the lender can in time have a share in the premium resulting from eventual exit from the venture. The debt interest will carry a risk premium, as it is subordinate to the senior debt and with less security: it may even be unsecured. Venture capital is a form of equity provided mainly by institutional investors, whose reward will usually be in some form of dividends, probably preferential, combined with appreciation of their MBO equity holding which will build up a capital gain for when the investment is realised. The last link in the structural chain is the equity holding granted to the MBO team itself which, if their activities are successful, will provide a substantial capital gain when the venture is exited, either through flotation or by other means. Meanwhile, the MBO management will draw salaries or fees for their services.

6.8.2 Evaluation by investors and financiers
Key points for investors – usually banks or other institutions – in deciding whether to support an MBO are as follows:

What is actually for sale, and why? It may be a division or subsidiary of a company which no longer fits that company’s strategy, or it may be separable assets such as a factory or group of retail outlets. Whether the activities are profitable and enjoy a satisfactory cash flow. The prospective returns must justify the operational and financial risks involved. Profits must be sustainable and cash flow adequate to sustain the level of activities proposed. Whether the management is sufficiently strong. This point is particularly significant if the MBO relates to loss-making activities, although sufficient allowance must be made for the possibility that its existing owners may be burdening it with excessive overheads. Financial competence and marketing skills in the MBO’s sector are especially important. Whether the price is reasonable and a sufficient contribution is being made by the managers. The managers should have some financial involvement and the future prospects for the new company should be demonstrable, especially in a ‘turn-around’ situation.

Investors, probably institutions, backing the MBO will initially hold a majority of the equity, with a relatively small minority of shares held by the managers. Although the backers must be prepared to hold their investment for the long term, they and the managers will be looking to the company growing successfully to the point where
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it can be launched on the stock exchange. At this stage, a market value can be obtained for the equity and, if desired, some portion of the investment can be realised. Where the backers desire a lower-risk element in their investment, they can require that some part of it will be in the form of redeemable convertible preference stock. This can give them priority in obtaining income through a preference dividend and preferential rights of repayment if the company should fail. There is also the prospect of redemption if the company does not develop satisfactorily, or conversely, the convertible aspect will allow backers eventually to increase their equity holding if the company should prove successful.

6.9 Reconstruction
If a company is in financial trouble it may have no recourse but to accept liquidation as the final outcome. However, it may be in a position to survive and indeed flourish by taking up some future contract or opening in the market. The only hindrance to this may be that its future operations can only be carried out with an injection of cash into the company. The problem facing the company may be that to get out of its present situation it will require extra cash, which it cannot raise because the present structure and status of the company will not be attractive to outside investors. This situation can sometimes only be resolved through some type of reorganising or reconstruction of the company. A typical company in this situation will have:
● ● ● ● ● ●

large accumulated losses, large debenture interest arrears, large cumulative preference dividend arrears, no ordinary dividend payments, a market price below the normal value of its shares, lack of market confidence in its future.

These features will hinder the chances of attracting new investment: Large losses will prevent the payment of ordinary dividends. This will make the company unattractive to prospective equity investors. ● Debenture interest and preference dividend arrears will need to be paid before any future ordinary dividends are paid. In some countries shares company law prevents from being issued at a price below the nominal value of the shares.

Reconstruction will involve some or all of the following:
● ● ●

Writing off accumulated losses; Writing of debenture interest and preference dividend arrears; Writing down the nominal value of the equity shares.

To do this the company must ask all or some of its existing stakeholders to surrender existing rights and amounts owing and exchange these for new rights in a new or reconstructed company. The main problem is to devise a scheme that will be acceptable to all parties:

Each party’s position must be better under the scheme than opting for liquidation. The first step is therefore to ascertain the amount each stakeholder could expect to receive without the scheme. This will require preparing a ‘break-up’ value balance sheet.
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The amount of additional risk to be carried by each party should be minimised. For example, debenture holders would be unlikely to accept ordinary shares in full settlement if they could receive some or all of their capital in the form of cash through liquidation. There must be realistic long-term prospects for survival of the company. There is no point in devising a scheme for a company that is not going to survive anyway.

This exercise will inevitably throw up some very difficult problems, not least the need to throw out the product which the chairman has supported for years in the face of its descent into ever-increasing losses. Indeed, the company may well face the need for a reconstruction simply because the top management, though well aware that certain activities were dragging the business down, kept on pushing more resources into them in the unrealistic hope that ‘they will come right again next year’. A management cannot be blamed for the company’s industry going into deep recession, or for the market for a product collapsing through technological advances or the sheer weight of competition from bigger players; however it can be blamed for continuing to waste resources on products or services which are not adding value, or in fighting competitive battles without adequate weapons. Disposing of part of a business even at a relatively unattractive price is better than facing a forced reconstruction at a later date. Other important factors of a reconstruction are that time is short and speedy action essential; also that in terms of monitoring financial performance, cash flows are almost certainly more important than profit, at least in the short term.

6.9.1 Effect on the share price of a listed company
If a listed company is facing a reconstruction, it is almost certain that it will previously have issued profit warnings, unless of course it was itself taken by surprise by a sudden trading collapse. In the case of warnings being given, the share price will probably have fallen significantly, but sudden and possibly unsuspected disasters can cause even more dramatic falls. The stock market dislikes uncertainty, so that the sooner a company in difficulties can make its proposals for reconstruction known, and can make clear the positive actions it is proposing to take to improve its position, the sooner it can look forward to an improvement in its share price. Clearly having announced its intentions, the company should follow up by implementing actions as quickly as possible.

6.10 Summary
In this chapter we have discussed various aspects of merger activity, including motives for merger, defence tactics, reasons for failure and the impact of regulation. We have also shown methods of valuing companies for takeover and explained the strengths and weaknesses of traditional approaches. How takeovers are financed and the relative advantages and disadvantages of each type of finance were also discussed. The chapter concluded with a discussion of reconstruction. MBOs and other forms of reconstruction involve the removal of some part of an entity from its present structure. However, a reconstruction is often a forced situation with limited choices of action, while MBOs are ususally wellconsidered strategic moves based on reasonable appraisal processes.
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Readings

6

The article below examines the management buy-out of Hamleys. The author explains how the business went private after a dismal decade on the stock market, and asks the finance director of the company how the firm plans to be successful in the long-term.

Shop of little horrors
Cathy Hayward, Financial Management, December/January 2003/04. Reproduced with permission.

Childhood haunts often seem much smaller and less impressive when you return to them as an adult. But if you walk through the doors of Hamleys on London’s Regent Street it won’t matter whether you’re 3ft or 6ft tall. You’ll still be overwhelmed by the atmosphere of pure excitement, the screams of delight and the sheer volume of kids’ stuff packing the world’s biggest toy shop. You can multiply that experience a hundred times if you visit the store just before Christmas. Thousands of starry-eyed children throng the floors, trampling over each other in their eagerness to grab as much as daddy can carry home. A well-padded Santa mingles with them, delving in his sack for little gifts, while harassed-looking adults fight their way through the hordes, searching for errant offspring or this year’s must-have present. It’s hardly less frantic behind the scenes. Christmas shopping accounts for 44 per cent of Hamleys’ annual takings, which means that the store spends most of the year getting ready for the festive flurry.
Toying with the figures 1760 500,000 44 5 million £7,995 £45.9 million Seven 6pm the year that Cornishman William Hamley opened a toy shop in Holborn. the number of teddy bears that Hamleys sells over the Christmas period. the percentage of Hamleys’ annual sales taken over Christmas. the number of visitors to the Regent Street store in 2002 (28 per cent of whom were from abroad). the cost of Hamleys’ most expensive toy: the Outrage! Deluxe board game. Its cards are edged with gold leaf and the replicas of the crown jewels are 18-carat gold. Hamleys’ turnover in 2002. the number of sales floors at the Regent Street store. the time it closes on Christmas Eve.

‘We started preparing by placing initial orders for our own-brand stock, such as the famous Hamleys teddy bears, at Easter time,’ explains Ian Parker ACMA, the company’s
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finance director. ‘Stocks change every year depending on what’s popular, but jigsaws, Monopoly and Cluedo are always big sellers.’ Keeping the store well stocked is a major challenge. Hamleys normally receives six deliveries a week, but in mid-December it will take six every day. Shift-workers spend the night replenishing the displays, ready for little hands to demolish them immediately the next morning. As Parker says: ‘It gets hairy in the run-up to Christmas.’ The festive period may be by far the busiest time of the year in the store, but Hamleys is also recovering from a frenetic summer in the boardroom, when the firm eventually went private after a long search for a backer. ‘After all the press interest and intense work on the management buy-out, it’s nice to get back to normal and focus on the business,’ Parker says. Since March, when it was announced that Parker and the chief operating officer, John Watkinson, were seeking finance for a management buy-out (MBO), the talk has been less about tricks and train sets and more about bid vehicles. In early June, Icelandic retail investment group Baugur agreed to finance the MBO and settled on a bid of 205p per share, valuing the business at £47.7 million. But later in the month it emerged that retail entrepreneur Tim Waterstone was also interested, so Baugur raised its bid to £52.2 million in order to fend him off. Waterstone’s eventual bid, which valued the business at £53.1 million, forced Baugur to up the ante again to £58.7 million, increasing Hamleys’ share price to a five-year high of 252p. Because Watkinson and Parker had been working with Baugur, the rival bids were considered by an independent committee of non-executive directors. But in the middle of July Waterstone bowed out and his bid vehicle, Children’s Stores, agreed to sell its shares to Soldier, the vehicle that Baugur had set up. The committee unanimously recommended that the shareholders accept the offer from Soldier, which represented a premium of more than 100 per cent on the share price before the bid talks were announced. Yet the media attention was not over: the deal came under the spotlight again when it was alleged that Jon Asgeir Johannesson, Baugur’s chief executive, had tried to use company funds to procure escort girls for a party on a yacht in Florida. Despite the furore, the sale went ahead on 4 August and Baugur took control of Soldier, with the Hamleys directors owning a minority interest. There was a collective sigh of relief at Hamleys, which had endured several years in the doldrums and had tried unsuccessfully twice before to go private. After floating on the stock market in 1994, the firm’s fortunes declined so far that it was forced to issue four profit warnings between 1998 and 2000. Parker attributes the company’s problems during that period to its decision to diversify ‘into a number of things it shouldn’t have touched’. For example, it acquired a firm called Toystack, opened franchise shops in Saudi Arabia, entered joint ventures in Singapore and opened department store concessions in Debenhams. ‘The business spread itself incredibly thinly and neglected its key asset: the Regent Street store,’ he says. In May 1999 Simon Burke became Hamleys’ third chief executive in two years and promptly set about revamping its image. He ordered the refurbishment of the Regent Street store and oversaw the modernisation of its product range. But in April 2000, before these changes could affect the balance sheet, the company had to disclose a decline in full-year profits from £6.3 million to £4.2 million. As a result, the group began to consider going private and talks were under way in June 2000 when Parker joined as a business information manager, with responsibility for finance and information technology. ‘The day after I joined Hamleys I read in the newspaper that there was an MBO going on,’ he says. ‘That was the first I’d heard of it.’
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But talks between Charterhouse Development Capital and Hamleys folded in July 2000 after a disagreement over the price. Hamleys’ then chairman, Howard Dyer, had demanded at least 200p a share, valuing the business at £42 million. The venture capital firm wasn’t prepared to pay more than 170p and Hamleys’ share price dived 26.5p to 141.5p as a result. Things began to change in October 2000 when Dyer left the firm. Burke immediately hired investment bank Close Brothers to review Hamleys’ options to see whether it should be seeking a private investor. A fruitless three-month search for a backer ensued, during which time the share price fell another 10 per cent. But Burke had plenty of other ideas. In 2001 he converted 12 Toystack stores into Bear Factory soft-toy shops. He also restructured the organisation, becoming executive chairman himself and appointing Parker to the board as FD in charge of merchandising, warehousing, finance, IT and legal matters. He made Watkinson chief operating officer, giving him responsibility for purchasing, operations, franchising and marketing. These changes proved so successful that 18 months later Hamleys was able to announce that group sales had risen 9.3 per cent, allowing it to open seven more Bear Factory shops. The firm is now completing its conversion into a private company, which is having a huge impact on boardroom discussions. ‘Everyone is focused on your next set of results in a listed company,’ Parker says. ‘The biggest change now that we’re a private company is that we can focus on the longer term.’ The MBO means that the firm is now highly geared, making cash extremely important. This in turn is putting more pressure on the finance function. ‘The role of my department now is to ensure that we use our cash effectively, and information is critical for the rest of the business,’ Parker says. ‘But it shouldn’t really make a huge difference, because at the end of the day only the goals are slightly different and the banks are different.’ Once Christmas is over and done with, the company plans to expand internationally. The global toy market is worth close to £50 billion and Hamleys currently has less than 0.05 per cent of that. Its three main brands – Hamleys, the Bear Factory and the English Teddy Bear Company (which was purchased almost 18 months ago) – will be extended abroad. Department stores in Sydney and Tokyo will stock some of Hamleys’ own-brand products, of which there are 500 different lines. The company may also open other stores around the world, but not in the UK. ‘The most important thing about the store at Regent Street is that it’s an experience. If you try to replicate it within the UK you will always compromise on that,’ Parker explains. This uniqueness was reflected in the attention that the MBO attracted. Before the deal, Hamleys was a small-cap company, but its every move was recorded religiously by the financial press. Parker attributes this to its successful recovery and also the nature of the business. ‘Everyone has a soft spot for it journalists and analysts can relate to Hamleys because they have all probably been there at some time in their lives and remember the first time they stepped through the doors.’ With the Christmas rush in full effect, the balance sheet is looking healthy. ‘The Regent Street store performs consistently, apart from the odd blip caused by events such as 11 September, the Iraqi war and the Sars outbreak, but every time it bounces back within a couple of months,’ Parker says, but his measurement for how well the store is doing is surprisingly simple. ‘All I do is go out on to Regent Street and watch the number of people walking out of the store with Hamleys bags. At the moment there’s a sea of white-and-red bags all over the West End, so I know things are going well.’
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Revision Questions

6

Question 1
WT plc is a manufacturer of car-care products. It carries insignificant amounts of stock. Turnover and profits after tax for last year are £145m and £40m, respectively. WT plc’s shares are currently quoted at 440 pence, the lowest price for five years. The directors believe that this is because the company is not growing as fast as the market expects. They believe that the fastest way to grow, and as a result improve the share price performance, is to acquire another company in a similar line of business with a lower P/E ratio. They are therefore evaluating SZ plc on the basis that its earnings can be ‘bootstrapped’, that is, on the assumption that, once the merger has been completed, the combined company’s P/E ratio will be the same as WT plc’s current ratio. SZ plc’s results for the past 3 years, and its directors’ own estimates for this year, are as follows:
Year to 30 June 1997 actual 1998 actual 1999 actual 2000 estimate Turnover £m 95 100 106 120 Profit after tax £m 12.1 12.5 13.5 14.0

SZ plc’s dividend payout ratio has been maintained at 50 per cent for the past 8 years. The company pays only one dividend per year at the end of December. Its shares are currently being traded at 126 pence. Summary balance sheets at 30 June 1999 for the two companies are as follows:
Non-current assets (net of depreciation) Net current assets Total assets less current liabilities Capital and reserves Called-up share capital Reserves WT plc £m 60.0 30.0 390.0 180.0 25.01 65.0 390.0 180.0 SZ plc £m 75.0 25.0 100.0 200.0 50.02 50.0 100.0 200.0

Notes: 1. 100m ordinary shares of 25p. 2. 100m ordinary shares of 50p.
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If the merger goes ahead, some fixed assets of SZ plc will not be needed following the merger, and will be sold at the end of the first year of operations. The estimated sales receipts from these assets at the time of sale is £25m, which will also be the written-down book value at that time. No other savings or synergies have been identified by the directors of WT plc at this stage. WT plc’s financial advisers believe that its directors are overvaluing SZ plc’s future earnings post-tax. They advise that, in their opinion, the merged company should be more prudently valued, and suggest that SZ plc’s growth for the foreseeable future is likely to be maintained at no more than the average of the last 4 years. The cost of capital for WT plc is 14 per cent, and for SZ plc is 12 per cent. Requirements (a) Estimate the maximum price, in total and per share, that WT plc might bid for the whole of the share capital in SZ plc, under each of the following assumptions: (i) the directors of WT plc are correct; (ii) the financial advisers are correct; and comment briefly on the weaknesses of the methods of valuation you have used. (10 marks) (b) Advise the directors of WT plc on an initial bid price and the maximum price they should offer for the shares of SZ plc. (6 marks) (c) Describe four possible defence tactics which the directors of SZ plc might use if they decide to resist the bid from WT plc. (6 marks) (d) The bid is eventually agreed at £176m. The directors of WT plc are now considering the most appropriate method of financing the bid, and two options have been suggested. The first is a share exchange; the second is an issue of £176m undated 12 per cent secured loan stock at par. At present the return on the market is 12 per cent, the return on the risk-free asset is 8 per cent. Corporation tax is currently payable at 33 per cent and this is not expected to change in the foreseeable future. All figures given above are post-tax, with the exception of the coupon rate on the loan stock. You are required to calculate, on the basis of your answers to (a) and (b) above, the cost of equity and the weighted average cost of capital of the merged firm which might be expected under each of the two financing options, using any reasoned assumptions you might consider necessary. (8 marks) (Total marks 30)

Question 2
QWE plc is a medium-sized food manufacturing company. It has recently sold a subsidiary that traded in what the company considered to be non-core business. The sale raised £1.4m in cash. The company’s long-term debt-to-equity ratio is relatively high compared with other companies in the industry and the directors have ruled out further borrowing at the present time. In fact, one of the directors thinks the cash raised from the sale of the subsidiary should be used to repay some of the company’s outstanding debt. This is not a view shared by the other directors who are evaluating three small but potentially profitable acquisition opportunities. The directors believe that the shareholders of all three target companies would not be opposed to a bid at this time, especially to a cash offer.
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However, to acquire all of them would require £2.3m. The share price is standing at an alltime high – a level considered unsustainable by the directors based on the company’s projected earnings. The directors therefore intend to limit their expenditure to the £1.4m cash raised by the sale of the subsidiary.
Expected after-tax cash flows Company AB Ltd CD Ltd EF Ltd Year 1 £000 (100) 125 200 Year 2 £000 750 275 325 Year 3 £000 1,100 380 450 Acquisition price £000 (1,100) (550) (650)

Note: The cash flows are in real terms, that is, they do not include inflation. QWE plc’s shareholders currently require a real return of 12 per cent on their investment in the company. The company uses this rate to evaluate all its investment decisions, including acquisitions.

Requirements Assume that you are a financial manager with QWE plc. Write a report to the directors evaluating the potential acquisitions. You should include the following information in your report:

● ●

The expected net present value and profitability indexes of the three projects. Based solely on these calculations comment on which company(ies) should be chosen for acquisition and comment on the use of 12 per cent as a discount rate in the circumstances here. Recommendation of uses for any cash that is left over after the acquisitions have been made. Comment on the directors’ decisions: (i) to invest rather than repay debt, and (ii) to limit their investment for the current year to cash purchases rather than raise new capital in the form of debt or equity. Comment on the advantages and disadvantages of growth by acquisition as compared with growth by internal (or organic) investment. (20 marks)

Question 3
PR plc is listed on the London Stock Exchange. The directors have made a bid for its main UK competitor, ST plc. ST plc’s directors have rejected the bid. If the bid eventually succeeds, the new company will become the largest in its industry in Europe. However, it will still be smaller than some of its US competitors. The directors of PR plc are aware that the company must continue to expand if it is to remain competitive in a global market, and avoid being taken over by a larger US company. Relevant information is as follows:
Share price as at today (21 May 2002) Shares in issue P/E ratios as at today Debt outstanding (market value) PR plc 671 pence 820 million 14 £2.2 billion ST plc 565 pence 513 million 16 £1.8 billion

Other information:
● ●

The average P/E for the industry is currently estimated as 13. The average debt ratio for the industry (long-term debt as proportion of total funding) is 30% based on market values.
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● ● ●

40% of PR plc’s debt is repayable in 2005; 30% of ST plc’s in 2006. PR plc’s cost of equity is 13% net of tax. PR plc has cash available of £460 million following the recent disposal of some subsidiary companies. ST plc’s cash balances at the last balance sheet date (31 December 2001) were £120 million.

Terms of the bid PR plc’s directors made an opening bid one week ago of 10 PR plc shares for 13 ST plc shares. They are aware that they might have to raise the bid in order to succeed and also may need to offer a cash alternative. Their advisers have told them that, typically, 50% of shareholders might be expected to accept the share exchange and 50% the cash alternative. Requirements Assume you work for PR plc’s financial advisers. You have been asked to write a report advising the directors of PR plc. Your report should cover the following issues: (i) A discussion of the implications that the current share prices of the two companies have for the bid. Recommend terms of a revised share exchange. (8 marks) (ii) The advantages and disadvantages of offering a cash alternative and how the cash alternative might be financed, based on your revised bid terms recommended in answer to (i) above. Your discussion should include an evaluation of the impact of the proposed finance on the merged group’s financial standing. Assume a rights issue is not appropriate at the present time. (17 marks) (Total marks 25)

Question 4
AB plc is a firm of recruitment and selection consultants. It has been trading for 10 years and obtained a stock market listing 4 years ago. It has pursued a policy of aggressive growth and specialises in providing services to companies in high-technology and high-growth sectors. It is all-equity financed by ordinary share capital of £50 million in shares of £0.20 nominal (or par) value. The company’s results to the end of June 2002 have just been announced. Profits before tax were £126.6 million. The Chairman’s statement included a forecast that earnings might be expected to rise by 4%, which is a lower annual rate than in recent years. This is blamed on economic factors that have had a particularly adverse effect on high-technology companies. YZ plc is in the same business but has been established much longer. It serves more traditional business sectors and its earnings record has been erratic. Press comment has frequently blamed this on poor management and the company’s shares have been out of favor with the stock market for some time. Its current earnings growth forecast is also 4% for the foreseeable future. YZ plc has an issued ordinary share capital of £180 million in £1 shares. Pre-tax profits for the year to 30 June 2002 were £112.5 million. AB plc has recently approached the shareholders of YZ plc with a bid of five new shares in AB plc for every six YZ plc shares. There is a cash alternative of 345 pence per share. Following the announcement of the bid, the market price of AB plc shares fell 10% while the price of YZ plc shares rose 14%. The P/E ratio and dividend yield for AB plc,
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YZ plc and two other listed companies in the same industry immediately prior to the bid announcement are shown below. All share prices are in pence.
2002 High 425 350 187 230 Low 325 285 122 159 Company AB plc YZ plc CD plc WX plc P/E 11 7 9 16 Dividend yield % 2.4 3.1 5.2 2.4

Both AB plc and YZ plc pay tax at 30%. AB plc’s post-tax cost of equity capital is estimated at 13% per annum and YZ plc’s at 11% per annum. Assume you are a shareholder in YZ plc. You have a large, but not controlling, shareholding and are a qualified management accountant. You bought the shares some years ago and have been very disappointed with their performance. Two years ago you formed a ‘protest group’ with fellow shareholders with the principal aim of replacing members of the Board. You call a meeting of this group to discuss the bid. Requirements In preparation for your meeting, write a briefing note for your group to discuss. Your note should: (i) evaluate whether the proposed share-for-share offer is likely to be beneficial to shareholders in both AB plc and YZ plc. You should use the information and merger terms available, plus appropriate assumptions, to forecast post-merger values. As a benchmark, you should then value the two companies using the constant growth form of the dividend valuation model. (13 marks) (ii) discuss the factors to consider when deciding whether to accept or reject the bid and the relative benefits/disadvantages of accepting shares or cash. (8 marks) (iii) advise your shareholder group on what its members should do with their investment in YZ plc, based on your calculations/considerations. (4 marks) (Total marks 25)

Question 5
DP plc is a family-owned company in the motor trade and had a revenue in 1995 of £12m. It has two main services – car body repairs and breakdown recovery. A few years ago Alan, the managing director of DP plc, was considering a public flotation for the company. However, in the past 2 years the rate of growth of both operations has slowed – particularly the car body repairs. This appears to be due to two main factors – increased competition for recovery services and a change of policy by insurance companies which has made car body repairs less profitable. Comments on the balance sheet A summary balance sheet for DP plc at 31 December 1995 is shown below. The ordinary and preference shares are all held by family members and their associates. The preference
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dividend had not been paid for 1995. The bank loan is secured by a charge on the company’s total non-current assets.
DP plc – balance sheet at 31 December 1995 £000 Non-current assets (net book value) Inventory Receivables Cash Total current assets Unsecured creditors EF plc (secured creditor) Tax payable Bank loan Preference dividend Total current liabilities Total assets less current liabilities Mortgage Bank loan due 31-3-1997 Net assets attributable to shareholders Financed by: Issued share capital Ordinary £1 shares Retained earnings/(loss) carried forward Preference shares (undated) £1 shares 8 per cent 825 2,150 2,155 2,980 (750) (300) (150) (300) z(100) (1,600) 5,730 (2,500) 2,(300) (2,800) (2,930 £000 4,350

2,500 (820) (1,250 (2,930

Problems current at today’s date (19 November 1996) The book value of DP plc’s assets increased by £1m in 1995 over their book value at the end of 1994. This was primarily a consequence of:

● ●

an increase in receivables. Prior to 1995, receivables had represented about 40 days’ revenue. At the end of December 1995 they represented 65 days, and the situation is deteriorating; an increase in inventory; a failure to cancel an order for new recovery vehicles in 1995.

The supplier of the new recovery vehicles, EF plc, has not been paid. Payment had been due in April 1996. The supplier has, however, obtained a floating charge on DP plc’s current assets and has now, reluctantly, commenced court proceedings against DP plc to recover its money. Of the bank loan, 50 per cent (i.e. £300,000) was due to be repaid on 30 September 1996. The balance is due on 31 March 1997. The September payment was not made and, as a consequence, the senior loan officer of the bank called in the directors of DP plc to discuss the problem. At this meeting, the bank agreed to allow DP plc to repay the entire amount of the loan at the end of March 1997. Future prospects and problems Despite the current problems, the directors of DP plc are confident of an upturn in business. They are negotiating new contracts with two major insurance companies which will be worth approximately £1.5m per year in additional gross revenue. However, time is against
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them and they must now consider a capital reconstruction and pay off the main creditors – the bank, EF plc and a number of smaller suppliers to avoid liquidation. Possibilities of injection of new capital DP plc’s bank is not prepared to advance any more money, but it has put the company in touch with a merchant bank which may be prepared to buy into the company. The merchant bank has now conducted an appraisal of DP plc and has concluded the following:
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The non-current assets are estimated to be worth £1m less than the 1995 balance sheet value. Inventory would realise in the market place no more than 50 per cent of its book value at 31 December 1995. Bad debts are estimated at 10 per cent of the 31 December 1995 receivables value. Invoicing and collections are expected to be roughly equal throughout 1996. All other assets and liabilities are considered to be worth their 1995 book values. If the company is liquidated, the administration costs are likely to be 20 per cent of the gross liquidation value. If the company can be rescued, earnings after interest and taxes are likely to be £320,000 for 1997. A prospective P/E ratio of 12 is estimated, based on the average for companies in similar trades and on expected growth for DP plc after the reorganisation.

The merchant bank decides it is willing to invest in DP plc provided it gains control of 51 per cent of the voting share capital. However, the merchant bank makes three conditions:
● ● ●

the family would have to agree to retire the preference stock without compensation; the family would have to forgo preference dividend arrears; some shares currently owned by the family would have to be cancelled and reissued to the merchant bank to provide it with the required 51 per cent ownership of DP plc. The merchant bank’s intention would be to hold DP plc’s shares as a medium-term investment, defined as 5–7 years, and then float the company on the Alternative Investment Market (AIM).

Requirements (a) (i) Calculate the estimated market value of DP plc’s equity. Base your answer on the merchant bank’s estimate of future earnings, assuming the company is rescued. (2 marks) (ii) Calculate the book value of net assets attributable to DP plc’s shareholders as at today’s date (19 November 1996), assuming the merchant bank’s conditions are met. In addition to the information provided in the case, you should assume that: ● all current liabilities are paid, with the exception of the portion of the bank loan not yet due; ● the values of non-current assets, inventory and receivables are as per the merchant bank’s estimates; ● the cash balance is cash on hand plus cash received from the merchant bank minus cash paid out; ● the merchant bank agrees to pay 140 pence per share for its shareholding. (7 marks) (iii) Comment briefly on the difference between the values you have found in answer to parts (i) and (ii) above. (3 marks)
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(b) Assume that you are employed by the merchant bank to advise on the rescue operation for DP plc and subsequently to assist the company in improving its profitability. Write a report to the bank’s board, on the basis of the information provided in the case, which critically reviews the investment and exit strategies from the point of view of the bank. (13 marks) (Total marks 25)

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Solutions to Revision Questions

6

Solution 1
(a) (i) The directors are thinking, in effect, of applying WT plc’s price/earnings (P/E) ratio of 11 to SZ plc’s earnings of £14m. This indicates a value of £154m, to which must be added the value of the assets which can be sold: £25m, discounted at the cost of capital, say, for argument’s sake, a net present value of £22m. Thus, the directors’ ‘walk away’ price would be around £176m, that is, 176p per share. The greatest weakness of this approach is that it ‘puts the cart before the horse’, that is, it assumes that the value of a business is a fixed multiple of reported profits. The P/E ratio, not the price, is the dependent variable. It is dependent, in fact, on a traded price, which cannot safely be extrapolated to provide a value of the business as a whole. (ii) The advisers, meanwhile, have urged caution, and suggested valuing SZ plc, in effect, on a stand-alone basis, using recent history as a surrogate for future potential. Its cost of equity capital being assessed at 12 per cent p.a. and its growth at 5 per cent p.a. (both assumed to be constant compound), then the value of its net cash generating potential, as at the end of year 2000: Using the dividend valuation model: P0 D1 Ke g , gives: £7,000,000 12% 5% £100m

To this should be added the disposal value of the assets, that is, £22m as above, bringing the total to £122m (122p per share) or slightly less than the existing ‘market capitalisation’. The greatest weakness of this approach is in the assumption that the future is a function of the past. Some of the most spectacular collapses of recent years have followed unbroken trends of increasing reported earnings. The presumption of a constant compound cost of capital is also a weakness. (b) If the advisers’ advice is valid, then a final offer should be at approximately the current market price. The fact that this is greater than the advisers’ stand-alone value suggests that ‘the market’ is using a lower cost of capital, is forecasting a higher rate of growth, or is anticipating a bid. Whatever the reason, it would provide very little room for manoeuvre. Most bids start off at a premium of, say, 10 per cent, which suggests an opening shot of around 1,140p per share.
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If the bid proceeds, it is because the directors have rejected the advisers’ advice, and their own calculations come to the fore. Their aim should be to offer a pound more than it is worth to anyone else, or a pound less than it is worth to WT plc, whichever is the lower. We have no information on other possible predators, but the value to WT plc was put by the directors at around £176m, that is, 176p per share. The final price needs to be less than this for the acquisition to benefit the bidder. (c) If the directors of SZ plc believe it to be against the best interests of their shareholders for the company to be taken over by WT plc, then they need to help them quantify the value of the business for, in such a situation, they would be arguing that the market capitalisation of the company fell short of its value to its equity investors – or persuade the bidder to increase the offer to the point that it was in the shareholders’ best interests. Possible defences include: ● issuing a forecast of profits and dividends, showing a greater potential than is implicit in the share price; ● (if it is a paper – as opposed to cash – bid) criticising the bidder’s management and prospects; ● accepting the industrial logic of the bid, but arguing that the terms are unrealistic, given the synergies, i.e. perhaps making a bid for the bidder; ● seeking intervention of government or regulatory agencies, for example, The Competition Commission; ● seeking a substantial investor big enough to block any effective merger or perhaps seeking a ‘white knight’, that is, a more acceptable bidder. In practice, it is clear that directors do not operate purely on behalf of shareholders. They take account, for example, of employees’ – and their own – interests. (d) Option 1: share issue The cost of equity capital of WT plc was put at 14 per cent, and that of SZ plc at 12 per cent, to reflect the differing risk/uncertainty associated with the forecast cash flows of the two businesses. Assuming that these margins of error are perfectly correlated (i.e. there are no favourable ‘portfolio effects’), the combined business will have a cost of equity capital somewhere between the two. The precise weighting is a moot point, but on any basis, WT plc is the bigger business. On the basis of pre-bid market capitalisation, for example, the ratios would be 440/126 for an average of 13.6 per cent. On the basis of the price paid for SZ plc, the ratios would be 440/176 for an average of 13.4 per cent. There being no borrowings, this would also be the weighted average of all capital. Option 2: loan stock This is issued at 12 per cent gross, that is, 8 per cent net (in line with the ‘riskfree rate’). The value of the combined entity (net of tax) is £440m £176m £616m, to which an overall cost of 13.4 per cent is attached, implying a return of £82.5m. Capital structure will not affect this, but will affect its attribution as follows:
Category Total Debt Equity Capital value £m 616 176 440 Return £m 82.5 14.1 68.4 % p.a. 13.4 8.0 15.5

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Solution 2
Calculations
Year → 12% discount factors → Cash flows Company AB Absolute Discounted Cumulative Profitability index 192/1,100 Company CD Absolute Discounted Cumulative Profitability index 52/550 Company EF Absolute Discounted Cumulative Profitability index 108/650 0 1.000 £000 (1,100) (1,100) (1,100) 17.5% (550) (550) (550) 9.5% (650) (650) (650) 16.6% 200) 179) (471) 325) 259) (212) 450 320 108 125) 112) (438) 275) 219) (219) 380 271 52 1 0.893 £000 (100) (89) (1,189) 2 0.797 £000 750) 598) (591) 3 0.712 £000 1,100 783 192

Report To: The directors of QWE plc From: Financial manager Date: Subject: Potential acquisitions Thank you for the data regarding the three possible acquisitions. I have reviewed the situation and would like to comment as follows. Evaluation I have evaluated the three possibilities on the basis of a 12 per cent p.a. cost of capital (all figures in ‘real’ terms). The details are appended but, in summary, the figures are as follows:
Outlay £000 1,100 550 650 Net present value £000 192 52 108 NPV/Initial outlay % 17.5 9.5 16.6

Company AB Company CD Company EF

On this basis, if we wish to keep our total outlay below £1.4m, we should invest in AB and forget the others, since this will add the most value, compared with the base case, which is to return the money to the shareholders. That assumes that the cost of capital is a realistic one in the circumstances, notably as regards the uncertainty/risk aversion factors it comprises. I would welcome the opportunity to discuss this with you. Unspent receipts If we invest only £1.1m, that leaves £0.3m to deal with. I would suggest that consideration be given to:

letting it reduce our borrowings, which are relatively high compared with other companies in our industry;

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using it to fund other opportunities, for example, carrying more stock or granting extra credit if this would increase demand: paying it out as a dividend.

Impact of past decisions Two of the tasks facing you as directors concern the capital structure of the company, and the pace of expansion. In turn, these decisions depend on identifying the equilibrium point as regards gearing relative to your risk-aversion, and the company’s prospective growth rate relative to its return on investment. If you were worried that the company’s gearing was too high relative to your riskaversion, you would seek to reduce it either by repaying borrowings or by raising additional equity. Since you have chosen to do neither, the implication is that you are comfortable with the present ratio, and I have no grounds for questioning your decision. What is less clear to me is why you have chosen to limit your capital expenditure to £1.4m (a small amount for the average plc), and hence to forgo opportunities which would add to the (net present) value of the business to its shareholders, discounted at your own assessment of the cost of capital. If this is valid, it means that equity could be raised at that cost (and borrowing at less). Alternatively, if you are firmly of the opinion that the share price is unsustainable, perhaps the answer is to think in terms of making paper offers for CD and EF. This would facilitate expansion without any cash absorption. Growth by acquisition The main benefits of growth by acquisition are that:
● ●

it speeds up the process, compared with starting afresh; it leaves capacity as it was, rather than increasing it (and hence increasing competition). On the other hand, the drawbacks are that:

acquisitions are made on the basis of public information only, whereas organic expansion can be based on inside knowledge and robust judgements; merging cultures takes a long time, and induces extra costs (including those related to redundancy).

All the evidence shows that the extra costs of mergers (e.g. higher head office coordination costs) are higher than acquirers expect, and many projected benefits do not arise, to the point that, in most cases, the only beneficiaries are the former shareholders in the acquired company. Signed: Financial manager

Solution 3
Report To: From: Subject: Date: Directors of PR plc Adviser Bid of ST plc 21 May 2002

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Introduction You have asked us to provide you with advice on your recent bid for ST plc. This report aims to cover two key issues: (i) The implications for the bid indicated by current share prices; (ii) The advantages and disadvantages of a cash alternative and how it might be financed. (i) Implications for the bid of current share prices The terms of the bid are 10 PR plc shares for 13 ST plc shares. On today’s share prices, the market appears to be expecting an increased bid; 10 PR plc shares are worth £67.10 whereas 13 ST plc shares are worth £73.45. This implies that you would need to raise the bid to at least 17 PR plc shares for 20 ST plc shares to gain acceptance (17 PR plc shares would be worth £114 and 20 ST plc shares £113). However, it must be recognised that the bid is taking place in a dynamic market and there are other, external influences that may affect share prices. The share prices of the two companies will also react to any revised bid based on market perceptions of the benefits to be gained by the shareholders of the two companies. Evidence has shown that in a hostile bid it is usually the target company’s shareholders who obtain all the gains from a merger. Our advice is that you must make a realistic assessment of what ST plc is worth to you. ST plc’s earnings last year were £181.15 million [(565p/16 513 million)/100]. If you apply your own cost of equity to their earnings in perpetuity, this would give a value for the company of £1.393 billion. Its current market capitalisation is £2.9 billion. This suggests potential for growth is already discounted by the market, although there will be a bid premium in the current share price that is difficult to quantify. (ii) The advantages and disadvantages of offering a cash alternative and how it might be financed The main advantage of offering cash as an alternative to a share exchange is that the future gains from the merger are obtained by a proportionately larger number of the bidding company’s shareholders. The disadvantages are, obviously, that cash has to be raised, most probably by the issue of a long-term debt instrument. There might also be taxation implications for individual shareholders, although as the offer is optional, this should not be a problem. If we assume a bid of 17 for 20 is accepted, this implies a price per ST plc share of 570 pence. If we assume 50% of ST plc’s shareholders are likely to accept a cash offer, then you need to raise approximately £1.46 billion. The combined cash at bank balances of £580 million could be used, leaving £880 million to be raised in new debt. The effect on gearing needs to be calculated based on the combined group’s debt: equity ratios. This is difficult to do without more information and it is almost impossible to forecast the value of the equity post-merger. If the combined firm increases the amount of debt in its capital structure, which is likely if a large proportion of ST plc’s shareholders opt for a cash alternative, then the gearing ratio will rise. However, this is unlikely to be an excessive increase, but any increase in the indebtedness of the company might have an adverse effect on cost of capital because of increased financial risk.

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Examiner’s Note: Candidates who make attempts at gearing calculations using any sensible assumptions would gain credit. The effect on the cost of capital could also be estimated by making a number of assumptions, for example, the cost of new debt. It is likely that any new debt will carry a higher rate of interest because of this increased risk. It is also necessary to recognise that as some of both PR plc’s and ST plc’s existing debt matures within the next 3–4 years, refinancing needs to be considered. You will, of course, obtain ST plc’s cash balances post-merger, but the cost of the acquisition process is likely to be very high and will require a considerable amount of cash-generating capacity in the short term. The most likely form of finance is a long-term debt instrument as noted above. Secured debt with a maturity of 10–15 years would be the most obvious, but alternatives that could be considered and that have cost advantages are convertible debt or debt with warrants. A discussion of the features and benefits of these types of debt are outside the scope of this report, but the key feature is that they tend to offer lower rates of interest because of the opportunity of buying into the company’s equity ‘cheaply’ at some future date. Debt with warrants also has the advantage that additional money will be raised at some time in the future, subject of course to the holders exercising their warrants. Convertible debt does not raise additional money, but has the advantage of being self-liquidating if all holders convert into equity on or before the final maturity date. Signed: Adviser

Solution 4
(i) Evaluation Background calculations
Profit before tax: £m Earnings after tax: £m Earnings per share: pence Pre-bid P/E ratio Pre-bid share price: pence MV of company: £m No of new shares post bid (millions) % of combined company owned by: Value to original shareholders (£m) assuming no ‘synergy’ Price per share/post bid announcement: pence AB plc 126.60 88.62 35.45 11 390 974.80 250 62.50 953.80 382 (953.8/250) YZ plc 112.50 78.75 43.75 7 306 551.30 150 37.50 572.30 318 (572.3/180) Total 239.10 167.37 41.84

1,526.10 400 100 1,526.10

These figures assume that, in the absence of any synergy or commercial benefits resulting from the takeover, the market value of the combined group of £1,526.1 million is equal to the total of the two individual company’s market values. It suggests postacquisition share prices of 382 pence for AB plc and 318 pence for YZ plc. There will be a transfer of wealth from AB’s shareholders to YZ’s based on the terms of this offer. AB’s share price has already fallen in anticipation of this. In reality, the price of YZ’s
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shares is likely to be influenced by the value of the cash alternative and the price that will be observed in the market is unlikely to be below 345 pence. It is unlikely the directors of AB plc would launch a bid unless they expected they could improve the performance of YZ plc, and the value of the cash alternative implies they are expecting to do so. The post-bid share price of the new firm could be estimated by applying a P/E ratio to the combined earnings of the two old firms. The problem is – what P/E ratio? AB’s directors might expect their own pre-bid P/E ratio to be applied to the combined earnings. In which case, the market value and share price would be:
Market value: Share price: £167.37 £1,841.1 400 11 £1,841.1 460 pence

AB’s shareholders have exactly the same number of shares as they did before the merger. Their shares would therefore rise by 70p (460 390) or 18%. YZ’s shareholders have five-sixths the number of their old shares. Their share value might therefore be expected to rise from 306p to 383p (460p 5/6), a rise of 77 pence or 25%. As shareholders in YZ plc we are therefore taking more of the gains from the merger in a share exchange. The cash alternative is lower and unlikely to be accepted, although it is an assured amount. With the cash offer the premium is only 12.7%. 100 306 An alternative method of valuing the shares is to use the dividend valuation model. Using Gordon’s model, we assume constant growth and all earnings are paid out as dividends. The value of AB plc would therefore be: AB Share price EPS1 Ke g 0.354 13% 1.04 4% 409 pence (345 306)

Using the same assumptions, the value of YZ would be: 0.4375 1.04 650 pence YZ Share price EPS1 11% 4% Ke g On this basis the market slightly under values AB’s shares but YZ’s are substantially undervalued, possibly because the market is sceptical about the growth forecast given previous disappointments. However, if we believe AB’s forecast, then AB are getting YZ’s shares cheap, and especially so if any of YZ’s shareholders accept the cash offer of 345p. Examiner’s Note: An alternative approach could use the dividend yield information given in the question to calculate a dividend per share and use this figure in the dividend growth model. (ii) Factors to consider when deciding whether to accept or reject the bid and the relative benefits/disadvantages of accepting shares or cash. ● If we reject the bid, will AB give even more of the gains away of YZ shareholders (us) by raising the offer?
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The market appears to be taking a middle-of-the-road view. It does not appear to think AB management can apply its growth rates to YZ’s earnings. The growth rate forecast by YZ’s management does not appear to be believed by the market – hence the substantial difference between the P/E ratios of the two companies. ● Evidence has shown that target companies gain most from merger in the short term but in the longer term the gains are much reduced. ● Our shares are currently near their low for the year; this could mean AB is buying us at an opportunistic price because YZ’s business is currently unfashionable. ● There are problems of valuation of companies like this, for example a low asset base. The value is in intellectual capital/expertise. However, the market is getting better at evaluating such companies, which could be to our long-term advantage. ● A comparison of YZ’s share price performance/growth expectations with other companies in the industry shows that we are more poorly rated. WX in particular has a P/E more than twice YZ’s. We should raise this issue with YZ’s directors to find out why there is such a large differential. ● Accepting a cash bid might involve capital gains tax for some of us. ● The costs of the bid will ultimately be borne in part by us if we take the share offer. If we take cash we know what we are getting. We may not participate in future gains but neither do we share in the costs, which if it is a hostile bid will become enormous. ● What will be AB’s future dividend policy if we accept shares? Their dividend yield is below YZ’s and at least one of its major competitors. However, to be fair, our dividend yield has been raised by the fall in the share price, which is near the year’s low. (iii) Recommendation of what to do with the investment Making a single recommendation on whether to accept or reject the bid is difficult. To some extent it is ‘six of one, half a dozen of another’. The offer gives us a greater opportunity to sell out, or exchange shares, than we have seen for some time. However, given YZ’s poor performance over recent years this is not saying a lot. We should request a meeting with the directors to obtain their views. If shareholders wish to take a short term gain then holding out for a higher bid, perhaps a one for one share exchange and an increased cash alternative, is probably the better option: evidence shows that bidders rarely leave the stage after an initial bid. In respect of accepting cash or shares, each shareholder in our group will have to determine their own objectives. However, if we take a longer term view based on my estimates of YZ’s value we might be better rejecting the bid and continuing our fight to replace the Board.

Examiner’s Note: Shareholders could of course also choose to sell their shares now, or even buy more if they think the long-term prospects are good – there is no one right answer to this part of the question.

Solution 5

This question involves a family-owned company facing financial difficulties and the threat of liquidation. The aim of the case was to test for an ability to evaluate a situation from the point of view of the owners, managers and potential investors. It also tested for an

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ability to analyse a changing competitive business environment and to formulate a new financial and operational strategy. (a) (i) Estimated market value £320,000 per annum EAIT at a P/E ratio of 12 if 2,500,000 shares are in issue. £3,840,000 or 154 pence a share

(ii) Net assets attributable to shareholders if company rescued First calculate the cash paid out by the merchant bank:
EF plc Other creditors Bank overdraft Total £000 300.0 900.0 1,300.0 1,500.0

Second, calculate cash balance after cash paid in less cash paid out:
Cash paid in: 1,275,000 shares at 140p Less cash paid out Balance £ 1,785,000 1,500,000 1,285,000

Third, calculate value of assets and liabilities:
£000 Non-current assets Inventory Receivables Cash (£285,000 £5,000) Total assets Less: Mortgage Bank Total liabilities Net assets attributable to shareholders £000 3,350.0 412.5 1,935.0 1,290.0 5,987.5

2,500.0 2,300.0 2,800.0 3,187.5

(iii) The estimated market value is based on future earnings capacity of the company’s assets if the company is rescued and the assets continue in productive use. The net asset value is based on estimated current realisable values, that is assuming the assets are disposed of. The net asset value is likely to be the most accurate because it is expected to be realised in the very near future. The market value, while higher than the asset value, is subject to all the recognised problems of forecasting into the future it is therefore almost certain to be wrong. Common errors in this type of question: – – – – – omitting the opening cash balance; failing to remove the preference share dividend; double-counting the bank loan; incorrectly revaluing the fixed assets, stock and debtors; misunderstanding the meaning of net assets.

In answer to sub-section (iii), many candidates could not understand the basis of the two methods and often suggested that the difference was simply a result of the P/E ratio being an estimate. The estimated market value is based on future earnings capacity of the company’s assets if the company is rescued and the assets continue in
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productive use. The net asset value is based on estimated current realisable values, that is assuming the assets are disposed of. (b) Report To: Board of merchant bank From: An accountant Date: Subject: Rescue of DP plc (i) Review of the investment and exit strategies ● Estimated current market value of the company is £3.84m if rescued. P/E ratios are difficult to predict with accuracy, but if 12 is a reasonable forecast the bank is buying 51 per cent of £3.84m (£1.958m) at a cost of £1.785. This is a premium of approximately 20 per cent (precisely, 19.2 per cent) which suggests the investment should be acceptable. It is often claimed that venture capitalists require IRRs of between 35 and 50 per cent. If this is the case here, the merchant bank might not be satisfied. ● Bank should provide management expertise which would involve additional cost but might improve chances of rescue succeeding and even exceeding present estimates. This might give rise to issues of control. ● There may be strategic considerations if the investment fits with the merchant bank’s portfolio of products. ● Exit strategies: continued existence of AIM, possibility/preferability of full market quote, takeover, management buyback, asset sale and split, but note possible problems re the state of the economy/market when the bank wants to sell. ● The value of DP plc on a net asset basis is irrelevant to the bank and need not be considered further.

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Investment Appraisal Techniques

7

LEARNING OUTCOMES
After completing this chapter you should be able to: understand the purpose of investment appraisal; analyse relevant costs and benefits of an investment project; evaluate domestic investment projects; recommend investment decisions when capital is rationed.

7.1 Introduction
In this chapter we discuss various methods of evaluating investment projects. These methods are, in the main, concerned with quantitative aspects but first you need to be clear that methods of evaluation are by no means the only factors to be taken into account in investment appraisal. Thus, we might define investment appraisal as being concerned with maximising shareholder wealth, but we must be careful to qualify this concept by making it subject to constraints associated with issues of social responsibility, such as effective controls over pollution. So shareholders’ wealth in this context needs to be linked with the wider view of stakeholder theory, whereby many other interested parties apart from shareholders – for example, suppliers, creditors, employees, lenders, managers, as well as the general public – need to be taken into account in assessing a project’s viability. Incidentally, in the case of ‘notfor-profit’ organisations, we should follow a similar path, but substituting maximising benefits in place of shareholders’ wealth. We must also be clear that maximising wealth is not the same thing as maximising profit from a project, by minimising costs regardless of the wider implications of so doing. Shareholders will best be served by action being taken to ensure that a project will meet an economic want while maintaining a good and respected image of the entity, and indeed

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projects which damage that image can negate the benefits of otherwise effective marketing and promotional activities. Clearly, then, qualitative aspects of a proposal are very important, and this leads us on to the data content needed to evaluate a project effectively. Bear in mind that the cash inflows and outflows involved are simply the standard means of translating into a common base of numbers all the underlying quantitative and qualitative assumptions which are the real determinants of projects viability. The management accountant needs to concern himself deeply with the strengths and weaknesses of these assumptions before finally converting them to cash flows. As to the evaluation methods described below, it should be borne in mind that in the continuing debate as between NPV and IRR, the main contention centres on the respective reinvestment assumptions: in the case of IRR, inflows are assumed to be reinvested at the IRR solution rate for the project; inflows from NPV are assumed to be reinvested at the cost of capital applied to the project. You should also be aware that payback is actually more of a measure of liquidity than of project profitability, though it remains a popular method of evaluation in many companies. These various considerations lead one to suggest that it is not the choice of a particular measure which is so important as the recognition that it is usually more effective – especially in these days of computer spreadsheets – to use two, three or even more evaluation methods for a particular appraisal, rather than depending on a single yardstick. Thus, especially for a major project, assessing its NPV, IRR, payback period and accounting rate of return (ARR) may well throw valuable light on various and different aspects of a project’s value, provided that the limitations of each method, as set out below, are kept in mind.

7.2 Accounting rate of return
Accounting rate of return (ARR) is calculated in basically the same way as ‘return on investment’ as: Profit Investment but whether ‘profit’ is before or after interest charges and whether ‘investment’ is the initial outlay or is averaged over the life of the project is unclear. This lack of clarity seems strange. The point of this technique is that it is based on the same principles as the published financial statements. Companies (and managers) are often evaluated by the ‘return on investment’ or ‘return on capital employed’ ratio derived from published profit and loss account and balance sheet. (The two ratios are identical, merely reflecting the two sides of the balance sheet; ‘capital employed’ reflects the financing of the business, ‘investment’ reflects the use of that finance.) It is therefore logical that it should be calculated in a way which makes it comparable with these ratios. As the balance sheet contains written-down asset values one would expect accounting rate of return to be calculated as: Profit Average (written-down) investment This accords with common sense, because if profit is after depreciation, then one would expect that depreciation to affect the value of the investment. Following the same principle

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(that the numerator and denominator must be comparable) allows other difficulties to be resolved. If we are measuring management’s performance the ratio would be: Profit before interest and tax Average (total) capital employed but if we are measuring return to shareholders the ratio is: Profit after interest and tax Shareholders’ funds We must compare ‘return’ with the funds (or investment) which generate that return.
Example 7.A
The figures below will be used to illustrate accounting rate of return, and will subsequently be used to illustrate payback, discounted payback, net present value and internal rate of return. £000 (100) 20 30 40 40 10

Investment Cash inflows: Year 1 Year 2 Year 3 Year 4 Year 5

Straight-line depreciation of £20,000 per year over the 5-year life of the asset would mean reported profits of: £000 – 10 20 20 (10) (40)

Year 1 Year 2 Year 3 Year 4 Year 5 Total

Average profit would be £8,000 per year. Average investment would be £50,000 (as the investment declines in value over the five years due to the depreciation charge) and ARR would be: £8,000 £50,000

16% Total profit Project life Original cost 2 £40,000 5

Note: Average profit

£8,000 £100,000 2 0

Average investment

residual value

£50,000

The advantages of ARR are:
● ●

it is simple to calculate; it considers the total life of the project.

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The disadvantages of ARR are:
● ● ●

it does not consider tax or capital allowances; it does not consider the timing of the cash flows; it uses profits rather than cash flows.

7.3 Payback
Payback is a simple investment appraisal technique which involves determining how long will be needed before the initial investment is ‘paid back’. Unlike accounting rate of return, which is bound by accounting definitions of ‘profit’ and ‘investment’, payback concentrates on the specific cash flows which an investment will generate. (In this respect, payback is superior to accounting rate of return because the management accounting theory of decision-making is based on whether the wealth of the decision-maker will be increased if a particular decision is made. The definitions and conventions of financial accounting should not be allowed to muddy the waters of this essentially simple problem.) The well-documented drawbacks of the payback technique are based on the fact that future cash flows, in themselves, do not indicate increased wealth. This is because a money flow in the future is not worth as much as the same money flow now. (Cash available now can be invested and so is worth more than the same cash flow at a later date.) The disadvantages of payback are:
● ● ●

all cash flows within the payback period are given equal weight; cash flows outside the payback period are ignored; it is not easy to determine how long the payback period should be.

Although one might expect payback to be little used because of these disadvantages, in practice, it is used extensively! Its simplicity probably explains its popularity:
● ● ●

decision-makers understand information presented to them; calculations are straightforward and likely to be error-free; since data is itself unreliable (estimates of future cash flows) sophisticated analysis may not be justified.

Payback can also be recommended if the business requires liquid funds at some date in the future – a project which ‘pays back’ before this date would be preferable to one which needs to be funded for a longer period. A further advantage is the ‘risk aversion’ of payback and this will be discussed later.
Example 7.B
Using data from Example 7.A, the payback period would be calculated as follows: Investment Cash inflows: Year 1 Year 2 Year 3 Year 4 £000 (100) 20 30 40 010 (25% of 40) – ––

So the payback period would be 3.25 years. If the stipulated payback period is equal to or longer than this, then the investment would be accepted, but if the required period was less, say 2.5 years, then it would be rejected.

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It is seldom wise to use payback on its own for investment appraisal and it should be combined with at least one other technique, preferably based on discounted cash-flow procedures, to ensure that all project returns are taken into account.

7.3.1 Discounted payback
One of the disadvantages of payback is its failure to take into account the time value of money, but this can be overcome by firstly discounting the cash flows to their present values and then using these discounted values to calculate the payback period. Taking the cash flow data from Example 7.B, and additionally requiring a discounted cash flow (DCF) rate of return of 10 per cent and a payback in DCF terms of 4 years, an example is as follows.

Example 7.C
Year 0 1 2 3 4 5 Cash flow £000 (100) 20 30 40 40 10 Discount factor 10% 1.000 0.909 0.826 0.751 0.683 0.621 Present value £000 (100.0) 18.2 24.8 30.0 27.3 6.2 Cumulative NPV £000 (100.0) (81.8) (57.0) (27.0) 0.3

As the project payback in DCF terms in just under 4 years, it would be accepted, but if payback had been required in say 2.5 years it would be rejected. Although this is an improvement over basic payback, the technique is also not suitable as a sole method of investment appraisal because it does not take into account all project cash flows.

7.4 Discounting techniques
7.4.1 Net present value
The theoretically correct approach is to calculate the net present value (NPV) of a proposed investment by discounting future cash flows to present value and summing (or netting) them together. The present value of a future cash flow is calculated by multiplying it by the factor 1 (1 r)n

where r is the discount rate and n is the number of periods (usually years) in the future when the cash flow will take place. Discounting is the opposite of compounding and, remembering that a principal, X, will grow to an amount, V, after n years if invested at a rate of interest r, we have: V and X V (1 r)n
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r)n

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We can say that X grows to V in n years or, equivalently, that the future cash flow V is worth X in present value terms. By discounting future cash flows the problem of the time value of money is eliminated and, if the net present value is positive (inflows in present-value terms exceed outflows in present-value terms), the project can be recommended.

Example 7.D
In practice, NPV calculations are easy because tables of discount factors are readily available. In our example, assuming a discount rate of 10 per cent per annum: Cash flow (£000) (100) 20 30 40 40 10 Factor 1.000 0.909 0.826 0.751 0.683 0.621 Present value (£000) (100.0) 18.2 24.8 30.0 27.3 06.2 06.5

Year 0 1 2 3 4 5

If the cost of capital were 10 per cent this project could be recommended because it generates a positive NPV of £6,500. One interpretation of NPV is that, if the project were financed by a loan at 10 per cent per annum, the interest on the loan and the original capital could be repaid out of project cash flows and this would eventually leave a cash balance at the end of the project worth £6,500 in present value terms. The NPV technique is the academic recommendation and it is theoretically sound. However, its use in practice implies that the decision-maker must judge a project by an absolute number and while it is easy to give the ‘rule’ – any project generating positive NPV is acceptable – a decision-maker will be interested not only in the final NPV ‘payoff ‘ but also in the size of the initial investment and the length of time before the project ‘matures’. Use of the NPV rule becomes problematic if capital is ‘rationed’ (see section 7.5), because not all projects can then be accepted. In this situation it becomes necessary to rank projects according to their ‘earning power’ – placing the project which generates the maximum NPV per pound invested at the top of the list. Conventionally the profitability index is calculated in order to rank projects, where: Profitability index In our example: Profitability index 106.5 100 1.065 NPV of cash inflows Investment outflow

This project would rank behind a project with profitability index of 1.1 but ahead of a project with profitability index of 1.05.

7.4.2 Internal rate of return
An alternative approach, still based on discounting principles, is the calculation of internal rate of return (IRR) – that discount rate at which the net present value of the project is zero. The decision rule now becomes: accept the project if its internal rate of return is greater than the cost of capital, reject if the IRR is less than the cost of capital. If a decision has to be made about a single project with ‘conventional’ cash flows (i.e. a single outlay followed by a series of inflows) IRR will lead to the same decision as NPV. However, in more complex circumstances IRR and NPV can lead to different decisions and IRR generally receives a bad press for a number of reasons, highlighted below.
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Calculation is complex
Example 7.E
In our example the IRR might be calculated as follows – by trying a different discount rate – from 10 per cent to, say, 15 per cent: Year 0 1 2 3 4 5 Cash flow (£000) (100) 20 30 40 40 10 Discount factor @ 15% 1.000 0.870 0.756 0.658 0.572 0.497 Present value (£000) (100.0) 17.4 22.7 26.3 22.9 15.0 ( (5.7)

A linear approximation between 10 per cent and 15 per cent allows the discount rate where NPV is zero to be calculated: IRR 10%

( 6.56.55.7

5%

)

12.7%

The calculation appears both messy and approximate. Nevertheless, neither of these criticisms is fair. The existence of powerful spreadsheets such as Lotus 1-2-3 and Excel allows IRR to be calculated instantly and accurately by using the relevant function. Multiple IRRs If project cash flows reverse during the life of the project – there may, for example, be an initial outflow followed by several inflows before another major outflow (as plant undergoes major refurbishment, for example) – there may be more than one IRR. A graph of discount rate versus NPV might appear as in Figure 7.1. In such an example, the IRR decision rule (accept if cost of capital is less than IRR) is misleading because the project should only be accepted if cost of capital is between IRR1 and IRR2. To explain this result it is necessary to understand the reinvestment assumptions implicit in the NPV and IRR calculations. All NPV calculations assume that incoming cash can be reinvested at the rate which is used in the NPV calculation. This means that the calculation of IRR1 assumes reinvestment at IRR1 while the calculation of IRR2 assumes reinvestment at IRR2. Only at rates between IRR1 and IRR2 can the incoming cash be reinvested at a rate which is sufficient to offset both the initial cash outflow and the eventual second cash outflow.

Figure 7.1

Discount rate and NPV – more than one IRR
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This analysis is perfectly sound and, arguably, the project is only acceptable if the cost of capital lies between IRR1 and IRR2. Unfortunately, however, it means that the IRR decision rule – accept if cost of capital is less than IRR – can be applied only to projects having conventional cash flows. The NPV approach avoids this problem quite simply. By using the cost of capital as the discount rate in the NPV formula a negative NPV is generated if cost of capital is less than IRR1, a positive NPV is obtained if cost of capital is between IRR1 and IRR2 and the NPV is negative again if cost of capital is greater than IRR2. The possibility of multiple IRRs is cited as a disadvantage of the IRR technique. However, the problem can be overcome. Multiple IRRs arise only when cash flows reverse more than once. In these circumstances it is only necessary to identify the (possibly) several IRRs (some calculators will draw the graph of NPV versus discount rate in a few seconds) and draw the correct conclusions. IRR and mutually exclusive projects The third problem concerns the selection of a favoured project from two or more projects which are ‘mutually exclusive’ (i.e. if one is chosen the others are automatically ruled out). Suppose that, instead of our project (A) being a simple accept/reject decision we have to choose between it and another project (B) which can be compared with project A as follows:
Initial investment (£000) Net present value (£000) Internal rate of return (%) Project A 100.0 6.5 12.7 Project B 50.0 5.0 18.0

The IRR approach would favour project B (18.0 per cent compared with 12.7 per cent). However, provided that funds are freely available project A would maximise wealth because, if chosen, it could generate £6,500 NPV compared with project B’s £5,000. In essence, IRR can mislead because it may select a lower investment with higher ‘earning potential’, when it may be preferable to invest a greater sum which generates a lower ‘return’ but (because of its scale) produces a greater sum in the end. The last objection does mean that IRR must be used with caution if a choice has to be made between mutually exclusive projects. And NPV is usually recommended in preference to IRR because of the three objections discussed above and a much more subtle point concerning the reinvestment assumptions implicit in the two methods. While the IRR technique assumes that cash flows can be reinvested at the IRR, the NPV technique assumes that cash flows can be reinvested at the cost of capital used in the discounting process. This difference has two repercussions: 1. Even if mutually exclusive projects have the same initial investment (so the third objection raised against IRR does not apply), NPV and IRR can give conflicting results. IRR may prefer a project with high early cash flows (assumed reinvestment at the IRR), while NPV may prefer a different project – with higher flows later. 2. If IRR is used to rank projects in a capital-rationing situation the ranking may be different from that obtained using the profitability index because IRR will favour early cash inflows (assuming reinvestment at the IRR), while the profitability index (being based on NPV) may produce a different ranking. It is usually assumed that NPV (and its derivative, the profitability index) provides the best guidance because the cost of capital reinvestment assumption is more conservative and likely to be more realistic.
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7.4.3 Modified internal rate of return
To help overcome the problems of IRR, a recent innovation is the development of the modified internal rate of return (MIRR), which is described by F. Lefley in Management Accounting ( January 1997) as follows:
The MIRR is, according to Lumby, ‘a cosmetic re-statement of an NPV analysis’. This is not, however, exactly the case as the MIRR does address some of the deficiencies of the conventional IRR. It eliminates multiple IRR rates; it addresses the reinvestment rate issue and reduces overoptimism; and produces a result which, when ranking projects, is consistent with the NPV rule. Using this method all cash flows after the initial investment are converted, by assuming that the cash flows can be reinvested at the cost of capital, to a single cash inflow at the end of the project’s life. The MIRR is obtained by assuming an outflow in year 0 and a single inflow at the end of the final year of the project. As the figure for the cash inflow in the final year of a project has been arrived at by assuming a reinvestment rate equal to the cost of capital and not at the project’s IRR (which will normally be in excess of the cost of capital) then the actual yield from a project will be more realistic when using the MIRR method. To illustrate the actual workings of the MIRR, a capital project (see Example 1) has first been evaluated using the conventional IRR method of investment appraisal. In this example, the IRR of the project is calculated at 14.7%. In theory this level of return would only be achieved if the funds generated from the project could be reinvested at 14.7% (the IRR of the project). As this is unlikely to be the case then the yield under the IRR method may be said to be overoptimistic. Example 1: Calculation of the IRR of a capital project Year 0 1 Cash flow £ (20,000) 6,500 —at 14%— factor £ (20,000) 0.8772 5,702 —at 15%— factor £ (20,000) 0.8696 5,652

Using the same cash-flow figures as used in Example 1, the MIRR of the same project is calculated at 11.3% (see Example 2). The MIRR is less than the conventional IRR because the funds generated from the project are assumed to have been reinvested (for the purpose of this evaluation) at 8%, being the cost of capital. This figure is significantly less than the original IRR. The 11.3% is, however, seen to be a more realistic return on the project under review and, if funds from the project were actually reinvested at 8%, would represent the actual return on the cash flows. Example 2: Calculating MIRR based on the cash flows from Example 1 Year 0 Cash flow £ (20,000)

The net cash flows from the project for years 1 to 5 are compounded at the same rate as the cost of capital (say, 8 per cent in this case) into a single figure for year 5. — at 8%— reinvestment rate factor £ 1.3605 8,843 1.2597 9,763 1.1664 6,707 1.0800 5,130 1.0000 33,750 34,193

Year 1 2 3 4 5

Cash flow £ 6,500 7,750 5,750 4,750 3,750

MIRR of the project (based on a cash outflow of £20,000 in year 0 and a single cash inflow in year 5 of £34,193) is 11.3%.
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The MIRR is calculated as follows: 20,000/34,193 0.5849

which, from the CIMA Mathematical Tables, suggests an MIRR between 11% and 12%. By interpolation: (0.5935 (0.5935 0.5849) 0.5674) 0.0086 0.0261 1% 0.3%

which, added to 11.0%, gives 11.3%. If, as may well be the case in very exceptional circumstances, a reinvestment rate is greater than the company’s cost of capital, then the MIRR will underestimate a project’s true rate of return. The determination of the life of a project can also have a significant effect on the actual MIRR if the difference between the project’s IRR and the company’s cost of capital is large. The MIRR, like the IRR, is still biased towards projects with short payback periods and those with large initial cash inflows, although possibly not to the same extent as the conventional IRR method. To what extent this method is being used in industry has yet to be reported in the academic literature; only time will tell its popularity amongst actual practitioners. Will it eventually replace the conventional IRR?

7.4.4 Discussion of techniques
First, it is by no means certain that the NPV method is definitely better than the IRR approach. It is certainly conceivable that the IRR reinvestment assumption is as realistic as the NPV assumption – any business which could only invest its funds at the cost of capital would not be in business for long! And in a capital-rationing situation there may be other projects readily available which would generate returns well in excess of the cost of capital. The IRR reinvestment assumption could be more realistic in this situation and a technique which favours early inflows (as IRR does) could be preferable because it makes finance available with which to fund other projects. The point can also be made that the technique which favours early inflows is also more risk-averse – because earlier cash flows are more certain than later ones. Having defended IRR on theoretical grounds it can be pointed out that it is, arguably, more ‘meaningful’ than NPV. A manager presented with an NPV of £6,500 may well ask what this figure ‘means’ – What investment? How long? etc. – an absolute number cannot easily be assessed in isolation. The same manager presented with an IRR of 12.7 per cent immediately has a ‘feel’ for the project – if money can be borrowed at, say, 5 per cent, then the project is probably sound. If the cost of capital is 10 per cent, then there does not appear to be much margin for error. These considerations are borne out in practice. A survey by Pike revealed that 41 per cent of firms surveyed used IRR as their primary method of investment appraisal compared with only 17 per cent which used NPV as their primary method. To sum up, IRR is criticised because it is complex, there may be multiple IRRs, it can mislead where projects are mutually exclusive and its reinvestment assumption may be optimistic. Nevertheless, provided that the method is thoroughly understood, none of these objections is insuperable and there are reasons why IRR may be preferred to NPV. It is interesting to compare the result obtained using IRR with that produced by the accounting rate of return (ARR) method. Remember that the accounting rate of return was 16 per cent but the IRR was 12.7 per cent. This is typical. On the basis of ARR it may
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appear that the project is profitable if the cost of capital is, say, 14 per cent. However, this is erroneous; the project is viable only if the cost of capital is less than 12.7 per cent. Note that the IRR and the ARR are comparable but IRR is less than ARR. This is what one would expect because ARR treats all future inflows as equally valuable while IRR takes account of the time value of money. If ARR were calculated in other ways, for example based on initial investment rather than average (depreciated) investment, the comparison between IRR and ARR would not make sense. Given that ARR does not take account of the time value of money, one might assume that it should not be used. However, this does not necessarily follow. Remembering that analysts often use return on investment to evaluate business performance, a change in the ROI ratio could actually affect the company’s share price! If an investment were big enough to have repercussions on the published profit and loss account and balance sheet it would be foolish not to calculate the ARR! Having made a case for at least considering IRR and ARR we can consider the payback technique. As discussed earlier, payback is often used in practice, probably because of its simplicity. However, it may also be used because of its risk aversion – early cash flows are given full value, late cash flows are ignored. The usual textbook advice is to take account of risk in the following ways: 1. If payback is used, reduce the required payback period; 2. If IRR is used, increase the required ‘cut-off ’ rate; 3. If NPV is used, increase the discount rate to take account of the ‘risk’ associated with the project. The capital asset pricing model provides a means of assessing the premium which ought to be added to the ‘risk-free’ discount rate; 4. Assign probabilities to ‘best’, ‘most likely’ and ‘worst’ values for each variable and calculate a range of possible outcomes together with their probabilities. (This approach can be refined by establishing distributions for the input variables and ‘simulating’ the project many times in order to build up a distribution of possible outcomes.) The relatively straightforward methods of handling risk if payback or IRR are used are cited as advantages of these techniques. However, none of the techniques described above deals with the important point that early cash flows are likely to be more certain than late ones. The discounting techniques take account of the time value of money but they assume that whatever cash flows are projected are certain. Only the payback technique clearly favours early inflows much more than later ones and this may partially account for its popularity. (The IRR approach favours early inflows when compared with the NPV approach because of its reinvestment assumption. However, this is a very fine point compared with payback which ignores late cash flows altogether.)

7.5 Capital rationing
Capital rationing: A restriction on an organisation’s ability to invest capital funds, caused by an internal budget ceiling being imposed on such expenditure by management (soft capital rationing), or by external limitations being applied to the company, as when additional borrowed funds cannot be obtained (hard capital rationing). (Official Terminology, 2000)
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The NPV assumes, implicitly, that funds will always be forthcoming for a project which offers the prospect of an adequate return on investment. This assumption needs some qualification, however:

Prospects are subjective judgements and, like beauty, are in the eye of the beholder. There may be problems perhaps on account of a poor track record in communicating that judgement to whoever controls the purse strings. The pace of growth may be limited by an unwillingness to seek capital from sources other than existing owners on the grounds that it would mean ceding control. Here, the usual response is to use a discount rate higher than the cost of capital, that is, trade off further back up the profit growth graph. An undue emphasis on short-term accounting numbers, for example, reported profits or return on assets ratios, so to avoid, perhaps, the accusation of jam tomorrow. Here, the response will be to evaluate in NPV terms, but then select those which have the most attractive accounting profile. A shortage of a particular resource, for example, engineering skills. Here, the appropriate response is an extension of the old marginal costing principle of maximising contribution or in this case NPV per unit of limiting factor.

Whatever the reason, however, turning away a viable project means weakening the longterm health of the enterprise. In practice, perhaps the biggest single problem is that opportunities do not surface at the same time, and choices are therefore made without all the information one would like. If capital is not rationed there is no problem; all projects which meet the cut-off criteria are accepted. When capital is rationed the ranking of projects becomes important. The various methods of investment appraisal – payback, IRR, NPV, etc. – often give conflicting rankings of investment priorities. Methods of determining how the investment decision should be made will depend on the type of capital rationing. Single-period capital rationing is a situation where capital is rationed at present (year 0), but will be freely available in the future. Multi-period capital rationing is a situation where capital is rationed over a number of periods. This syllabus concentrates on single-period capital rationing.

7.5.1 Single-period capital rationing
In such situations, only a slight modification to the standard NPV rule is required. The overall return will be maximised by maximising the return per unit of limiting factor, where the limiting factor in this case is capital funding. Projects should be selected whose cash inflows have the highest NPV per £1 of capital invested. A profitability index can be calculated for each project to rank the projects. CIMA’s Management Accounting: Official Terminology defines the ‘profitability index’ as: Profitability index: Represents the net present value of each £1 invested in a project. Present value of cash inflows Initial investment

Profitability index

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Example 7.F
XYZ Ltd is planning its capital investment programme for next year, 200X. It has five projects, all of which give a positive NPV at the company cut-off rate of 15 per cent, the investment outflows and present values being as follows: Investment £000 (50) (40) (25) (30) (35) NPV @15% £000 15.4 18.7 10.1 11.2 19.3

Project A B C D E

The company is limited to a capital spending of £120,000. Optimise the returns from a package of projects within the capital spending limit. The projects are independent of each other and are divisible (i.e. a part-project is possible).

Solution
First ascertain the NPVs per £1 of investment and rank the projects on this basis as follows: Investment £000 (50) (40) (25) (30) (35) NPV @15% £000 15.4 18.7 10.1 11.2 19.3 Profitability index 1.31 1.47 1.40 1.37 1.55

Project A B C D E

Ranking 5 2 3 4 1

Next, build up a programme of projects based on their rankings as follows:

Project E B C D

Investment £000 (35) (40) (25) ( (20) (120)

NPV @15% £000 19.3 18.7 10.1 2 ( 7.5 (3 of project total) 55.6

Thus, project A should be rejected and only two-thirds of project D undertaken.

7.5.2 Single-period rationing with mutually exclusive projects
The decision rule changes slightly if any of the projects are mutually exclusive. If we assume that either project C or project E could be accepted, but not both, the ranking process shown in Example 7.F will need to be undertaken twice. The first run would exclude Project C and the second run would exclude Project E. The optimal selection of projects would be given by the combination with the highest total NPV.

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Assuming that projects C and E are mutually exclusive:
Project E B D A Investment £000 (35) (40) (20) (25) (120) Investment £000 (40) (25) (20) ((35) (120) NPV @15% £000 19.3 18.7 11.2 17.7 56.9 NPV @15% £000 18.7 10.1 11.2 10.8 50.8

( 1 of project total) 2

Project B C D A

(70% of project total)

The optimum combination of projects is given by E

B

D

1 2

A.

7.5.3 Single-period rationing with indivisible projects
When projects are not divisible, use of a profitability index may lead to an incorrect ranking. In these situations the investment selection decision has to be undertaken by examining the total NPV values of all the possible combinations of whole projects that do not exceed the amount of capital available. There may also be a small amount of unused capital with each combination of projects.
Example 7.G
Continuing with the data from Example 7.F, XYZ Ltd now discovers that the projects are not divisible. Surplus funds can be invested to earn 20 per cent per annum in perpetuity. Which combination of projects will maximise NPV?

Solution
PV of interest earned for each £1 invested at 20% in perpetuity NPV per £1 invested £1.33 Investment £000 100 105 £1 £0.33 Surplus funds £000 20 15 NPV @ 15% £000 6.6 5.0 Total NPV £000 54.7 54.2 £1 0.20 0.15 £1.33

Projects E B E B

C D

NPV @ 15% £000 48.1 49.2

The highest NPV will be achieved by investing in projects E, B and C, and investing the surplus funds of £20,000 externally. Notice that if XYZ Ltd had been unable to invest surplus funds at a return higher than its cost of capital, a combination of E, B and D would have been preferable.

7.6 Annual equivalent cost
This is basically a method of discounting especially for asset replacement decisions but it also has value when comparing the sensitivity of variables where projects have unequal lives.
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When the present value (of a capital project) is expressed as an annual amount, this is called annual equivalent cost and is used to compare projects having different life cycles. As an example, suppose that the NPV of cash outflows for asset replacement project A is £64,300, with discounting at 12 per cent and an asset life of 4 years, while for project B, the NPV of outflows is £79,355, also after discounting at 12 per cent but with an asset life of 6 years. Annual equivalent costs are: £64,300 Project A: (12% cumulative over 4 years) £21,172 3.037 £79,355 Project B: (12% cumulative over 6 years) £19,303 4.111 So on an annualised basis, project B has the lowest cost and would be preferred even though on a non-annualised basis project A would have seemed more advantageous. Note that the 12 per cent discount rate must be a real rate rather than a nominal rate. See Chapter 8 for an explanation of the relationship between real and nominal rates. Unequal lives There are also means of comparing mutually exclusive projects with unequal lives. When two or more mutually exclusive investments with unequal lives are being compared, consideration must be given to the time period over which a comparison of the investments is to be made.
Example 7.H
Let us consider two such mutually exclusive investments, X and Y, with cash flows as shown below: Year Project X Project Y 0 £ (30,000) (30,000) 1 £ 20,000 37,500 2 £ 20,000

It is possible to compare X and Y on the cash flows as given. However, a comparison can also be made over an equal time span for both investments: the lives of X and Y can be equalised by assuming that the company can reinvest in another project like Y at the end of year 1. The cash flows of two consecutive investments in Y would be as follows: Year Project Y Project Y repeated Total cash flow 0 £ (30,000) (30,000) 1 £ 37,500 (30,000) 7,500 2 £ 37,500 37,500

The NPVs and IRRs of X and Y under each of these alternatives are as follows: NPV (r £ 1. Unadjusted cash flows (i.e. X over 2 years, Y over 1 year) 2. Cash flows adjusted to equalise project lives (i.e. X and Y both over 2 years) NPVX NPVY NPVX NPVY 4,711 4,090 4,711 7,810 10%) IRR 22% 25% 22% 25%

The ranking based on IRR makes project Y the superior choice, irrespective of the period over which the comparison is made. The IRR is a rate of return per pound invested, and it is obvious that this rate will be unchanged by subsequent repetitions of a project: if project Y were to be repeated on 50 consecutive occasions, its IRR would remain the same 25 per cent. However, this does not hold true for NPV, as it measures the absolute return on an investment. A comparison of the NPVs of X and Y under the two alternatives illustrates this point: X has the higher NPV when the lives are unequal, but Y has the higher NPV when the lives are equal.
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As each case must be judged on its merits, it is not possible to stipulate that mutually exclusive investments should be considered over the same time period. The choice will be determined by the level of freedom of action enjoyed by the company at the termination of the shorter-lived project. If it is forced to reinvest in similar assets at this point, the projects should be compared over equal time periods. However, comparison over differing lives may be perfectly valid if there is no presumption that the company will be required, or even able, to act in this way. Some generalisations can be made. For example, if investments X and Y are alternative machines for a particular process, and it is known that the output from the process will be required for at least two years, then one investment in Y will not meet the company’s requirements. At the end of the first year, the company will have to make an additional investment to provide the output required in the second year – X and Y must therefore be compared over an equal time period. However, the situation might be completely different if X and Y happen to be alternative marketing strategies for a novelty product. Let us assume that project X represents a low price and Y a high price strategy, and that, in charging the high price, the life of the product would be limited to 1 year. If this is the case, the product clearly cannot be relaunched at the end of that time. The options open to the company at the end of year 1 are independent of the fact that it adopted strategy X in year 0, and an unadjusted comparison between X and Y will thus be perfectly valid.

Before making a comparison between mutually exclusive projects with differing lives, an explicit decision must be taken as to whether it is necessary to equalise the lives. A choice should be made on the basis of NPV, whether equalisation is required or not, although, as our earlier example showed, the process of equalisation may alter the ranking of the projects under consideration.

7.6.1 Asset replacement cycles
The concept of annualised equivalents can be used in determining the optimum replacement cycle for an asset. This decision involves how long to continue operating the existing asset before it is replaced with an identical one. As the asset gets older, it may become less efficient, its operating costs may increase and the resale value will reduce. An example will demonstrate how annualised equivalents are used in this type of decision.
Example 7.I
Lita Ltd operates a delivery vehicle, which cost £20,000 and has a useful life of 3 years. Lita Ltd has a cost of capital of 5 per cent. The details of the vehicle’s cash operating costs for each year and the resale value at the end of each year are as follows. Year 1 £ 9,000 14,000 Year 2 £ 10,500 11,500 Year 3 £ 11,900 8,400

Cash operating costs End of year resale value

Requirement
Determine how frequently the vehicle should be replaced.

Solution
The first step is to calculate the present value of the total costs incurred if the vehicle is kept for 1, 2 or 3 years, respectively. Keep for 1 year Cash Present flow value £ £ (20,000) (20,000) 5,000 4,760) 1 5,240 (15,240) Keep for 2 years Cash Present flow value £ £ (20,000) (20,000) (9,000) (8,568) 1,000 907) 27,6 61 (27,661) Keep for 3 years Cash Present flow value £ £ (20,000) (20,000) (9,000) (8,568) (10,500) (9,524) (3,500) 2(3,024) (41,116)

5% discount Year factor 0 1.000 1 0.952 2 0.907 3 0.864 Total present value

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These present value figures are not comparable because they relate to different time periods. To render them comparable they must be converted to average annual figures, or annualised equivalents, by dividing by the cumulative discount factors as before: Keep for 1 year £15,240 0.952 £16,008 Keep for 2 years £27,661 1.859 £14,880 Keep for 3 year £41,116 2.723 £15,100

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Total present value of cost Cumulative 5% factor Annualised equivalent

The lowest annualised equivalent cost occurs if the vehicle is kept for 2 years. Therefore the optimum replacement cycle is to replace the vehicle every 2 years.

7.7 Summary
In using discounting and other techniques of investment appraisal, you must always be aware that financial analysis is only a part of the decision-making process and that, often, social and other factors may also be of considerable importance. However, accepting this point and the need for a rounded, pragmatic approach to investment decisions, it is still essential that a management accountant should thoroughly understand the application of the ‘tools of his trade’. The arguments put forward here suggest that all the techniques of investment appraisal need to be well understood if they are to be wisely used. In summary: 1. NPV is the principal theoretical recommendation and should be used if the cost of capital is a realistic reinvestment assumption. 2. IRR, like NPV, incorporates discounting principles and, for some managers, may be more meaningful than the absolute NPV of the project. However, IRR needs to be thoroughly understood because of possible difficulties concerning multiple IRRs and its use if projects are mutually exclusive. MIRR is a recent innovation worthy of consideration. 3. Payback is much used in practice and, aside from its obvious simplicity, it can also be recommended if a risk-averse decision is needed (or if liquidity is a major problem). 4. ARR takes no account of the time value of money and could lead to an incorrect decision if compared with the cost of capital. However, because of the extensive use of the return on capital employed or return on investment ratio, in practice it could be foolish not to calculate it. The analysis suggests that there may be a place for all the techniques of investment appraisal in the management accountant’s armoury. However, a thorough understanding of their theoretical nuances is important, as is the background to appraisal techniques outlined in the introduction to this chapter. You should now be able to calculate annual equivalent cost, especially when faced with projects such as plant replacement decisions, where alternative projects have different lives, while it is also necessary for you to understand situations when capital rationing must be taken into account.

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Revision Questions

7
5 £ 70,000 40,000 Initial outlay £ 246,000 180,000 175,000 180,000 180,000 150,000

Question 1
Banden Ltd is a highly geared company that wishes to expand its operations. Six possible capital investments have been identified, but the company only has access to a total of £620,000. The projects are not divisible and may not be postponed until a future period. After the projects end it is unlikely that similar investment opportunities will occur.
Expected net cash inflows (including salvage value) Project A B C D E F Year 1 £ 70,000 75,000 48,000 62,000 40,000 35,000 2 £ 70,000 87,000 48,000 62,000 50,000 82,000 3 £ 70,000 64,000 63,000 62,000 60,000 82,000 4 £ 70,000 73,000 62,000 70,000

Projects A and E are mutually exclusive. All projects are believed to be of similar risk to the company’s existing capital investments. Any surplus funds may be invested in the money market to earn a return of 9 per cent per year. The money market may be assumed to be an efficient market. Banden’s cost of capital is 12 per cent per year.
Requirements

(a) Calculate: (i) the expected net present value; (ii) the expected profitability index associated with each of the six projects, and rank the projects according to both of these investment appraisal methods. Explain briefly why these rankings differ. (8 marks) (b) Give reasoned advice to Banden Ltd, recommending which projects should be selected. (6 marks) (c) A director of the company has suggested that using the company’s normal cost of capital might not be appropriate in a capital rationing situation. Explain whether you agree with the director. (4 marks) (d) The director has also suggested the use of linear or integer programming to assist with the selection of projects. Discuss the advantages and disadvantages of these mathematical programming methods to Banden Ltd. (7 marks) (Total marks 25)
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REVISION QUESTIONS P9

Question 2
The board of directors of CP Ltd is considering two investments, each of which is expected to have a life of five years. The company does not have either the physical capacity or the funds to undertake both investments. Forecast profits and other financial data for the two investments are:
Investment 1 0 £000 (500) (50) 1 £000 2 £000 Year 3 £000 4 £000 5 £000

Non-current assets Working capital Forecast revenue Forecast costs Finance charges Depreciation Profit before tax Investment 2

370 300 15 (100 (45)

500 325 15 100 060

510 335 15 100 060

515 330 15 100 070

475 325 15 100 035

Non-current assets Working capital Forecast revenue Forecast costs Finance charges Depreciation Profit before tax

0 £000 (450) (50)

1 £000

2 £000

3 £000

4 £000

5 £000

420 310 15 380 015

510 385 15 380 030

575 420 15 380 060

550 400 15 380 055

510 350 15 380 065

Additional information ● The company pays tax at 33 per cent. Writing-down allowances are available on the initial investment in both projects at 25 per cent per year. Tax is payable/receivable 1 year in arrears. ● The data is in real terms, that is, it contains no increases for inflation. This has been ignored on the grounds that both sales and costs are expected to increase by 5 per cent per year. ● The company’s nominal cost of capital is 12 per cent per year. Its target accounting rate of return (average profit before tax as a percentage of average investment) is 25 per cent. ● All cash flows may be assumed to occur at the end of the year except the initial capital cost and working capital. ● For each project the value of working capital expected to be released back to the project’s cash flows at the end of year 5 is £50,000 nominal. There will be no other terminal value of the investment. ● The £50,000 left over if investment 2 is chosen (i.e. the difference between the initial investment of £550,000 in investment 1 and £500,000 in investment 2) could be invested in the money market at between 6 per cent and 7 per cent. Requirement Assume that you are the financial manager with CP Ltd. Recommend to the board which investment, if either, should be selected using whatever methods of evaluation you think appropriate. Include in your report a discussion of the various methods of evaluation and any non-financial factors which might be relevant to the decision. Note: Your cash flows should be presented in nominal (as opposed to real) terms. (20 marks)
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Question 3
REM is a family-owned business. The family owns 80 per cent of the shares. The remaining 20 per cent is owned by four non-family shareholders. The Board of Directors is considering the purchase of two second-hand (that is, previously used) freight planes to deliver its goods within its key markets in the USA. The Managing Director, an ex-pilot and one of the non-family shareholders, commissioned an evaluation from the company’s accountants and was advised that the company would save money and be more efficient if it performed these delivery operations itself instead of ‘outsourcing’ them to established courier and postal services. The accountants built into their evaluation an assumption that the company would be able to sell spare capacity on the planes to other companies in the locality. The Managing Director has decided that the accountants’ recommendation will be conducted as a ‘trial’ for 5 years when its success or otherwise will be evaluated. The net, posttax operating cash flows of this investment are estimated as:
Year 0 Years 1 to 4 Year 5 $12.50 million (the initial capital investment) $3.15 million each year $5.85 million

Year 5 includes an estimate of the residual value of the planes. The company normally uses an estimated post-tax weighted average cost of capital of 12 per cent to evaluate investments. However, this investment is different from its usual business operations and the Finance Director suggests using the capital asset pricing model (CAPM) to determine a discount rate. REM, being unlisted, does not have a published beta so the Finance Director has obtained a beta of 1.3 for a courier company that is listed. This company has a debt ratio (debt to equity) of 1:2, compared with REM whose debt ratio is 1 :5. Other information:

● ●

The expected annual post-tax return on the market is 9 per cent and the risk-free rate is 5 per cent. Assume both companies’ debt is virtually risk-free. Both companies pay tax at 30 per cent.

Requirements (a) Using the CAPM, calculate: (i) an asset beta for REM; (ii) an equity beta for REM; (iii) an appropriate discount rate to be used in the evaluation of this project; (iv) the NPV of the project using the discount rate calculated in (iii); and comment briefly on you choice of discount rate in part (iii). (11 marks) (b) Evaluate the benefits and limitations of using a proxy company’s beta to determine the rate to be used by REM in the circumstances here, and recommend alternative methods of adjusting for risk in the evaluation that could be considered by the company. (9 marks) (c) Advise the Managing Director on the benefits of a post-completion audit. (5 marks) A report format is not required in answering this question. (Total marks 25)
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Solutions to Revision Questions

7
252,350 246,000 1.026. 0.712 £180,000

Solution 1
(a) Calculations of expected net present value and profitability indices: Project A NPV £70,000 3.605 £246,000 £6,350 Present value of cash inflows Initial investment

Profitability index Project B NPV £75,000 £1,882

0.893 181,882 180,000

£87,000 1.010.

0.797

£64,000

Profitability index Project C NPV £48,000 (£2,596)

1.69

£63,000 0.985.

0.712

£73,000

0.636

£175,000

Profitability index Project D NPV £62,000

172,404 175,000

Profitability index Project E

3.037 £180,000 188,294 1.046. 180,000

£8,294

£40,000 0.893 £50,000 0.797 £60,000 0.712 £70,000 0.636 £40,000 0.567 £180,000 £5,490 185,490 Profitability index 1.031. 180,000
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SOLUTIONS TO REVISION QUESTIONS P9

Project F NPV £35,000 0.893 £82,000 1.509 154,993 1.033. 150,000
Project Rankings 1 2 3 4 5 6 NPV D A E F B C

£150,000

£4,993

Profitability index

PI D F E A B C

The profitability index shows the present value per £ of incremental outlay, and is a relative measure. NPV is an absolute measure showing the expected benefit from a project. If projects differ in the amount of capital outlay, as they do in this case, NPV and PI may give different rankings. (b) The projects selected should be the combination of projects with the greatest total NPV, subject to the constraints that the total initial outlay must not exceed £620,000, and projects A and E are mutually exclusive. Possible combinations of three projects are:
Projects A,B,D A,B,F A,D,F B,D,E B,D,F D,E,F Expected NPV (£) 6,350 1,882 8,294 6,350 1,882 4,993 6,350 8,294 4,993 1,882 8,294 5,490 1,882 8,294 4,993 8,294 5,490 4,993 Total expected NPV (£) 16,526 13,225 19,637 15,666 15,169 18,777 Total outlay (£) 606,000 576,000 576,000 540,000 510,000 510,000

The recommended selection is projects A, D and F, which maximises expected total NPV subject to the constraints. Notes: 1. Project C is not considered, as it has a negative NPV. 2. Combinations of two projects are also possible, but none would have a higher expected total NPV. No combination of four or more projects is possible. 3. As the money market is efficient, any surplus funds invested in the money market will have zero NPV. Total NPV cannot be increased by investing surplus funds in the money market. (c) If a binding budget constraint exists in a capital rationing situation, the opportunity cost of the marginal pound will increase if profitable projects exist. The relevant discount rate is the higher of: (i) The yield forgone on the most profitable investment opportunity rejected because of the budget constraint (the marginal opportunity cost, which is represented by the shadow price in a linear programming solution). (ii) The company’s normal cost of capital. The director is correct in stating that the company’s cost of capital might not be appropriate. (d) Linear programming may be used in complex problems to choose an ‘optimum’ strategy involving the comparison of the value of various alternative uses of resources. The
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technique also provides information regarding the marginal value of resources through the dual values. It offers speed of calculation, can direct management’s attention to key areas (e.g. the main constraints on activity) and allows changes in variables, objectives or assumptions to be quickly incorporated. In capital rationing situations, linear programming may be criticised: (i) As it assumes projects are infinitely divisible – most capital investment projects are not. (If there are a large number of projects this might not be a serious problem.) (ii) The data used in the model are treated as being certain. Much of the data will actually represent uncertain forecasts. Additionally, the assumption of inflexible constraints may not be realistic; in practice a cash constraint will probably have some flexibility, but in the model it must be strictly adhered to. (iii) The relevant discount rate is unknown, and is given only after the linear programming problem is solved – yet it is required as an input for the linear programming problem. Integer programming produces an ‘optimal’ solution using only whole projects, which is more realistic for most capital budgeting situations and would be suitable for the needs of Banden Ltd. Except for project divisibility, it is subject to similar criticisms as linear programming. However, the small number of projects under consideration and the relatively simple nature of the capital rationing experienced by Banden allows the selection of projects to be made without formal use of mathematical programming techniques.

Solution 2
Calculations
Investment 1 0 Inflation factors £000 Real terms revenue Real terms costs Cash flows Plant Tax (25% p.a., 33%) Sales Costs Tax @ 33% Working capital Net 12% p.a. discount factors Discounted cash flow, £000 NPV 5.1% of outlay (500) 41 389 (315) 3(50) (550) 1.000 (550) 3 1 41 0 115 0.893 0 103 31 552 (359) (24) 3 41 0200 0.797 0 159 23 591 (388) (64) 3 41 0162 0.712 0 115 17 626 (401) (67) 3 41 0175 0.636 0 111 13 606 (415) (74) 3 50 0180 0.567 0 102 40 1 1.05 £000 370 (300) 2 1.103 £000 500 (325) Year 3 1.158 £000 510 (335) 4 1.216 £000 515 (330) 5 1.276 £000 475 (325) 6 £000

(63) 3 41 0(23) 0.507 0 (12) 0 28)

Note: Total profit before tax 22 per cent per annum.

£386,000. This amounts to 110 per cent of average assets of £350,000, an average of

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SOLUTIONS TO REVISION QUESTIONS P9 Investment 2 0 Inflation factors £000 Real terms revenue Real terms costs Cash flows Plant Tax (25% p.a., 33) Sales Costs Tax @ 33% Working capital Net 12% p.a. discount factors Discounted cash flow, £000 NPV 7.8% of outlay (450) 37 441 (325) 3(50) (500) 1.000 (500) 3 41 0 153 0.893 0 0137 28 564 (425) (38) 3 41 0 129 0.797 0 0103 21 666 (486) (46) 3 41 0 155 0.712 0 0110 16 669 (486) (59) 3 41 0 140 0.636 0 0089 11 651 (447) (60) 3 50 0 205 0.567 00116 36 1 1.05 £000 420 (310) Year 2 1.103 £000 510 (385)

3 1.158 £000 575 (420)

4 1.216 £000 550 (400)

5 1.276 £000 510 (350)

6 £000

(67) 33 4 1 0 (31) 0.507 0 (16) 0 390

Note: Total profit before tax 23 per cent per annum.

£372,000. This amounts to 116 per cent of average assets of £320,000, an average of

Report To: The directors of CP Ltd From: Financial manager Date: Subject: Mutually exclusive investment opportunities Purely on the basis of the information provided, given that the two projects are mutually exclusive, the company should opt for investment 2: it shows a higher NPV in absolute terms and relative to the initial investment, and leaves £50,000 available for other opportunities – or for distribution to shareholders. The criterion should be the cost of capital which, one would expect, is higher than the rate which can be earned on deposit. A more important consideration, however, might be the opportunities contingent upon embarking on the alternative projects: what are referred to and evaluated, these days, as real options. Other methods of ‘evaluating’ investment proposals include:
● ● ●

the accounting rate of return – simple but ignores the value of time; payback period – simple but ignores cash flows after payback; internal rate of return – complex, and unrealistic (requiring constant cost of capital, uncertainty and risk aversion). Non-financial factors worthy of consideration include:

● ● ●

consistency with the company’s declared strategy; consistency with the company’s declared values, for example, environmental impact; consequences for other aspects of the business: – does it open up other opportunities (perhaps by bringing the company into contact with new customers)? – does it enable employees to develop additional skills? – the availability of suitable labour, spare parts, etc.; – technical difficulties in respect of installation/maintenance. Signed: Financial manager

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Solution 3
An equity beta is the beta that attaches to a company’s shares; it is this beta that is published. An asset beta reflects business risk assuming a company is ungeared. In the case here, the proxy company has a different debt ratio from REM, so it is necessary to ungear its beta and ‘regear’ it using REM’s debt ratio. (a) (i) Ungear proxy beta Bu Bu Bu Bd 0 0.96. VD[1 t ] VD[1 t ] VE 1.3 2 2 1[1 0.3] Bg VE VE VD[1 t]

(ii) Regear using REM’s debt ratio Bg Bg Bg Bu 0.96 1.09. VE 5 VD[1 VE 1[1 5 t] 0.3]

(iii) The discount rate using the CAPM: (Rm R f ) DR Rf DR 5% 0.96 (9% 5%) DR 8.84%. In theory, it is the asset beta that should be used to calculate a discount rate as it is the business risk of the project that the company wishes to reflect, not the financial risk also reflected in the proxy company’s equity beta. However, an argument could be made in the case here that it is total risk that is important and the equity beta should be used. This would give a discount rate of 9.36 per cent. (iv) The NPV of the project
Year Cash flows (in $m) Discount rate @ 8.84% DCFs NPV ($m) 0 (12.50) 1 (12.50) $1.571 1 3.15 0.9188 2.894 2 3.15 0.8442 2.659 3 3.15 0.7756 2.443 4 3.15 0.7126 2.245 5 5.85 0.6547 3.830

Examiner’s Note Candidates who had correctly calculated NPVs using a rounded discount rate of 9 per cent, or used the discount rate using the equity beta and commented on this fact, would have received full marks. (b) Benefits:
● ●

If no other option, perhaps better than nothing. Gives some indication of risk of the project.
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SOLUTIONS TO REVISION QUESTIONS P9

Limitations:

No two companies exactly alike, the two operations may be quite different in terms of business risk. For example here the courier company will have a diversified range of external customers. REM will mainly have internal customers. Variance surrounding beta is large, using the CAPM at all can only provide a rough estimate. All the problems of CAPM: single period model, deals only with systematic risk, based on historical data, etc. Is the method appropriate anyway for a company owned by a small group of shareholders? The CAPM assumes a fully diversified portfolio, which may not be the case here. A discount rate reflecting total risk may be more appropriate. Alternative methods:

What Brealey and Myers call ‘fudge factors’. These are not theoretically acceptable but provide a good rule of thumb. Use the marginal rate of the new finance, not theoretically sound but has practical advantages. Use the company’s cost of equity. To calculate this using CAPM we would require to find a quoted company that is in a similar line of business to REM as a whole. The new project is likely to have a lower discount rate, but the project is dependent on REM’s business. There would therefore be some logic in arguing the discount rate should be REM’s cost of equity. Use REM’s WACC. Using an estimated WACC is a practical expedient for many companies and understood by many non-finance people. The argument against using the WACC would be (a) theory does not support using WACC for investment appraisal other than in very specific circumstances, and (b) here it is estimated – how is not explained but unlikely to be based on a theoretically correct formula (e.g. CAPM). Use certainty equivalents to calculate riskless cash flows, which would be discounted at the risk free rate of return although note the difficulty in determining appropriate probabilities. A recommendation might be to commission consultants/advisors to determine a rate/method, but note expense and distrust of consultants, especially by smaller companies.

(c) A post-completion audit (PCA) can be defined as ‘an objective and independent appraisal of all phases of the capital expenditure process as it relates to a specific project’. The main purposes may be summarised as:
● ● ●

project control; improving the investment system; assisting the assessment of performance of future projects. A major requirement of a PCA is that the objectives of the investment project must be clear and an adequate investment proposal should have been prepared. The objectives should also be stated, wherever possible, in terms, which are measurable. The main advantages are:

It enables a check to be made on whether the actual results correspond with the expected results, for example if the proportions of own use to sale of spare capacity

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are as expected. If this is not the case, the reason can be sought. This could form the basis for improvements in projects that are not functioning as expected or can cause projects to be abandoned. It generates information, which allows an appraisal to be made of the managers who took the investment decision. Managers will therefore tend to arrive at more realistic estimates of the advantages and disadvantages of their proposed investments. It can produce lessons for the decision-making process. If these lessons are actually learned, people will be able to make a better evaluation of the significance and the profitability of future periods. It can provide for better project planning. If, in the evaluation, it is found that the planning of the investment programme was poor, provision can be made to ensure that it is better for future investments.

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Advanced Investment Appraisal Techniques

8

LEARNING OUTCOMES
After completing this chapter, you should be able to: analyse relevant costs, benefits and risks of an investment project; evaluate domestic investment projects taking account of potential variations in business and economic factors; evaluate procedures for the implementation and control of investment projects.

8.1 Introduction
The topics covered in this chapter are: ● identification of a project’s relevant costs, benefits and risks; ● linking investment in IS/IT with strategic, operational and control needs; ● recognising risk using the certainty equivalent method; ● adjusted present value; ● capital investment real options; ● project implementation, control and audit.

8.2 Taxation
Payments of tax or reductions of tax payments are cash flows and should be taken into account in discounted cash flow projections. Taxation rules may be simplified in an examination question, but the main tax implications are as follows: 1. Corporation tax. Project cash flows must be stated after tax and discounted at an after-tax discount rate, while you must take care over the timing of the tax cash flows. These usually slip 1 year in the projections, that is, tax related to profits in year 1 will usually be taken into the cash flows for year 2. Slippage does not always occur and, as with all aspects, you must read an examination question carefully to be clear as to what is actually required.
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STUDY MATERIAL P9

2. Capital allowances. (Tax allowable depreciation) These allowances take the place of profit and loss account provisions for tax relief, except of course in those cases where Inland Revenue tax allowances are used also for the profit and loss account calculations. The effect of allowances is to reduce taxable profits and therefore they represent a cash saving or inflow in the DCF projections.

Example 8.A
Pogle Ltd buys a machine costing £100,000 which is expected to have a resale value of £15,000 at the end of its 4-year life. The machine will attract capital allowances at 25 per cent per annum on a reducing-balance basis. Corporation tax is at the rate of 33 per cent. What are the capital allowances and their associated tax savings over the asset’s life?

Solution
Asset (start of year) £ 100,000 75,000 56,250 42,187 31,640 (15,000) Rate of allowance % 25 25 25 25 Value of allowance £ 25,000 18,750 14,063 10,547 16,640 85,000 85,000 Tax rate % 33 33 33 33 33 Tax saving £ 8,250 6,188 4,641 3,481 5,491 Year of tax saving 2 3 4 5 5

Year 1 2 3 4 4 (end)

The total capital allowances claimed are £85,000. The amount of £16,640 at the end of year 4 is a balancing allowance which ensures that the total claimed equates with the asset cost less any sale or terminal values. If the amounts claimed exceed the asset cost adjusted for sale or terminal value, then a balancing charge will accrue.

8.2.1 Depreciation and capital allowances
Depreciation is the recognition in accounting of the diminution in the value of fixed assets which occurs as a result of time or use. The calculated amount of depreciation for a period of time is credited to the asset account, thus reducing its ‘book value’ and debited to the profit and loss account, thus showing the cost of using the asset as a charge against revenue. There are many different methods used for calculating depreciation, each based on a different concept. The Financial Strategy syllabus is not specifically concerned with the accounting treatment or methods of depreciation. Depreciation is not cash and the key point to remember is that if a question requiring a DCF calculation includes depreciation (or other non-cash items, including accruals and prepayments), these items have to be added back to profits or losses to arrive at operational cash flows. ‘Capital allowances’ is the term used in the UK for what might be called tax-allowable depreciation. Most countries have similar schemes. The important point is that capital allowances themselves are not cash, but they affect the tax liability of a company, which in turn affects tax payable or refundable. Capital allowances do therefore have an effect on cash flow and their calculation needs to be understood. Capital allowances are generally given in the form of first-year allowance followed by writing-down allowances. In the UK at present there is no difference in rate between
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first-year and subsequent writing-down allowances. At present, plant and machinery (and most other fixed assets such as motor vehicles up to a maximum allowance of £3,000, but not buildings) attract capital allowances at the rate of 25 per cent per annum on a reducingbalance basis. Different methods and rates may apply to different types of asset.

8.3 Inflation
A common source of confusion and misunderstanding in DCF calculations is the treatment of inflation. Typically, the discount rate is the money cost of capital (often referred to as the nominal cost of capital), that is, the rate payable on borrowed money (the source of funds may be a bank loan, debentures, equity or some combination of sources). Such a rate includes an allowance for inflation in the sense that the lender cannot expect any more than the interest rate. ( The lender may charge a 15 per cent rate assuming that inflation will be 8 per cent and so a 7 per cent ‘real return’ will be generated.) If a money cost of capital is employed, then the cash flows on which the analysis is performed should also include any inflation which is expected. (And, if different rates of inflation are expected on revenues and costs, then this should be reflected in the cash flows.) In practice, cash flows are often projected in so-called ‘real’ terms, that is, excluding inflation. Given the uncertain nature of estimated future cash flows this is not surprising – inflating ‘guestimated’ future cash flows may give even the most determined accountant pause for thought! And, since inflation might be expected to affect all companies equally, it can reasonably be assumed that, if there are unexpected inflationary pressures, they will be compensated by price adjustments. There are therefore arguable reasons for the use of cash flows in ‘real’ terms in DCF analysis. However, it therefore follows that the discount or ‘cut-off ’ rate should also be in ‘real’ terms. Any inflation element in the cost of capital should then be excluded from the discount rate before proceeding with the analysis. It would not be surprising if this important point were overlooked in practice and a survey by Carsberg and Hope showed that this was indeed the case. The relationship between real and nominal rates is embodied in the formula originally considered by Fisher: (1 or (1 N) (1 R) (1 I) nominal) (1 real) (1 inflation)

where N, R and I represent rates. Remember that nominal rates are often termed money rates.
Example 8.B
Mr Jordan invests £1,000 on 1 January 200X, for 1 year. The required rate of return is 20 per cent, and inflation is at the rate of 10 per cent per annum. If £1,200 is received on 31 December 200X, what is Mr Jordan’s real rate of return?
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STUDY MATERIAL P9

Solution
Owing to inflation, the purchasing power or real value of the pound has fallen in the period, and so restating £1,200 on 31 December in terms of its purchasing power on 1 January, we get: 1,200 1 r 1,200 1 0.1 £1,091

where r is the rate of return. This gives a real rate of return of 9.1 per cent, that is: (1 (1 0.20) ≈ (1 0.091) N) ≈ (1 R ) (1 I) (1 0.10)

In deciding which rate to use in discounting, remember that for real cash flows you must use the real rate, and for actual (or nominal or money) cash flows you must use the nominal or money rate.

Example 8.C
A company has under review a project involving the outlay of £55,000 and expected to yield the following net cash savings in current terms: Year 1 2 3 4 £ 10,000 20,000 30,000 5,000

The company’s cost of capital, incorporating a requirement for growth in dividends to keep pace with cost inflation, is 20 per cent, and this is used for the purpose of investment appraisal. On the above basis, the divisional manager involved has recommended rejection of the proposal. Having regard to your own forecast that the rate of inflation is likely to be 15 per cent in year 1 and 10 per cent in each of the following years, you are asked to comment fully on his recommendation.

Solution
Divisional manager’s appraisal Net cash flow £ (55,000) 10,000 20,000 30,000 15,000 10,000 DCF factor at 20% 1.000 0.833 0.694 0.579 0.482 Net present value £ (55,000) 8,330 13,880 17,370 1 2,410 (13,010)

Year 0 1 2 3 4

Comment The anticipated inflation rate has been incorporated into the required rate of return and, on this basis, the project has produced a negative NPV. A better approach would be the adjustment of the forecast net cash flows to reflect the effect of the anticipated inflation rate. Revised appraisal Net cash flow £ (55,000) 11,500 25,300 41,745 37,653 31,198 DCF factor at 20% 1.000 0.833 0.694 0.579 0.482 Net present value £ (55,000) 9,580 17,558 24,170 53,689 0 (3)

Year 0 1 2 3 4

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Revision of cash flows Year Year Year Year 1: 2: 3: 4: £10,000 £20,000 £30,000 £5,000 1.15 1.15 1.15 1.15 £ 11,500 25,300 41,745 7,653

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1.10 1.102 1.103

Comments 1. It can be seen that the revised appraisal has produced a significantly different result from that which the divisional manager produced. 2. Because DCF factors to three decimal places have been used in the revised appraisal, a small negative NPV of £3 has been produced. In fact, the DCF yield on the project will be found to be identical to the cost of capital. 3. Before any final decision is made regarding the acceptance/rejection of the project, it is recommended that some form of probability or risk analysis is carried out.

Finally, there is the problem of using the real rate when there are taxation implications in an examination question. In general, we suggest that in using real rates, taxation will be adjusted to exclude inflation, so that it will appear in real terms for the year in which it falls in the DCF projections – that is, when the cash is saved or paid – but again we must emphasise that you should check carefully for any special requirement as to the treatment of tax cash flows given in the question. If there are any taxation implications in an investment appraisal, it would not usually be appropriate to leave the cash flows in terms of present-day prices and discount those cash flows at the real cost of capital. This would understate the overall tax liability as capital allowances are based on original, rather than replacement cost, and do not change in line with changing prices. The cash flows will have to be adjusted by the appropriate estimate of price change.

8.4 Working capital
Next, we identify the correct approach, which may be called the incremental approach, for the incorporation of working capital into DCF analysis, particularly where inflation is involved.
Example 8.D
The cumulative working capital requirements for project A have been identified as follows: Year £(000) 0 200 1 300 2 350 3 350 4 400

These figures are based on present-day costs. Working capital requirements are expected to increase by 7 per cent per year. The project has an expected life of 4 years. What are the relevant working capital requirements for the appraisal of project A in nominal terms?

Solution
Cumulative requirement in nominal terms £000 300 1.07 321 350 1.072 401 350 1.073 429 400 1.074 524 200)
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Increase/decrease £000 121 80 28 95 (524)*

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8.5 Identification of a project’s relevant costs and benefits
A common difficulty experienced by students is how to choose which cash flows to include and which to exclude in the investment appraisal procedure. We have listed below a number of examples of the items that should be regarded as being of particular importance:

● ●

Accounting adjustments such as depreciation do not represent cash outflows, as no physical movement of cash takes place. However, tax allowances do represent inflows as they reduce the amount of tax actually to be paid in cash. Cash inflows should be after-tax, as we are concerned with the PV benefits to the shareholder, not to both the shareholder and the Inland Revenue. Cash flows represent dividends which would be paid if the project were financed entirely with equity. Financing decisions would be analysed separately from operational project decisions, which are based on investment appraisal evaluations. Incidental effects need to be included if they represent cash movements. Working capital needs to be included, but bear in mind that it will usually have a terminal value at the end of the project. Sunk costs should be excluded as they do not involve a new cash movement created by the project. For good or ill, they represent past cash flows, which cannot reasonably be recouped from a project which is not related to the purpose for which they were originally expended. Opportunity cost could be defined as ‘the value of a benefit sacrificed in favour of an alternative course of action’. Thus if a scarce resource used for a project A is greater than the amount required for a project B, for example 3 hours of limited machine time for a unit of A compared with 2 hours for a unit of B, then the cost of the extra hour per unit is an opportunity cost to be regarded as an outflow of A. Cash flows should as far as possible relate to directly distinguishable cost elements, otherwise it could be extremely difficult to successfully apply probabilities or sensitivity analysis in a meaningful way to the PVs ascertained. If you discount real cash flows at a nominal rate you are trying to mix oil and water!

Exercise 8.1
This exercise covers an NPV calculation including the aspects of taxation, capital allowances, terminal values and working capital. PQ Ltd, a motor components subsidiary of a conglomerate holding company, has to decide near the end of year 0 whether to invest in a new production line. The project involves equipment costing £600,000 and working capital costing £180,000 at year 0, and the projected net cash inflows for the products are £200,000 per annum for 5 years at current price levels. At the end of 5 years it is projected that the equipment will have a terminal value of £50,000, and that the elimination of working capital will provide an inflow equal to its year 0 book value. PQ Ltd’s post-tax cost of capital is 14 per cent in nominal (money) terms and the inflation rate is projected to be 5 per cent per annum. Taxation data is as follows: (i) The equipment will be subject to writing-down allowances of 25 per cent per annum on a reducing-balance basis, which can be claimed against taxable profits as from the
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current year (year 0) which is shortly to end. A balancing charge or allowance will arise on disposal. (ii) The rate of corporation tax is 35 per cent payable 1 year in arrears.
Requirement

Determine whether or not the net present value of the project will justify the investment.

Solution
You should note that the figures required are in nominal (money) terms, but in this case, while it is possible to convert net cash flows back from nominal to real terms, it is not possible to ascertain a discount rate in real terms, from the data given, because of the mixture of inflated and non-inflated cash flows in the projections. If PQ Ltd’s planners wished the figures to be in real terms, then the company’s real discount rate would have to be separately determined. Care would also be required in adjusting the tax savings on capital allowances.
Equipment Year £ 0 (600,000) 1 – 2 – 3 – 4 – 5 50,000 6 – Net present value Working capital £ (180,000) – – – – 180,000 – Net cash inflows £ – 210,000 220,500 231,525 243,101 255,256 – Tax on cash inflows @35% £ – – (73,500) (77,175) (81,034) (85,085) (89,340) Tax saved on capital all’nces £ – 52,500 39,375 29,531 22,148 16,611 32,335 Net cash flows £ (780,000) 262,500 186,375 183,881 184,215 416,782 (57,005) Discount factor 14% 1.000 0.877 0.769 0.675 0.592 0.519 0.456 Present values £ (780,000) 230,213 143,322 124,120 109,055 216,310 2(25,994) 0 17,026

The net present value is positive and therefore the investment should be accepted. Workings Tax saved on capital allowances
Year (A) 0 1 2 3 4 5 Sale proceeds Balancing all’nce Investment (B) £ 600,000 450,000 337,500 253,125 189,844 142,383 (50,000) – Allowance claimed @ 25% of (B) (C) £ 150,000 112,500 84,375 63,281 47,461 35,596 – 56,787 Written-down value (B)–(C) (D) £ 450,000 337,500 253,125 189,844 142,383 106,787 (50,000) – Tax saved on allowances @ 35% of (C) (E) £ 52,500 39,375 29,531 22,148 16,611 32,335 Year of tax saving (F) 1 2 3 4 5 6

8.6 Linking investment in IS/IT with strategic, operational and control needs
Until quite recently, most organisations regarded their IT systems and their information systems as a resource that was necessary but not strategically significant. The IT department
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was treated like any other collection of overheads, and the information systems allowed to evolve rather than being formally planned. Many organisations now realise that the information system is a strategic resource, and should be treated as such. This often includes having a formal strategy.

Exercise 8.2
Why should organisations have a formal strategy for their information systems?

Solution
The information system should have its own strategy, as part of the overall corporate strategy, for the following reasons:
● ● ● ● ● ●

the information system is an adaptive, open system; the organisation exists in a dynamic environment; information needs are constantly changing; the organisation relies upon the information system in order to construct its strategic plan; the information system requires significant investment over a long period; and the information system and information technology can help the organisation achieve a competitive advantage.

8.6.1 Benefits of a formal strategy
The major benefits of a formal information systems strategy are the following:

● ●

we can achieve goal congruence between the information systems objectives and the corporate objectives; the organisation is more likely to be able to create and sustain a competitive advantage; the high level of expenditure on information systems will be more focused on supporting key aspects of the business; and developments in IT can be exploited at the most appropriate time (which is not always when they are first available).

8.6.2 IS, IT and IM strategy
Some authors, including Earl, distinguish between three components (or levels) of strategy as follows: 1. IS strategy, which looks at the way in which the information systems in various parts of the organisation are organised; 2. IT strategy, which looks at the technology infrastructure of the systems; and 3. IM strategy, which considers how the systems support management processes. In this chapter we use the term ‘information systems strategy’ to encompass all three of these components.

8.6.3 Content of information systems strategy
It is unlikely that the information systems strategy will remain unchanged within an organisation over any significant period of time. Strategies may need amending for various
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reasons including:
● ● ● ●

change in the overall objectives of the organisation; development of new information technologies; update of existing hardware and software; change in the number of employees, resulting in existing systems not coping with new information requirements.

Whatever the reason for the change, it is important that some formal process is followed to ensure that the IS and business objectives remain in alignment. In the worst case scenario, the IT department may decide that some new technology is useful, and implement this. However, if it does not support the overall business objectives of the organisation, then the business may not be able to operate successfully. A general strategy to follow when information systems require amendment is outlined below. Initially, the business strategy of the organisation must be determined. Checking this strategy is essential, because the IT strategy must support this strategy and not drive it. Just because new IT systems may be available does not mean that they have to be used in the organisation. Also, new IT systems may not be compatible with other software or hardware used in the organisation. Additional checks will be necessary to confirm compatibility. Within any organisation, amending part of the information strategy may have an impact on other sections. For example, if information is suddenly provided in a different format, it may no longer be accessible by other divisions or branches. Amendments to the information strategy must be checked against the business plan and individual requirements of each part of the organisation. Having decided to amend the IS strategy in some way, a plan for developing and implementing the system will have to be developed. As well as setting out the plan in an appropriate manner alternative hardware and software as well as development methods may need to be considered. The choice will be between development in-house or outsourcing. A full cost–benefit analysis (CBA) may also be used now, or earlier in the change process, to check that the change will provide the necessary benefits to the organisation at an acceptable cost. Having determined the overall strategy for change, this can be implemented and systems amended. Checks may also be required to ensure that staff and customers are kept fully informed. Particularly where the change will result in some competitive advantage, advertising that the change has taken place will be essential. Finally, a review will be necessary to ensure that the initial objectives of the change have been met. If this is not the case, then further review may be required to determine why, and confirm what additional changes are actually required.

8.6.4 Cost–benefit analysis
Traditional CBA tends to be focused on costs and benefits derived from the accounting system. With many of the costs and benefits of information being intangible, then this analysis may not form a suitable way of assessing the value of information. This section summarises the benefits and limitations of CBA, and these are given below: Which tangible costs to include in the CBA? The main issue is identifying which costs are actually attributable to producing the new information. Most organisations have a network of some description, so distributing any
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additional information for a new system should not be a problem. However, increase in network traffic will result from the new information, along with growth in information transfer from other applications. When the network bandwidth needs upgrading, which specific project pays for this? How to measure intangible costs Many intangible costs arise from not having information available for a specific decision. For example, lack of information about competitors may result in incorrect decision making within the organisation. The issue is how to measure the cost of not having all the information to make a decision. As the accounting system does not trap these costs, then they may be excluded from the CBA. Diminishing returns from benefits Some of the benefits of enhanced information systems can be seen in terms of the improvement in quality of information being provided. For example, if information is provided in 2 seconds rather than 20 seconds, then the information is probably timelier. Placing some value on this benefit may be difficult, although it could be included in the CBA under a heading of ‘other benefits’ and a guess made as to the value. However, there will be significant diminishing returns to this provision, for example, providing information in 0.2 of a second rather than 2 seconds will attract a much smaller amount of benefit. Humans cannot necessarily react to information this quickly. There are limits to benefits from automation so the benefits of improving the quality of information should not be overstated. How to measure intangible benefits Enhanced information may be provided by a new system, however, placing a value on how that information helps people make better decisions is more difficult. The benefits of having additional information may be measured in terms of improved customer service, competitive advantage gained, etc. Again, these items are not identified in the accounting system and it may be very difficult to place any value on them. The benefits from providing more or better information may also take a long time to accrue. Information systems have to be accepted by staff, and time will be taken for historical analysis to build up to any meaningful level. Traditional measures of CBA such as Payback or ROI may be inappropriate, because they provide too short a timeframe for assessing the benefits of information.

Exercise 8.3
List the main costs (one-off and continuing) of an information system implementation project, and the major benefits we might expect from it.

Solution
One-off costs
● ●

purchase of hardware and software; project team costs (feasibility, design, testing, etc.);

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production of documentation; training.

Running costs ● staff salaries; ● overheads; ● training; ● maintenance; ● financing. Benefits ● better decision-making; ● fewer delays; ● better service to customers; ● competitive advantage; ● reduced staff levels. The most noticeable thing is that, with the exception of staff reductions (which hardly ever happen in real life), the benefits are difficult or impossible to quantify. This is the major problem that we must address if we are to provide a meaningful evaluation of information system performance.

8.6.5 Evaluating system performance
Given the weaknesses of the decision-making techniques outlined above, how are we to assess the performance of an information system? There are three approaches we might take: 1. Ignore the benefits. If we choose to ignore those benefits or savings that are ‘too difficult’ to quantify, information systems will almost always appear to have negative cash-flow effects. This is obviously misleading, so this approach would be meaningless. 2. Quantify the benefits. We can attempt to take each of the benefits and turn it, by means of some educated guesswork and dubious assumptions, into a cash-flow stream. There are two problems with this approach: ● our colleagues will dispute our rationale and assumptions; ● it will be difficult, or impossible, to post-audit the system in order to prove that the claimed benefits have been realised. 3. Change the approach. Probably the best approach is to recognise and accept the qualitative nature of the benefits, and find some reasonable (but non-financial) way of assessing them. This might lead us to an evaluation such as the following given in Figure 8.1. The non-financial benefits could be assessed by means of an information audit. The issue then becomes determining appropriate ways to measure those benefits.

Exercise 8.4
Suggest measures for the following qualitative benefits of an information system:
● ●

customer service level; competitive advantage.
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Figure 8.1

Systems performance evaluation

Solution

Customer service level can be assessed by means of a questionnaire, asking customers to rate the service they receive on a scale, possibly with a set of specific criteria such as telephone responses, problem-solving, and flexibility. Competitive advantage could be assessed by measuring market share or cost reductions in production. The problem here is separating the effect of the information system from those of the other relevant factors.

8.7 Adjusting for risk
A key aspect of investment appraisal is the determination of a discount rate, following consideration of project risk. Project risk arises when:
● ● ●

one of a range of outcomes may occur; each possible outcome has a known probability; probabilities are assessed by reference to past information about relative frequencies of outcome of repetitive phenomena (i.e. probabilities are objective). Uncertainty is a situation where:

● ● ●

range of outcomes is unknown, or probability of outcomes is unknown, or both.

In practice, the terms ‘risk’ and uncertainty are used interchangeably. Risk may be considered the case where the decision-maker is willing to act on probabilities, however determined. We set out below brief descriptions of procedures that can be used to help evaluate the role of projects.

8.7.1 Sensitivity analysis
So far in this chapter it has been assumed that all the quantitative factors in the investment decision – the cash inflows and outflows, the discount rate and the life of the project – are
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Table 8.1

Variable Project life

Adverse variation – overestimated by 1 year 2 years – underestimated by 5% 10% – overestimated by 2% 5%

Revised NPV £50 (£550) £300 (£150) £150 (£650)

% change in NPV 83% 192% 50% 125% 25% 208%

Cost of labour

Sales volume

known with certainty. In reality this is very rarely the case. Sensitivity analysis recognises this fact. The CIMA Terminology defines sensitivity analysis as: A modelling and risk assessment procedure in which changes are made to significant variables in order to determine the effect of these changes on the planned outcome. Particular attention is thereafter paid to variables identified as being of special significance. As the definition indicates, sensitivity analysis can be applied to a variety of planning activities and not just to investment decisions. For example it can be used in conjunction with breakeven analysis to ascertain by how much a particular factor can change before the project ceases to make a profit. In sensitivity analysis a single input factor is changed at a time, while all other factors remain at their original estimates. There are two basic approaches:

An analysis can be made of all the key input factors to ascertain by how much each factor must change before the NPV reaches zero, the indifference point. Alternatively specific changes can be calculated, such as the sales decreasing by 5 per cent, in order to determine the effect on NPV. The latter approach might generate results such as those in Table 8.1, while the former approach is illustrated in the example that follows.

Exercise 8.5
The initial outlay for equipment is £100,000. It is estimated that this will generate sales of 10,000 units per annum for 4 years. The contribution per unit is expected to be £6 and the fixed costs are expected to be £26,000 per annum. The cost of capital is 5 per cent.

Requirements
(i) Calculate the NPV. (ii) By how much can each factor change before the company becomes indifferent to the project?
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Solution
(i)
Contribution £6 10,000 Less: fixed costs Cash inflow per annum Cash flow £ (100,000) 34,000 £ 60,000 26,000 34,000 Discount rate 5% 1 3.546 NPV £ (100,000) 120,564 020,564

Year 0 Years 1–4

Outlay Annual cash inflow

(ii) NPV can fall by £20,564 before the indifference point is reached. This means that the annual cash flows can change by X X 3.546 £20,564 £5,800

Therefore, the fixed costs can rise by £5,800 to £20,200 – this is a change of 22 per cent. The contribution can fall by £5,800 to £54,200 – this is a change of 9 per cent. This is the variation caused by price changes, volume changes and efficiency changes in costs. Without more detailed knowledge of the project, it can probably be safely assumed that the project is not sensitive to a change in fixed costs as a change of 22 per cent seems very unlikely. This project is not particularly sensitive to changes in any of the factors calculated. On the other hand, it is very difficult to predict future sales of some projects and an error of 10 per cent may be expected. The contribution is made up of many factors (the individual variable costs and the selling price) and without more detailed knowledge it is not possible to comment further. Sensitivity analysis is very simple to carry out using a spreadsheet model and as a consequence has become very popular in recent years. Once the model has been built a single cell can be altered by trial and error to determine the change needed to make the NPV zero. As sensitivity analysis is carried out without the specification of the precise probability of a particular event occurring, it is easy to apply. Any outcome that appears critical as a result of the analysis can then be examined in more detail before a final decision is made. Its usefulness therefore lies in its role as an attention-directing technique as it directs attention to those factors that have the most significant impact on the outcome of the project. Armed with this knowledge management can take action to make sure that the events that are within their control stay within acceptable parameters. In the example in Table 8.1, wage rates may be critical. So management may seek to obtain a wage agreement that will limit rates of pay in the future so as to prevent the danger of even higher rates. In the example in Table 8.1, the life of the project and the sales volume are likely to be outside the control of management. If, after sensitivity analysis, the decision-makers are still unsure about a particular factor, such as sales volume, they may seek a full risk assessment based on a probability distribution for this particular factor and assess the resulting NPVs. It is important that the output from a sensitivity analysis is not misinterpreted. Sensitivity analysis looks at the change in one factor in isolation but in the real world it is likely that several factors would move together and so the actual outcome of the project might depend
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on the combined performance of several or all of the variables. Table 8.2 shows the probability of the occurrence of the ‘most likely’ figure for each of the factors given in Table 8.1. The figures in Table 8.2 indicate a high degree of confidence in the estimate of the project life while there is less confidence in the other two factors. If it is assumed that the outcomes of each of the variables are independent, the probability of all three most likely outcomes occurring together is obtained by the multiplication of the probabilities, that is: 0.9 0.7 0.5 0.315

This shows that there is a 32 per cent probability that the most likely NPV will occur.

8.7.2 Decision trees
In appraisal situations where uncertainty can apply to more than one variable, and values of the variables can be interdependent, many different outcomes are possible. The decision tree is a useful tool for reviewing a multiplicity of choices and outcomes. Imagine the trunk of the tree as representing a project to be appraised, perhaps a new product to be added to a range, then the first branches (of which there may be two, three or more) may represent alternative predictions as to expected volume of sales to each of which probabilities are assigned. Each sales volume branch then creates secondary branches to represent contributions, to which again probabilities are assigned, and finally these branches create tertiary branches with allied probabilities to represent fixed costs. The probabilities of each branch sequence are then multiplied and the joint probabilities thus obtained are applied in turn to each sequential set of values to give a series of pay-offs or outcomes as shown in Figure 8.2. As can be seen from the diagram, we arrive at eight joint probabilities leading to eight outcomes arising from 2 2 2 branches, representing 2 sales volumes 2 contributions 2 fixed cost values. By relating the joint probabilities to the value figures we obtain the eight pay-offs which are added to give an overall predicted net contribution of £68,000.
Table 8.2

Variable Project life Cost of labour Sales volume

Probability of ‘most likely’ outcome 0.9 0.7 0.5

Figure 8.2

Decision tree
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The pay-offs also show a range of net contributions from £24,000 positive to £18,000 negative, and by adding the joint probabilities, there is a 58 per cent chance of a positive outcome, 24 per cent of a breakeven and 18 per cent of a negative result.

8.7.3 Certainty equivalents
Suppose that in testing the sensitivity assumptions regarding our variables we find that there is an evident risk of our cash inflows falling short of base case predictions, possibly by, say, 20 per cent in the first year of a project. If we want a high degree of safety it seems prudent to assume that the following years, by being further in the future, will show still higher percentage falls from the base case. By applying safety factors of, say, 20, 30 and 40 per cent reductions of base net inflows we arrive at new figures called certainty equivalents for those years. Let us compare possible outcomes:
Base cash flow £ (10,000) 6,000 5,000 4,000 Discount factor 10% 1.000 0.909 0.826 0.751 Base PV £ (10,000) 5,454 4,130 1 3,004) 1 2,588 . Certainty equivalents % of base 80% 70% 60% Present value £ (10,000) 4,363 2,891 1 1,802. 1 (944).

Year 0 1 2 3

£ (10,000) 4,800 3,500 2,400

Clearly with the new inflows, what seems a satisfactory NPV for the project base case, has turned into a negative with certainty equivalents. A risk-averse management is likely to reject the project. The danger of using certainty equivalents lies in the high level of subjective judgement required from the decision-maker, while it could also be argued that risk-averse management might be better off using a high cut-off rate. Nevertheless certainty equivalents do represent a useful tool in the investment appraisal armoury, especially in assessing cases where an apparently small change in a key variable can interact with others to create significant falls in inflows, with a possible cumulative effect over the life of the project.

8.7.4 The discount rate
In all the examples considered so far, a constant discount rate has been used, on the assumption that the cost of capital will remain the same over the life of the project. As the factors which influence the cost of capital, such as interest rates and inflation, can change considerably over a short period of time an organisation may wish to use different rates over the life of the project. NPV and discounted present value allow this but IRR and ARR present a uniform rate of return. Using NPV, for example, a different discount factor can be used for each year if so desired. Perhaps one of the major problems in using a discounted cash flow method is deciding on the correct discount rate to use. It is difficult enough in year 1 but deciding on the rate for, say, year 4 may be very difficult because of changes in the economy, etc. If a very low rate is chosen almost all projects will be accepted, whereas if a very high discount rate is chosen very few projects will be accepted. Looking back over the years it would appear that the majority of managers have probably used too high a discount rate and have, as a consequence, not invested in projects that
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would have helped their organisation to grow in relation to their competitors. There are no prizes for being too conservative; it is just as much a failing as being too optimistic. Porter (1992) and Baldwin and Clark (1994) have blamed this tendency on the perceived need for short-term share price appreciation. But it may be that Kaplan and Atkinson (1989) are closer to the mark when they suggest that it is because discount rates are based on accounting rates and incorrectly include an inflationary element. If there is any doubt over the correct discount rate to use, sensitivity analysis can help.

8.7.5 Adjusted discount rate
A further way of allowing for risk is to add a premium to the cut-off rate whereby more marginal projects would be less likely to have a positive NPV. A useful scheme is to have a risk category schedule providing say for four different risk gradings, ranging possibly from cut-off rate to cut-off plus 10 per cent, with cut-off itself probably being from 2 to 4 per cent above the risk-free rate (e.g. the rate obtainable on government securities). The difficulty with risk-adjusted rates lies mainly in the need for skilful management judgement as to the risk category, even though considerable product and market research may have been undertaken.

8.7.6 Capital asset pricing model
The capital asset pricing model (CAPM) argues that total risk, as measured by standard deviation, can be split into two elements: the risk which can be reduced by diversification, known as specific risk, and the risk which will not be reduced by diversification, known as market risk. Market risk can be broken down further, as shown in Figure 8.3. The risk that can be removed through diversification – specific risk – is that risk which is specific to the individual investment. For example, if you had a single investment of ordinary shares in a company which built houses, the specific risks would include particular planning applications, subsidence problems, non-payment by particular customers, etc. Market risk is associated with the economic environment in which all companies operate, so changes in interest rates, exchange rates, of prices, taxation, etc., affect all companies and their share prices to a greater or a lesser extent. Because investors can avoid specific risk through diversification, the CAPM would argue that the only risk worthy of consideration is market risk. This market risk is measured as beta. Business risk is the risk associated with the particular activities undertaken by the enterprise. Financial risk is the risk resulting from the existence of debt in the financing structure of the enterprise. Beta and the CAPM are covered in detail in Chapter 4 of this text, and you should revisit that chapter to be certain that you understand this important topic.

Figure 8.3

Elements of total risk
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8.8 Evaluating and reporting investment opportunities
The following exercise brings together aspects from this and the previous chapter.

Exercise 8.6
You are required to report on investment opportunities, setting out necessary assumptions further to those stated in the question below and evaluating the two proposals. Part (b) of the question deals with the deeper analysis of factors other than the basic assumptions used for the calculations, including the opportunity cost of capital. The directors of ST Ltd are determined to increase the value of the company’s equity. The company has £250,000 available. It is also in a position to borrow a further £200,000 on a 5-year loan at an effective fixed rate of interest, after allowing for tax concessions, of 10 per cent per annum. Repayments of principal and interest will amount to £52,760 per annum. Investment opportunities available to the company are as follows: (i) The assets of ZQ Limited might be acquired. These would generate cash flows, after allowing for the incidence of corporation tax, in addition to those which ST Ltd might gain otherwise. Details are given below. (ii) Shares in Q J plc could be purchased, when dividends would be received as franked investment income. The shares in Q J plc would be sold in 1996. ST Ltd does not trade with Q J plc nor would it be in a position to have direct influence on the policies of that company. Cash flows would be as follows:
Year 1991 1992 1993 1994 1995 1996 Year 1991 1992 1993 1994 1995 1996 Probability 1.0 0.5 0.4 0.1 As 1992 As 1992 0.7 0.3 0.4 0.4 0.2 ZQ Limited £ (200,000) (50,000) 75,000 150,000 190,000 40,000 Q J plc £ (190,000) 9,500 13,500 19,000

14,250 4,750 209,000 228,000 171,000

Requirements
(a) Prepare a report advising the directors of ST Ltd whether the investment opportunities ought to be taken up. (b) Discuss what other factors should be taken into account.
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Solution
(a) Report To: The Board of ST Ltd From: Management accountant Date: Re: Investment opportunities You asked me to look at the ZQ and Q J projects, in the context of your determination to increase the value of the company’s equity. In our subsequent telephone conversation, we agreed to make the following assumptions:

‘value’ in this context is the net present value of projected cash flows, discounted at the cost of capital; the cost of capital is assessed by the treasurer at the 10 per cent level in line with the cost of the incremental finance available; you see £450,000 as the maximum cash deficit which is sustainable without affecting the risk profile of the equity capital. Against that background, we should look at the proposals as follows:
Year ZQ: 1991 1992 1993 1994 1995 1996 10% discount factor 0.909 0.826 0.751 0.683 0.621 0.564 Forecast cash flows £000 Absolute Discounted (200) (50) 75 150 190 40 (182) (41) 56 102 118 123 076

The positive net present value indicates that this is a viable project, and is within your cash limits.
Year Q J: 1991 1992 1993 1994 1995 1996 10% discount factor 0.909 0.826 0.751 0.683 0.621 0.564 Forecast cash flows £000 Absolute Discounted (weighted average of expectations) (190) (173) 12 10 12 9 12 8 11 7 209 118 ((21)

The negative net present value indicates that this is not a viable project. (b) The assumptions attributed to the telephone conversation were necessary to be able to quantify the opportunities within the constraints of the information given. In practice, however, they would be the subject of considerable thought and elaboration. For instance: whether the financial objective should be expressed as a kind of cash limit; ● whether the marginal borrowing rate should be used as the cost of capital; ● there is a strong argument for saying that any amount of finance can be obtained if the project shows the prospect of an adequate return;

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increasing the apparently cheap source of finance will increase the risk associated with the equity, and thereby increase its cost. Gearing, according to many theorists, does not affect the cost of capital (other than via tax distortions), the primary factor being perceived risk; whether it is wise to assume that there will not be further projects becoming available, which are mutually exclusive with ones being considered. This may sound very judgemental, but then all decision-making is. It helps to think not in terms of the historical cost of capital, but the opportunity cost. Thus, without being specific as to the projects, the question is what rate of return is being forgone, which boils down to the market rate appropriate to the perceived risk; whether the management resources are available to manage the project. Often, this is the limiting factor, rather than finance as such.

8.9 Adjusted present value
Adjusted present value is covered in detail in Chapter 4 and is revisited in Chapter 9. You should revisit Chapter 4 to be certain that you understand this important topic. The opportunity cost of capital is frequently used as the discount rate in investment decisions. This is not always entirely correct; the rate to be used in the investment decisions should, in theory, be a specific risk-adjusted discount rate which reflects the business risk of the project. This adjusted rate is the basis of the concept of adjusted present value (APV) which suggests that the net present value (NPV) of a project can be increased or decreased by the side-effects of financing. In using APV you proceed by taking NPV as a first stage (‘base case NPV’), evaluating a project as if it was totally financed by equity, and then introduce APV as a second stage by making adjustments to the base case to allow for the side-effects of the intended method of financing. A simple example will serve to illustrate the basic idea.
Example 8.E
A project has a net present value of £50m (the ‘base-case’ NPV). However, as the project is considered socially desirable it qualifies for an immediate tax-free government grant of £10m. This is a special financing arrangement and hence needs to be taken into account: APV NPV side effect of financing £50m £10m £30m

More complicated examples could be found, for example, to show how the tax benefits of debt interest might increase the base case NPV of a project. The issue costs would of course have the effect of decreasing base case NPV.

Note that the calculation of APV usually takes the form of first calculating NPV as if the project financing was all by equity, and then incorporating adjustments to allow for the effects of the financing method to be actually used. Bear in mind that difficulties in using APV may arise either in determining the costs involved in the financing method to be used, or in finding a suitable cost of equity for the basic NPV calculation. Nevertheless, APV often has the advantage of being a more positive approach than making an arbitrary adjustment of the company’s cut-off rate. The APV approach also suggests that an adjusted cost of capital can be calculated to use as a discount rate in specific circumstances. A further example of APV follows.
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Example 8.F
A project requires £1 million capital investment. The project will save £220,000 per year after taxes. Assume the savings are in perpetuity. The business risk of the venture requires a 20 per cent discount rate. In this case the project’s base case NPV is just positive: Base-case NPV (1,000,000) 220,000 0.2 £100,000

However, assume that this project has one financial side-effect: it expands the firm’s borrowing power by £400,000. The project lasts indefinitely so we treat it as supporting perpetual (i.e. undated) debt. If we assume that the borrowing rate is 14 per cent and the net tax shield is 35 per cent, the project supports debt which generates an interest tax shield of 0.35 0.14 £400,000, which is £19,600 per annum for ever. The PV of the tax shield is: £19,600 0.14 £140,000

The project’s APV is therefore: APV base case NPV PV shield £100,000 £140,000 £240,000.

Adjusted discount rate The adjusted discount rate, or adjusted cost of capital, is the rate at which APV 0, that is, the IRR. To calculate the adjusted discount rate we must first calculate the minimum acceptable annual income, that is, the income that would result in an APV of zero. APV Base case NPV PV tax shield Initial investment (Annual income/Base case discount rate) £1m (Annual income/0.2) £140,000 0, we can rearrange the equation to give: 0.2 (£1m £172,000 £140,000) PV tax shield

Assuming APV

Min. annual income

The minimum IRR is therefore: IRR Minimum annual income/Initial Investment (gross) £172,000/£1m 0.172 or 17.2%

This is the adjusted cost of capital – denoted r *. To calculate r * we find the minimum acceptable rate of return – the IRR at which APV 0. The rule is, accept projects which have a positive NPV at the adjusted cost of capital. You should clearly understand the two concepts of cost of capital. Opportunity cost of capital, r, is ‘the expected rate of return offered in capital markets by equivalent-risk assets’, depending on the risk of project cash flows. Use r where there are no significant side-effects from financing. Adjusted cost of capital, r *, is an opportunity cost rate which also reflects the financing sideeffects of an investment project. If these are significant, use r * and accept projects having positive APVs (adjusted present values).
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8.10 Assessing investments as options on future cash flows
Option-pricing theory is not part of the syllabus, but it is useful to consider the option-like features found in investment decisions. When a project is slipping behind forecast managers can take action in an attempt to achieve the original NPV target. In other words, they can create options, or take action to mitigate losses or exploit new opportunities presented by capital investments. Before discussing investment decisions as options on future cash flows, it may be useful to identity the meaning of call and put options:

a call option is an option to buy a specified asset at a specified exercise price on or before a specified exercise date; a put option is an option to sell a specified asset at a specified exercise price on or before a specified exercise date.

The net present value approach to investment appraisal makes two assumptions that may be questioned:
● ●

a project is reversible; a project cannot be delayed.

The assumption that a project is reversible implies that if the project does not work out, the original investment can be recovered and applied to a new project. This is flawed, as in most significant projects the original investment will either be wholly or partly irreversible. In some instances it may not be possible to delay an investment decision, but in the majority of cases a delay is possible – although there may be costs associated with delay. If a project is irreversible to some degree, the ability to delay the investment decision in order to obtain new information is valuable. The additional costs associated with delay should be assessed against the benefits associated with that new information. Investment projects can be related to financial call options, in that the project provides the right, but not the obligation, to purchase an asset (or commit to a series of cash flows) in the future. When an irreversible investment decision is made, the call option becomes exercised. The opportunity to delay an investment and keep the option alive has a value, which is not normally reflected in a net present value calculation. The real options approach suggests that decisions that increase flexibility by creating and preserving options should be pursued. Decisions that reduce flexibility by exercising options and irreversibly committing resources should be valued at a lower figure than conventional net present value would suggest. In the context of investment decisions there are three options to be considered: 1. The abandonment option (financial put option). 2. Timing options (financial call option). 3. Strategic investment options (financial call option).

8.10.1 The abandonment option
Major investment decisions involve heavy capital commitments and are largely irreversible: once the initial capital expenditure is incurred, management cannot turn the clock back and act differently. Because management is committing large sums of money in pursuit of higher, but uncertain, payoffs, the ability to abandon, or ‘bail out’, should things look grim, can be valuable.
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Example 8.G
Cardiff Components Ltd is considering building a new plant to produce components for the nuclear defence industry. Proposal A is to build a custom-designed plant using the latest technology, but applicable only to nuclear defence contracts. A less profitable scheme, B, is to build a plant using standard machine tools, giving greater flexibility in application. The outcome of a general election to be held one year hence has a major impact on the decision. If the current government is returned to office, their commitment to nuclear defence is likely to give rise to new orders, making proposal A the better choice. If, however, the current opposition party is elected, its commitment to run down the nuclear defence industry would make proposal B the better course of action. Proposal B has, in effect, a put option attached to it, giving the flexibility to abandon the proposed operation in favour of some other activity. (adapted from Pike and Neale)

Example 8.H
Case I A project, P, has expected cash flows as shown in Table 8.3. Table 8.3 Year 0 1 2 3 Expected cash flow £ (3,500) 2,000 2,000 2,000 Discount rate 10% 1.000 0.909 0.826 0.751 Expected net present value Discounted cash flow £ (3,500) 1,818 1,653 1,503 1,474

The initial investment of £3,500 in project P represents the purchase of a customised machine, the price of which is known with certainty. Because it is a customised machine its resale value is low; it can only be sold for £1,000 immediately after purchase. Once the machine is bought, therefore, the expected value of abandoning the project would be £1,000 (1.0 £1,000). This must be compared with the expected value of continuing with the project, which is £4,974 (£1,818 £1,653 £1,503). In this case the expected benefits of continuing with the project far outweigh the returns from abandoning it immediately. Case II The decision to abandon a project will usually be made as a result of revised expectations of future revenues and costs. These revisions may be consistent with the data on which the original investment decision was based, or represent an alteration to earlier expectations. If the decision is consistent with the original data, the possibility, but not the certainty, that the project might have to be abandoned would have been known when the project was accepted. In these circumstances, project abandonment is one of a known range of possible outcomes arising from accepting the project. The cash flows in Table 8.3 were the expected ones, based on the probabilities given in Table 8.4. Table 8.4 Year 0 £ (3,500) Year 1 p 0.33 0.33 0.33 £ 3,000 2,000 1,000 2,000 p 0.33 0.33 0.33 Year 2 £ 3,000 2,000 1,000 2,000 p 0.33 0.33 0.33 Year 3 £ 3,000 2,000 1,000 2,000

Expected value

In Year 0, the expected net cash inflow in each year of project P’s 3-year life is £2,000. The actual outcome of any of the 3 years is unknown at this point, and each of the three possible outcomes is equally likely. The factors that will cause any one of these results to occur may differ each year, or they may be the same each year. In some instances, a particular outcome in the first year may determine the outcome of years 2 and 3 with certainty. For example, the outcome of £3,000 in year 1 may mean that this same outcome will follow with certainty in years 2 and 3. Similarly outcomes of £2,000 and £1,000 in year 1 may be certain to be repeated in years 2 and 3. In year 0, the investor can only calculate the expected net cash flow in years 2 and 3, but with perfect correlation of flows between years these future flows are known with certainty at the end of year 1. If the year 1 inflow is either £3,000 or £2,000, perfect correlation between years will ensure that the actual NPV of the project will be positive. But if the first year’s outcome is £1,000, the investment will have a negative NPV of £1,014, that is (£[3,500] £1,000 2.486). Should the project be abandoned? The information is now certain and so the decision on whether to abandon should be made using
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a risk-free interest rate and not the company’s normal cost of capital. If we assume that the risk-free rate is 5 per cent, the present value of continuing at the end of year 1 will be: Year 0 1 2 Cash flow £ (1,000) 1,000 1,000 Discount rate 5% 1.000 0.952 0.907 Discounted cash flow £ (1,000) 952 1,907 0 859

Clearly, the project should not be abandoned. Case III Suppose a buy-back clause had been part of the sale agreement for the machine, which requires the supplier to repurchase the machine on demand for £2,000 at any time up to and including the first anniversary of the sale. The abandonment value of the project at the end of year 1 will be £2,000. When this is compared with the £1,859 present value of continuation, it is clear that the company should plan to terminate the project at the end of year 1, if the actual outcome of that year proves to be £1,000. When the buy-back option is included, the possible outcomes will change as shown in Table 8.5. Table 8.5 Year 0 £ (3,500) Year 1 p 0.33 0.33 0.33 £ 3,000 2,000 1,000 2,000 2,667 p 0.33 0.33 0.33 Year 2 £ 3,000 2,000 0 1,667 p 0.33 0.33 0.33 Year 3 £ 3,000 2,000 0 1,667

Expected value

Including abandonment in the plan increases the expected NPV of the project by £80: Year 0 1 2 3 Cash flow £ (3,500) 2,667 1,667 1,667 Discount rate 10% 1.000 0.909 0.826 0.751 Discounted cash flow £ (3,500) 2,424 1,378 1,252 1,554

This type of problem can be analysed using a decision tree. Figure 8.4 sets out the data in this format.

Figure 8.4
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The method outlined above can be utilised even where the correlation of cash flows between years is less than perfect. The correlation can range from perfectly positive (as in our example) to perfectly negative. Where the correlation is zero, that is total independence of cash flows between years, the method cannot be used. But in all other instances the knowledge gained in Year 1 will enable the forecast for later years to be refined to a greater or lesser extent. This in turn will allow the expected present value of continuing with the project to be compared with the present value of termination. Case IV During a project’s life, events that were unforeseen at the time of the original decision may occur and have an impact on the expected cash flows of the project. Such events will require a revision of future predictions. In the previous example, the announcement of a new tax charged on revenues during the course of year 1 would necessitate a review of the project’s profitability. If the effect of the new tax would be to reduce the project’s revenues after year 1 by 50 per cent, the position would be as shown in Table 8.6. Table 8.6 Year 0 £ (3,500) Year 1 p 0.33 0.33 0.33 £ 3,000 2,000 1,000 2,000 p 0.33 0.33 0.33 Year 2 £ 1,500 1,000 500 1,000 p 0.33 0.33 0.33 Year 3 £ 1,500 1,000 500 1,000

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Expected value

The introduction of the new tax means that a cash flow of £2,000 in year 1 will now be followed by only £1,000 in years 2 and 3. This will mean that the project should be abandoned in year 1. At the time the project was being considered, this situation was not, and could not have been, foreseen by the decision-maker. Under these circumstances, it would be surprising if there was any resistance to the idea of terminating the project, as external events, for which no one could be held responsible, had made it necessary. But when a revision in future expectations arising from errors in the original forecasts, or due to problems in project implementation, indicate that abandonment is necessary, it can be much more difficult to acknowledge and accept. The post-completion audit team will play a significant role in identifying and highlighting the changed circumstances in such situations.

Example 8.I
Project X had the following expected cash-flow pattern at the time of its approval: Year 1 2 3 4 Net present value Discounted cash flow £m (8) (16) (24) 55 07

The company experienced great difficulty in implementing the project in year 1, and the actual costs incurred during that year were £16m. The company must then ask itself whether the actual outcome in year 1 necessitates any revision in the expected outcomes of later years. If no revision is required, further costs of £40m (year 0 values) must be incurred to secure inflows of £55m (year 0 values). The expected net present value of continuing with project X beyond year 1 will thus be £15m (year 0 values). (Note that adjusting the figures to Year 1 values would increase the expected NPV slightly, strengthening the case for continuation.) The overall result of the investment would, of course, be negative by £1m, if years 2–4 costs and revenues are as forecast. The excess spend of £8m in year 1 is greater than the £7m net present value originally predicted. However, at the end of year 1 the £16m is a sunk cost and does not influence a decision on termination made at that time.

8.10.2 Timing options
Example 8.G not only introduced the concept of abandonment, it also raises the possibility of a ‘wait and see’ policy. Management may have viewed the investment as a ‘now or never’ opportunity, arguing that in highly competitive markets there is no scope for delay: money is made by
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staying ahead of the competition. In effect, this amounts to viewing the decision as a call option which is about to expire on the new plant for the capital investment outlay. If a positive NPV is expected, the option will be exercised, otherwise the option lapses and no investment is made. The option to defer the decision by, say, 1 year until the outcome of the general election is known, makes obvious sense. An immediate investment would yield either a negative NPV – in which case it would not be taken up – or a positive NPV. Delaying the decision by a year to gain valuable new information is a more valuable option. This helps us to understand why management sometimes does not take up apparently wealth-creating opportunities: the option to wait and gather new information is sufficiently valuable to warrant such delay.

8.10.3 Strategic investment options
Certain investment decisions give rise to follow-on opportunities which are wealth-creating. New technology investment, involving large-scale research and development, is particularly difficult to evaluate. Managers refer to the high level of intangible benefits associated with such decisions. What they really mean is that these investments offer further investment opportunities (e.g. greater flexibility).

8.10.4 Valuing options
The Black–Scholes option valuation model identifies five elements that together determine the premium payable on a call option for a share. These are:
● ● ● ● ●

the current market price of a share; the exercise price, or strike price, of the option; the time to expiry of the option; the variability of the share price over a period of time measured by the variance; the risk free rate of interest.

The five factors used in the Black–Scholes formula can be related to a call option on an investment appraisal to give the following elements:
● ● ●

● ●

present value of the future cash flows from the investment; initial outlay on the investment; time until the investment opportunity disappears, that is, the length of time that an investment decision can be deferred without losing the opportunity to invest; variability of project returns; risk-free rate of interest.

Pricing an option using values for these factors will arguably provide more information about the value of a project than using net present value. However, quantifying these factors objectively is not straightforward.

8.11 Project implementation and control
8.11.1 The investment cycle
The financial evaluation of projects is only one part of the investment process. The full process is represented in Figure 8.5. This shows that the investment process is a cycle, rather than a single discrete event.
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Figure 8.5

The investment cycle

The cycle from concept through development, construction, manufacturing, operation and disposal can also be represented as follows:

Gather information – collect historical costs – gather external information – assess opportunity costs – consider strategic direction Make predictions – determine costs of project e.g. purchase and installation – evaluate the expected hard and soft benefits of the new system Accept project – compare predicted costs with benefits over a period of years, that is, investment appraisal – consider all other aspects of decision Implementation decision – prepare plan for implementation – carry out implementation Evaluate performance – monitor events by collecting regular statistics – carry out a post-completion appraisal Use knowledge gained – assess findings of post-completion appraisal – implement improvements to system
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– publicise findings for future benefits – adjust or terminate project.

8.11.2 Post-completion auditing
A post-completion audit (PCA) can be defined as ‘an objective and independent appraisal of all phases of the capital expenditure process as it relates to a specific project’. The main purposes may be summarized as:
● ● ●

project control; improving the investment system; assisting the assessment of performance of future projects.

A project’s PCA provides the mechanism whereby experience of past projects can be fed into the firm’s decision-making processes as an aid to the improvement of future projects. PCAs have, until recently, been relatively neglected in the UK, both in the academic literature and in practice. However, both large surveys (e.g. by Pike and Wolfe, and Neale) and small, in-depth studies (e.g. by Kennedy and Mills) have made it clear that the extent of PCA in the UK has increased substantially in recent years, and it is likely to be practised by more than 80 per cent of large companies. None of the surveys cited is able to provide a definitive explanation for the increase in PCA, although suggestions are made, and anecdotal evidence is adduced in support of the suggestions. It is argued that PCA is now seen as the final link in the investment process, and that to have attempted PCA in the absence of formal investment procedures would have been futile. As we saw earlier, empirical evidence has shown that sophisticated evaluation techniques have been increasingly adopted in recent decades, and it is only to be expected that there would be a time lag between the adoption of other parts of a more rigorous investment process and PCA. Anecdotal evidence also suggests that the growing interest in PCA has arisen from a realisation that past investments have frequently failed to live up to expectations, and firms are keen to avoid repetition of the same mistakes.

8.11.3 Benefits of post-completion auditing
Six potential benefits from the operation of a post-auditing system have been identified, and these are listed below in the order in which they appear in Management Accounting Guide 9: Post Completion Auditing (CIMA, 1993): 1. It improves the quality of decision-making, by providing a mechanism whereby past experience can be made readily available to decision-makers. 2. It encourages greater realism in project appraisal, by providing a mechanism whereby past inaccuracies in forecasts are made public. 3. It provides a means of improving control mechanisms, by formally highlighting areas where weaknesses have caused problems. 4. It enables speedy modification of under-performing/over-performing projects, by identifying the reasons for the under- or over-performance. 5. It increases the frequency of project termination for ‘bad projects’.

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6. It highlights reasons for successful projects, which may be important in achieving greater benefits from future projects. Mills and Kennedy reclassified these benefits into three types:

● ●

Type (a) – those which relate to the performance of the current project, i.e. the project under review. Type (b) – those which relate to the investment system itself. Type (c) – those which relate to the choice and performance of future projects.

Using this subdivision, the benefits listed in the Guide are grouped under the three categories, as follows:
Type (a) (b) (c) Guide benefit 4, 5 3 1, 2, 6

The authors reported that all the surveyed companies that had an operational PCA system at the time of their research gained type (b) benefits from their system, and almost 40 per cent sought type (c) benefits. Only 20 per cent of the companies sought type (a) benefits, which may be considered surprising. However, it is pointed out that control of the current project during its life may be effectively gained through other procedures, such as routine project monitoring.

8.11.4 Organisation of PCA
PCA does not adopt a narrow accounting focus. A good PCA report does not set out to identify the costs and benefits of a project in precise detail (as pointed out above, this particular task will normally have been carried out as part of a routine project-monitoring system), but rather seeks to identify general lessons to be learned from a project. It is not a policing exercise, and, if it is to be effective, should not be seen as such. PCA will nevertheless encourage honesty in facing problems at all levels of the organisation, as attempts to ignore or hide realities are unlikely to remain uncovered. The task is often carried out by small teams, typically consisting of an accountant and an engineer who have had some involvement in the project. Surprising though it may seem, it is not common to find PCA as the responsibility of the internal audit section. A post-audit reviews all aspects of a completed project, to assess whether it lived up to initial expectations in terms of revenues and costs, and analyses the causes of deviations from planned results. Its main purpose is to enable the experiences – good or bad – gained during the life of one project to be made available for the benefit of future projects. The role of post-audit is thus essentially a forward-looking one; it seeks to establish lessons from the past for the future benefit of the organisation. The formal mechanism for transmitting the information to management is the final postaudit report, which provides a history of the project from inception to completion. In the case of successful ventures, the reports will distinguish between projects which have a good outcome due to effective planning and management, and projects whose good outcome is the result of luck; in the case of unsuccessful ventures, the causes will be fully disclosed. It is at the planning stage that project control is most important and effective, and past experience provides an invaluable input into the process.

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8.11.5 Role of post-appraisal in project abandonment
Those intimately involved with a project may be reluctant to admit, even to themselves, that early problems with a project are likely to continue. When problems are being experienced in project implementation, those involved may be tempted to try to resolve the situation in one of two ways. They can make a change in the original plans and/or incur further expenditure in order to meet the original objective. Whether either of these responses is appropriate will depend on the particular circumstances of the project but any significant changes or deviations should not be undertaken without the formal approval of higher management. The control systems in place will normally require changes of scope to be documented and approved before they are undertaken. It is usually the responsibility of the engineers associated with the project to ensure that this is done. Expected project cost overruns should be highlighted by the routine monitoring of project expenditure by accounting staff, and formal approval should be obtained for the anticipated overspend. A prerequisite of approval by top management will often be the provision of the same level of detailed justification as was required when the initial funds were sanctioned. These controls ensure that significant changes to the character of a project cannot be made without top management’s approval. However, they do not, of themselves, ensure that the option to terminate a project is considered, although it would be unlikely that management would fail to consider this possibility. Some companies require an audit to be carried out on all projects that need additional funds. The request for further funding would then be considered alongside the audit report. Routine monitoring of projects tends to focus almost exclusively on costs. An audit will review both costs and revenues, and, most importantly, focuses on the future. By checking the continuing validity of both forecast costs and revenues, the post-audit team is in a position to prepare a report to advise management on the wisdom of continuing with the project.

8.12 Summary
The discounting of cash flows is most relevant to the work of the financial manager. Specifically, it is how the imposed discipline of the capital market is translated into a criterion for the making and monitoring of decisions. Expansion opportunities, for instance, almost always involve an outlay now for a return in later periods. To see whether a particular proposal is viable, its projected cash flows can be discounted back to a present value. If the net result is positive, the proposal is seen to be financially worth while, that is, to augment the value of the enterprise. If, on the other hand, it is negative, it is seen as not being financially worthwhile, that is, as detracting from the value of the enterprise. Identifying the cost of capital is a vital component of financial management at the strategic level, and hence to the financial health of the enterprise. For its application, you must understand the interrelationship of cash flows, interest rates, growth and inflation, and the ways in which these come together in using discounted cash-flow techniques for investment appraisal. You must take particular care not to confuse real rates and nominal rates. The computer and spreadsheet are of great importance in using those measures of risk which involve the interaction of several variables, such as sensitivity analysis. Indeed, the asking of ‘what if ?’ questions in evaluating a project has been made enormously more effective by computer power.

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The decision tree represents a form of probability estimating which can often be of especial value in that it forces the decision-maker to think clearly through a sequence of events triggered by an initial action, e.g. initiating a capital expenditure project, before arriving at a final outcome (an overall NPV) built up from the separate outcomes of all the possible alternatives contained in the tree. You should be able to calculate certainty equivalents, especially where the high risk of a project makes it desirable to know how far net cash flows can change adversely before the project outcome becomes negative. The approach to evaluating and reporting on investment opportunities is an important aspect of Financial Strategy. We also consider assessing investments as options on future cash flows, while the section on post-completion auditing makes clear the benefits of learning from the experience gained by keeping careful records of previous project implementations.

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Readings

8

Assessing investments as options on future cash flows

The two articles in this section consider approaches to investment decisions that use ideas developed for financial and commodity options. The use of real options allows managers to take into account intangible factors such as strategic issues. The method, therefore, provides a complementary approach to traditional DCF analysis, which is predominantly quantitative.

Keeping all options open
The Economist, 14 August 1999 © The Economist Newspaper Limited, London 1999. Reprinted with permission.

‘Those who can, do; those who cannot, teach.’ Many a manager has at times been tempted to borrow this aphorism to put woolly professors in their place. Company bosses find it especially hard to resist grumbling about academic other-worldliness whenever they are deciding where to invest their shareholders’ money. To evaluate potential projects, they almost invariably have to resort to a theory of corporate finance called the ‘Capital Asset Pricing Model’ (CAPM). Yet real-life managers tend not to like this model, for the simple reason that it ignores the value of real-life managers. So they might welcome some recent academic work. In the ivory tower, they are talking about ditching the CAPM for a rival, called ‘real-options theory’, that places managers at its very core. To see why bosses are likely to prefer this new approach, consider what is wrong with the traditional model. The CAPM involves forecasting all the cash flows of an investment project and discounting them to their net present value (NPV). Getting the cash-flow projections right (or even close) is staggeringly difficult. But it is even trickier to choose the correct discount rate. Conceptually, that rate is the opportunity cost of not investing in another project of similar systematic risk (i.e. risk that, in a large portfolio, cannot be diversified away). So the higher a project’s risk, the higher its discount rate and the lower its NPV. But in practice, setting discount rates at the right level is almost impossible. The CAPM often spits out negative NPVs for many of the most exciting strategic opportunities. The main reason for this shortcoming is that the model can use only information that is already known. That is typically not much, and the resulting uncertainty tends to be reflected in an excessive discount rate. Combining an NPV calculation with decision trees (which assign numerical probabilities to various possible outcomes) may help, but not much. For each branch of the tree, the analyst still has to pick and apply an appropriate discount rate, and that of course was the problem in the first place. More fundamentally, the flaw in the CAPM is
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that it implicitly assumes that when firms buy new assets, they hold these passively for the life of the project. But they do not. Instead, they employ managers precisely in order to react to events as they unfold. Obviously, this managerial flexibility must be worth something.
Getting real

To quantify exactly how much it is worth is the point of real-options analysis. It starts by recognising that most investment opportunities have embedded in them a series of managerial options. Take, for instance, an imaginary oil company. Its bosses believe that they have found an oil field, but they know neither how much oil it contains nor what the price of oil will be once they are ready to pump. So, as a first step they could simply put enough money down to buy or lease the land and explore. If they do not find oil, they can cap their outlays at the costs already sunk. If they do strike oil, however, they might invest a bit more and put the drilling gear in place. But suppose the oil price then plummets. Management could put the project on hold and let its field lie fallow. Perhaps it could also switch to producing gas instead of oil. Or it could drop the project and sell the land. If, on the other hand, the oil price goes up, the firm is ready to pump. Since oil prices and other factors are uncertain, in other words, the mere option to produce has value. The logic is similar in other industries. Pharmaceutical companies, for instance, are in the business of searching for new pills, but never know which ones will work. So they may start researching a number of drugs, in the hope of striking lucky with just a few. By contrast, if they stuck strictly to the CAPM in making their investment decisions, they would almost certainly turn down most of these projects, since the uncertainty surrounding them would require such high discount rates. Poker provides a good analogy. If players had to place their final bets right as the first hand is dealt (as the CAPM requires them to), most would (reasonably) opt out quickly. Instead, they merely put down a small initial stake to stay in the game. Depending on the next card, they then pass, match or raise, and so on. Options on ‘real’ assets (and indeed poker bets) behave rather like options on financial assets ( puts and calls on shares or currencies, say). The similarities are such that they can, at least in theory, be valued according to the same methodology. In the case of the oil company, for instance, the cost of land corresponds to the premium (or down-payment) on a call option, and the extra investment needed to start production to its strike price (at which the option is exercised). As with financial options, the longer the option lasts before it expires and the more volatile the price of the underlying asset – in this case, oil – the more the option is worth. This is in sharp contrast to the CAPM, which deals harshly with both long time horizons and uncertainty. There is a snag, of course: sheer complexity. Pricing financial options is daunting, but valuing real options is harder still. Their term, unlike that of financial options, is usually open-ended or undefinable. The volatility of the underlying asset can be difficult to measure or guess, especially since it is not always clear what it is – if, for example, it is yet to be invented. How can one define the appropriate benchmark asset-class in the case of a new drug for a rare disease? And there may be additional variables to consider, such as the strategic benefit of pre-empting a rival. So will real-options analysis replace the CAPM? Archie Pitts, a professor of finance at Warwick Business School, says that this would be likely only if all managers had doctorates in applied mathematics. He conducted a survey of Britain’s 100 largest companies and discovered that the finance directors of only four of them had heard of the term. They might do well to start paying attention, if only to keep the academics in their place.
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Beyond DCF
Roger Peskett, Management Accounting, November 1999. Reprinted with permission.

Real options

J. S. Busby and C. G. C. Pitts (Assessing Flexibility in Capital Investment, CIMA Publishing, 1998) use the term ‘real options’ for ‘situations of flexibility in irreversible investments in real assets, such as factories and production lines’. The flexibility provided by real options in investments appears in many guises. Busby and Pitts identify the following types:
● ● ● ●

Timing : options to embark on an investment, to defer it or abandon it; Scale: options to expand or contract an investment; Staging: the option to undertake an investment in stages; Growth : options to make investments now that may lead to greater opportunities later, sometimes called ‘toe-in-the-door’ options; Switching : options to switch inputs or outputs in a production process.

Beyond DCF

Discounted cash flow (DCF) techniques see if a project is worth undertaking by calculating the net present value of the future cash flows generated. The DCF approach to a firm’s investment decisions could be likened to assessing projects as if they were investments held in a portfolio – if the Capital Asset Pricing Model (CAPM) was used to determine the discount rate (on the assumption that market risk has been diversified away). Investors’ decisions to buy, hold or sell financial assets are based on monitoring investment performance. If one of their investments is not performing, they would probably sell the asset. Similarly, managers could take action to help boost a project’s NPV if it falls behind forecast. They can create and take advantage of options in managing projects.
Choosing to create choices

Conventional DCF analysis looks at whether a project is going to add value for shareholders. In practice, managers of a business are unlikely to consider net present values of projects alone. Investing in a particular project might lead to other investment opportunities that may have been ignored in a DCF analysis. If a manager ignores these and chooses between projects on grounds of NPV alone, the manager may be turning away from options to undertake ‘follow-on’ investments that have a value to the business. A follow-on investment could involve a change in the scale of operation (scale option).
Case 1

Suppose that a brewing company with a mineral water source in its brewery is considering buying adjacent land on which to build a water-bottling plant. It prefers to buy more land and build a bigger factory than is needed for the plant it initially plans to install, in case future demand outstrips supply of the new product. It is investing in excess capacity because it sees value in the scale option. Planning a project so that it can be implemented in a number of phases over time may add costs, and scale economies may be less than if it were not phased. The benefit of phasing is that, as each phase is completed, there is the option of going no further (staging option).
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The added costs of phasing the project plus any forgone economies are the counterpart to the ‘premium’ paid for a financial or commodity option. We should choose to phase the project if the benefits of having the option to drop later stages exceed this premium.
Case 2

For example, a new railway might be built in parts. Information on demand for earlier phases of the railway line, once they are operating, will help to establish whether the option to build later phases should be taken up. Undertaking a first loss-making project in a new area – for example, a new technology or a new market – can create an opportunity to undertake other projects later (growth option). Many Western companies set up operations in China during the 1990s. Although these operations have often made losses, they have provided the companies with entry into a potentially huge market in that country in the future. The loss made by the ‘toe-in-the-door’ project, or the negative NPV in DCF terms, can be seen as the option premium. Switching options can be illustrated by the choice of a plant that uses different fuels.
Case 3

Even if gas is now relatively a much cheaper fuel than oil for a company’s production process, volatility in the relative prices of oil and gas may make dual-fuel oil/gas equipment an attractive investment even if it costs more than a single-fuel system. The company is buying the flexibility to switch between fuels as relative prices change.
Options to delay and abandon

The option to ‘wait and see’ in the expectation of gaining further information before making a decision is common in investment decisions. Does this timing option provide the financial manager with a justification for indefinite procrastination? No, because only ‘wait and see’ options that have a positive value should be selected. It is unusual for investments to be ‘now-or-never’ opportunities. Often, there is a time period over which a project can be postponed corresponding to the period of time during which the option to invest can be exercised. Even if DCF analysis indicates a positive NPV, there may be a value in delaying before embarking on a project to allow time for new information to come to light. Weighing against the value of waiting (equivalent to a call option), we need to consider any cash inflows forgone during the period of postponement. Once a project has been started, having an option to abandon it (equivalent to a put option) can be of great value if the benefits of the project are highly uncertain. A break clause in a lease would be an example.
Valuing real options

Valuing real options might seem like a tricky task. An approach cited by Busby and Pitts involves replicating the option by a combination of traded assets such as commodities, shares and government bonds whose value closely matches that of the option. This is rather like estimating the value of a house by looking at the prices at which similar houses have recently traded. The various factors contributing to the value of a real option can be compared with the determinants of the value of a share option. For a follow-on investment, for
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example, the factors will include:

● ● ●

the present value of the future benefit streams of the follow-on project (counterpart to the current value of the share); the initial cost of the follow-on project (counterpart to the exercise price); the time within which the option must be exercised; the variability of expected project returns (counterpart to variability of the share price).

Iterative methods, using a computer program to work by trial and error towards the answer, are used to value options. Will quantitative valuation methods actually be encountered in the exam or in practice? In an exam – no, such complex calculations are beyond the syllabus. In practice – financial decision-makers are currently unlikely to go very far down the road of putting figures to the value of real options. However, option-like decisions are often made in business, even if managers are only now beginning to talk of them as ‘real options’. A qualitative appreciation of the various aspects of option-like situations, supplemented by some broad-brush estimates of the quantitative value of options, could help to elucidate many investment decisions.

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Revision Questions

8
£ 12.00

Question 1
(a) Explain how inflation affects the rate of return required on an investment project, and the distinction between a real and a nominal (or ‘money terms’) approach to the evaluation of an investment project under inflation. (4 marks) (b) Howden plc is contemplating investment in an additional production line to produce its range of compact discs. A market research study, undertaken by a well-known firm of consultants, has revealed scope to sell an additional output of 400,000 units p.a. The study cost £0.1m, but the account has not yet been settled. The price and cost structure of a typical disc (net of royalties), is as follows:
£ Price per unit Costs per unit of output Material cost per unit Direct labour cost per unit Variable overhead cost per unit Fixed overhead cost per unit Profit

1.50 0.50 0.50 1.50 (4.00) 08.00

The fixed overhead represents an apportionment of central administrative and marketing costs. These are expected to rise in total by £500,000 p.a. as a result of undertaking this project. The production line is expected to operate for five years and require a total cash outlay of £11m, including £0.5m of materials stocks. The equipment will have a residual value of £2m. Because the company is moving towards a JIT stock management policy, it is expected to decline at about 3 per cent p.a. by volume. The production line will be accommodated in a presently empty building for which an offer of £2m has recently been received from another company. If the building is retained, it is expected that property price inflation will increase its value to £3m after 5 years. While the precise rates of price and cost inflation are uncertain, economists in Howden’s corporate planning department make the following forecasts for the average annual rates of inflation relevant to the project:
Retail Price Index Disc prices Material prices Direct labour wage rates Variable overhead costs Other overhead costs 343 6% p.a. 5% p.a. 3% p.a. 7% p.a. 7% p.a. 5% p.a.
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REVISION QUESTIONS P9

Requirement Given that Howden’s shareholders require a real return of 8.5 per cent for projects of this degree of risk, assess the financial viability of this proposal. Note: You may ignore taxes and capital allowances in this question. (10 marks) (c) Briefly discuss how inflation may complicate the analysis of business financial decisions. (6 marks) (Total marks 20)

Question 2
The board of directors of Portland Ltd are considering two mutually exclusive investments, each of which is expected to have a life of 5 years. The company does not have the physical capacity to undertake both investments. The first investment is relatively capital intensive while the second is relatively labour intensive. Forecast profits of the two investments are as follows:
Investment 1 (requires four new workers) Year Initial cost Projected revenue Production costs Finance charges Depreciation1 Profit before tax Average profit before tax £30,600. Investment 2 (requires nine new workers) Year Initial cost Projected revenue Production costs Depreciation1 Profit before tax Average profit before tax £39,200. 0 (500) 1 400 260 21 125 (6) £000 1 500 460 44 (4) £000 2 450 300 21 94 35 3 500 350 21 70 59 4 550 450 21 53 26 5 600 500 21 40 39

0 (175)

2 600 520 33 47

3 640 550 25 65

4 640 590 18 32

5 700 630 14 56

Note: 1. Depreciation is a tax-allowable expense and is at 25 per cent per year on a reducingbalance basis. Both investments are of similar risk to the company’s existing operations.

Additional information (i) Tax and depreciation allowances are payable/receivable one year in arrears. Tax is at 25 per cent per year. (ii) Investment 2 would be financed from internal funds, which the managing director states have no cost to the company. Investment 1 would be financed by internal funds plus a £150,000 14 per cent fixed-rate term loan. (iii) The data contains no adjustments for price changes. These have been ignored by the board of directors as both sales and production costs are expected to increase by 9 per cent per year, after 1 year. (iv) The company’s real overall cost of capital is 7 per cent per year and the inflation rate is expected to be 8 per cent per year for the foreseeable future. (v) All cash flows may be assumed to occur at the end of the year unless otherwise stated. (vi) The company currently receives interest of 10 per cent per year on short-term money market deposits of £350,000. (vii) Both investments are expected to have negligible scrap value at the end of 5 years.
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Director A favours Investment 2, as it has a larger average profit. Director B favours Investment 1, which she believes has a quicker discounted payback period, based upon cash flows. Director C argues that the company can make £35,000 per year on its money market investments and that, when risk is taken into account, there is little point in investing in either project. Requirements (a) Discuss the validity of the arguments of each of Directors A, B and C with respect to the decision to select Investment 1, Investment 2 or neither. (7 marks) (b) Verify whether or not Director B is correct in stating that Investment 1 has the quicker discounted payback period. Evaluate which investment, if any, should be selected. All calculations must be shown. Marks will not be deducted for sensible rounding. State clearly any assumptions that you make. (14 marks) (c) Discuss briefly what non-financial factors might influence the choice of investment. (4 marks) (Total marks 25)

Question 3
The directors of XYZ plc wish to expand the company’s operations. However, they are not prepared to borrow at the present time to finance capital investment. The directors have therefore decided to use the company’s cash resources for the expansion programme. Three possible investment opportunities have been identified. Only £400,000 is available in cash, and the directors intend to limit their capital expenditure over the next 12 months to this amount. The projects are not divisible (i.e. cannot be scaled down) and none of them can be postponed. The following cash flows do not allow for inflation, which is expected to be 10 per cent per annum constant for the foreseeable future. Expected net cash flows (including residual values):
Project A B C Initial investment £ (350,000) (105,000) (35,000) year 1 £ 95,000 45,000 (40,000) year 2 £ 110,000 45,000 (25,000) year 3 £ 200,000 45,000 125,000

Company shareholders currently require a return of 15 per cent nominal on their investment. Ignore taxation. Requirements (a) (i) Calculate the expected net present value and profitability indexes of the three projects; and (ii) comment on which project(s) should be chosen for investment, assuming the company can invest surplus cash in the money market at 10 per cent. Note: You should assume that the £400,000 expenditure limit is the absolute maximum the company wishes to spend. (10 marks)
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(b) Discuss whether the company’s decision not to borrow, thereby limiting investment expenditure, is in the best interests of its shareholders. (10 marks) (Total marks 20)

Question 4
Harry is financial manager of RP plc. He is nearing retirement. You have been appointed as his deputy with a view to taking over from him in twelve months’ time. The company is considering an investment in a new product which will cost £1,200,000 in new machinery and will result in profit before depreciation and tax of £375,000 per annum in real terms for 5 years. At the end of the 5 years, the machinery can be sold for its written-down book value. The investment will require working capital at the beginning of each year as follows (figures in real terms):
Year Amount (£) 1 100,000 2 200,000 3 300,000 4 400,000 5 500,000

Harry is proposing to evaluate the investment using the company’s (nominal) weighted average cost of capital (WACC) of 16 per cent. The following notes are relevant: 1. At the end of year 5, the total working capital can be released in cash back to the company. 2. Inflation is expected to be 4 per cent per annum on all operating cash flows and working capital for the period under review. 3. The company pays tax at the rate of 33 per cent. There is a twelve-month time lag for tax payments or refunds. 4. Tax relief is available on capital expenditure at 25 per cent on a reducing balance. The company also depreciates its plant and equipment on this basis. 5. Assume all cash flows occur at the end of the year except the purchase of fixed assets (that is, the new machinery) and working capital. Both these items of expenditure occur at the beginning of the year. Requirements (a) Evaluate the investment using the company’s WACC, as suggested by Harry. (12 marks) (b) Whatever your own answer to part (a), assume the results of your financial evaluation suggest the investment is not worthwhile (i.e. the NPV is negative). You think that some of Harry’s assumptions are unrealistic. In particular, you are concerned about the uncertainty surrounding each year’s cash flows and the use of the WACC as the discount rate. You are required to explain how the evaluation might be refined, or developed, to overcome your concerns. Note: You are not required to revise your calculations for part (a) of the question to answer part (b) of the question. (8 marks) (Total marks 20)

Question 5
ABC Limited is considering the purchase of a fleet of small delivery vehicles. The usage of the vehicles would be very heavy as they would be operated round the clock by teams of
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drivers working in shifts. The estimated maximum life of the vehicles is therefore only three years, after which they would be virtually worthless and scrapped. However, if they were taken out of service before the end of three years, they would have a positive ‘abandonment’ cash flow. The estimated post-tax cash flows for each vehicle are as follows:
Year 0 1 2 3 Initial investment and operating cash flow £ (10,000) 4,200 4,000 3,500 End of year ‘abandonment’ cash flow £ (10,000) 6,200 4,000 0

The company uses a cost of capital of 12 per cent to evaluate investments of this type. Requirements (a) Calculate: ● the NPV for each vehicle if it is operated for the full three years; ● the NPV for each vehicle if it is abandoned at the end of year 2 or year 1. (13 marks) (b) Comment on the economic life of this project and discuss, briefly, the advantages of including an abandonment option in the investment appraisal exercise. (7 marks) (Total marks 20)

Question 6
(a) Discuss the implications of the CAPM for senior managers involved in making major investment decisions, assuming that their aim is to maximise shareholder wealth. (12 marks) (b) Explain the main differences between the arbitrage pricing model (APM) and the CAPM, and the practical difficulties of using the APM. (8 marks) (Total marks 20)

Question 7
The shares of ZX plc are quoted on a stock market. Two of the directors are also major shareholders in the company. They have been evaluating investment in a project which will require £3.9m capital expenditure on new machinery. The directors expect the capital investment to provide annual cash flows of £600,000 indefinitely. This figure is net of all tax adjustments. The company is at present all equity financed. The discount rate, which it applies to investment decisions of this nature, is 14 per cent net. The directors believe that the current capital structure fails to take advantage of the tax benefits of debt, and propose to finance the new project with undated debt secured on the company’s assets. The current annual gross rate of interest required by the market on corporate undated debt of similar risk is 10 per cent. The after-tax costs of issue are expected to be £162,000. The company intends to issue sufficient debt to cover the cost of capital expenditure and the after-tax costs of issue. The company’s marginal tax rate is 30 per cent. You should use a sensible approach to rounding your answers throughout the question.
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Requirements (a) Calculate the adjusted present value of the investment and the adjusted discount rate, and explain the circumstances in which this adjusted discount rate may be used to evaluate future investments. (10 marks) (b) The company is considering three other investment opportunities. The initial capital investment required, the NPVs and duration of these three projects are as follows:
Initial investment £m 3.85 4.25 2.95 NPV £m 0.85 0.90 0.68 Duration Years 3 4 2

Project 1 Project 2 Project 3

However, resource constraints mean that the company cannot invest in all three projects. It wishes to restrict investment to £7.5m. Notes: ● The projects are not divisible. ● The company has used its cost of capital of 14 per cent to evaluate all three investments. ● Any surplus cash could be invested in the money market at 6 per cent. ● Assume all rates in this part of the question are net of tax. You are required to discuss and recommend, with reasons, which project(s) should be undertaken. (15 marks) (Total marks 25)

Question 8
Explain: (i) the five input variables involved in the Black–Scholes pricing model; and (ii) how the five input variables can be adapted to value ‘real’ options, as opposed to traded share options. (10 marks)

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Solutions to Revision Questions

8

Solution 1
(a) Investors advance capital to companies expecting a reward for both the delay in waiting for their returns (time value of money) and also for the risks to which they expose their capital (risk premium). In addition, if prices in general are rising, shareholders require compensation for the erosion in the real value of their capital. If, for example, in the absence of inflation, shareholders require a company to offer a return of 10 per cent, the need to cover 5 per cent price inflation will raise the overall required return to about 15 per cent. If people in general expect a particular rate of inflation, the structure of interest rates in the capital market will adjust to incorporate these inflationary expectations. This is known as the ‘Fisher effect’. More precisely, the relationship between the real required return (r ) and the nominal rate (n), the rate which includes an allowance for inflation, is given by: (1 r) (1 i) (1 n)

where i is the expected rate of inflation. It is essential when evaluating an investment project under inflation that future expected price level changes are treated in a consistent way. Companies may correctly allow for inflation in two ways, each of which computes the real value of an investment project: (i) inflate the future expected cash flows at the expected rate of inflation (allowing for inflation rates specific to the project) and discount at n, the fully inflated rate – the ‘money terms’ approach. (ii) Strip out the inflation element from the market-determined rate and apply the resulting real rate of return, r, to the stream of cash flows expressed in today’s or constant prices – the ‘real terms’ approach. (b) First, the relevant set-up cost needs identification. The offer of £2m for the building, if rejected, represents an opportunity cost, although this appears to be compensated for by its predicted eventual resale value of £3m. The cost of the market research study has to be met irrespective of the decision to proceed with the project or not, and is thus not relevant. Second, incremental costs and revenues are identified. All other items are avoidable except the element of apportioned overhead, leaving the incremental overhead alone to include in the evaluation.
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SOLUTIONS TO REVISION QUESTIONS P9

Third, all items of incremental cash flow, including this additional overhead, must be adjusted for their respective rates of inflation. Because (with the exception of labour and variable overhead) the inflation rates differ, a disaggregated approach is required. The appropriate discount rate is given by: (1 i) (1 r) 1 n (1.06) (1.085) 1 15%

Assuming that the inflated costs and prices apply from and include the first year of operation, the cash flow profile is: Cash flow profile (£m):
Year 0 Item Equipment Forgone sale of buildings Residual value of building Working capital Revenue Materials Labour and variable overhead Fixed overhead Net cash flows Present value at 15% (10.50) (2.00) 3.00 0.50 6.13 (0.70) (0.56) (0.64) )9.73) )4.84) 1 2 3 4 5 2.00

(0.50) 5.04 (0.62) (0.43) (0.53) )3.46) )3.01) 5.29 (0.64) (0.46) (0.55) )3.64) )2.75) 5.56 (0.66) (0.49) (0.58) )3.83) )2.52) 5.83 (0.68) (0.52) (0.61) )4.02) )2.30)

(13.00) (13.00) (13.00)

NPV £2.42m, therefore the project appears to be acceptable. However, the financial viability of the project depends quite heavily on the estimate of the residual value of the building and equipment. Note: The working capital cash recovery towards the end of the project is approximately equal to the initial investment in stocks because the rate of material cost inflation tends to cancel out the JIT-induced reduction in volume, leading to roughly constant stock-holding in value terms throughout most of the project life-span. (c) In addition to the problems offered for investment appraisal, such as forecasting the various rates of inflation relevant to the project, inflation poses a wider range of difficulties in a variety of business decision areas. Inflation may pose a problem for businesses if it distorts the signals transmitted by the market. In the absence of inflation, the price system should translate the shifting patterns of consumer demand into price signals to which producers respond in order to plan current and future output levels. If demand for a product rises, the higher price indicates the desirability of switching existing production capacity to producing the good or of laying down new capacity. Under inflation, however, the producer may lose confidence that the correct signals are being transmitted, especially if the prices of goods and services inflate at different rates. He may thus be inclined to delay undertaking new investment. This applies particularly if price rises are unexpected and erratic. Equally, it becomes more difficult to evaluate the performance of whole businesses and individual segments when prices are inflating. A poor operating performance may be masked by price inflation, especially if the price of the product sold is increasing at
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a rate faster than prices in general or if operating costs are inflating more slowly. The rate of return on capital achieved by a business is most usefully expressed in real terms by removing the effect on profits of generally rising prices (or better still, the effect of company-specific inflation). The capital base of the company should also be expressed in meaningful terms. A poor profit result may translate into a high ROI if the capital base is measured in historic terms. Unless these sorts of adjustment are made, inflation hinders the attempt to measure company performance on a consistent basis, and thus can cloud the judgement of providers of capital in seeking out the most profitable areas for investment.

Solution 2
(a) Director A. Average profit is a poor criterion to use in investment appraisal. Although readily understood by managers, it fails to take into account the time value of money or the incremental cash flows from the investments. A resource allocation decision should be based upon cash flows not profit, which is a reporting measure. The size of the initial outlay of the project is also ignored by this measure. Director B. Payback is frequently used as part of investment appraisal, often being argued by management to select less risky investments from among several alternatives. Its major weakness is that it ignores cash flows after the payback period is complete. Such cash flows might be substantial, and influence the investment decision where mutually exclusive investments are concerned. Discounted payback has the advantage of taking account of the time value of money, but still ignores cash flows after the discounted payback period. However, if the investment has a discounted payback period within its expected lifespan, it must have a zero or positive net present value, and be considered to be financially viable. If investments are not mutually exclusive, discounted payback will lead to the same decisions as NPV. If, as in this case, investments are mutually exclusive, an investment that does not maximise net present value could result from using discounted payback. A further problem is that working capital cash flows are difficult to incorporate within this technique. Director C. Director C is considering profit, not net present value. If the company’s cost of capital is in excess of the 10 per cent yield on money market deposits, then investing funds in deposits will result in a negative present value. If either project produces a zero or positive NPV, on financial grounds it should be selected, not the money market.

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SOLUTIONS TO REVISION QUESTIONS P9

(b) Payback is normally calculated using after-tax cash flows.
Investment 1 Year Initial cost Revenue (9% increase) Production costs (9% increase) Taxable Tax Tax saved by depreciation Balancing allowance saving Net cash flows Discount factors1 Present values Payback period: None Expected NPV: ( £37,000) 0 500 1 400 260 140 2 Cash flows (£000) 3 4 594 416 178 (41) 24 11111. 1 161 0.648 1 104 712 583 129 (45) 18 11111. 1 102 0.561 1 57 5 847 706 141 (32) 13 1111 1. 1 122 0.485 1 59 6

1111 1. 1(500) 1.000 1(500)

1111 1. 1 140 0.865 1 121

491 327 164 (35) 31 11111. 1 160 0.749 1 120

(35) 10 2 30 1 5 0.420 1 2

Note: 1. Discount factor is 1.07 1.08 15.56 per cent. Money cash flows are being used and must be discounted by a money rate. (If a real discount rate is used, tax allowances must be deflated by the inflation rate, otherwise too high an NPV will result.)
Investment 2 Year Initial cost Revenue (9% increase) Production costs: (9% increase) Taxable Tax Tax saved by depreciation Balancing allowance saving Net cash flows Discount factors Present values 0 (175) 1 500 460 40 2 Cash flows (£000) 3 4 760 653 107 (22) 8 1 . 0 93 0.648 0 60 829 764 65 (27) 6 1 . 0 44 0.561 0 25 5 988 889 99 (16) 5 1 . 0 88 0.485 0 43 6

654 567 87 (10) 11 1 . 0 88 0.749 0 66

1 . 0(175) 1.000 1(175)

1 . 0 40 0.865 0 35

(25) 4 - 10 0(11) 0.420 0 (5)

Discount payback period: approximately 3 years 7 months (3 14/25 years) Expected NPV: £49,000

Investment 1 does not have the quicker discounted payback period, as it fails to pay back within its expected life. On financial grounds, Investment 2, with an expected NPV of £49,000, should be selected. Notes: (i) The financing costs of the investment are not included as cash flows as they are encompassed within the discount rate. Internal funds are not free; there is an opportunity cost of the cash flow that could have been earned from investing the funds elsewhere. (ii) It is assumed that the company has other investments generating profits against which the depreciation allowance can be set. (c) Relevant non-financial factors might include: (i) The availability of suitably skilled labour. (ii) Environmental factors; is one investment environmentally more acceptable?
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(iii) (iv) (v) (vi)

Investment 2 creates more jobs and could be socially more acceptable. Speed of delivery and installation of capital equipment. Availability of spare parts and servicing (if required). Reliability of capital equipment.

Solution 3
(a) (i)
15% discount factors Project A: Project B: Project C: absolute discounted absolute discounted absolute discounted Year 0 1.000 £000 (350.0) (350.0) (105.0) (105.0) (35.0) (35.0) Year 1 0.870 £000 104.5 90.9 49.5 43.1 (44.0) (38.3) Year 2 0.756 £000 133.1 100.6 54.5 41.2 (30.2) (22.8) Year 3 0.658 £000 266.2 175.2 59.9 39.4 166.4 109.5 Total £000 16.1 18.7 13.4 1.05 1.18 1.38 P/I*

* Defined as in Brealey and Myers, that is, NPV of later cash flows as ratio of initial flow.

(ii) Projects should first be ranked by NPV and P/I (all figures are in £000).
Project B A C NPV 18.7 16.7 13.4 Rank by NPV Cum NPV Capital exp 18.7 105.0 35.4 350.0 48.8 35.0 Rank by profitability index Cum NPV Capital exp 13.4 35.0 32.1 105.0 48.8 350.0 Cum cap exp 105.0 455.0 490.0

Project C B A

NPV 13.4 18.7 16.7

Cum cap exp 35.0 140.0 490.0

When capital is rationed, P/I may be the best decision method, as it shows the percentage return per pound invested and, all other things being equal, these investments should be chosen. However, NPV shows in absolute terms how much shareholder wealth is increased by an investment in each project. In the case here, using P/I would suggest C B, but only £140,000 would be invested for a cumulative NPV of £32,100. Although the surplus could be invested in the money market at 10 per cent, this is below the company’s cost of capital. It does not make sense, other than in the very short term, to invest surplus cash in the money market. Using NPV ranking, B and A would be chosen, giving a cumulative NPV of £35,400 for expenditure of £455,000. This is above the company’s limit, but by a relatively small amount (just over 10 per cent) and it is unlikely it could not be raised. However, if this was indeed the case, only project B could be undertaken. (b) The higher the borrowings (and hence the extent to which cash flows are pre-empted for the payment of interest), the greater will be the volatility of returns to the shareholders. In turn, that volatility will inversely influence the value placed on prospective returns to the shareholder, thus partly offsetting the apparent benefit of the lower cost of borrowing. However, the fact that interest is tax deductible usually reduces the
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offset. Hence, what is an appropriate stance depends on a number of factors:

● ●

the volatility of prospective returns to the entity as a whole (the greater this is, the more attractive an ‘equity only’ stance is); interest rate expectations, relative to the perceived cost of equity capital; the tax position of the company, notably any unused allowances, and its dividend policy.

A company which has no borrowings is clearly going to be more flexible than one which has high borrowings, for example, better able to take advantage of unexpected opportunities.

Solution 4
(a) Calculation of NPV
Year Tax calculations Profit before depreciation Inflated at 4% Capital allowances Taxable Profit/–Loss Tax @ 33% Cash flows Cost of machine Working capital Second-hand value Profit before depreciation Tax payments Net cash flows DF @ 16% DCF NPV 0 1 375,000 390,000 300,000 390,000 29,700 2 375,000 405,600 225,000 180,600 ( 59,598 3 375,000 421,824 168,750 253,074 ( 83,514 4 375,000 438,697 126,563 312,134 103,004 5 375,000 456,245 94,922 361,323 119,237 6

1,200,000 100,000

108,000 390,000 282,000 282,000 0.862 243,084

116,480 405,600 2 29,700 259,420 0.743 192,749

125,466 421,824 32 59,598 236,760 0.641 151,763

134,984 438,697 32 83,514 220,199 0.552 121,550

282,000 1,300,000 1 1,300,000

584,929 284,766 456,245 3 103,004 1,222,936 0.476 582,117 3 3

119,237 119,237 0.410 48,887 57,623

The NPV is negative at undertaken.

£57,623 which suggests that the project should not be

(b) All projects have considerable uncertainty surrounding their cash flows when forecasting into the future. One way of adjusting/allowing for this uncertainty is by using techniques such as certainty equivalents and sensitivity analysis.

Certainty equivalents require detailed examination of probabilities, correlation of cash flows between years, variances, covariances, etc., which are difficult to forecast with accuracy. Sensitivity analysis is used to analyse the effect on project profitability of possible changes in input variables such as sales, direct costs, items of expenditure, etc. Sensitivity analysis expresses cash flows in terms of unknown variables and then calculates the consequences of under- or over-estimating the variables. It can help expose inaccurate or inappropriate forecasts. A major problem with sensitivity analysis is that underlying variables are likely to be interrelated.

Theory suggests adjusting the discount rate but in practice this has problems. Cost of capital would not be constant over such a long period of time: it would follow the yield curve of the market.
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The WACC assumes the project has the same risk and is financed in the same way as the company. This is unlikely to be the case. In theory, Harry should use a specific risk-adjusted discount rate using the CAPM and a proxy company to evaluate the project. The rate should reflect the risk of the project, not that of the company. The problem noted above remains: would any discount rate remain constant over a period of time. In reality, the problems of using this method to derive a discount rate are as follows:

How realistic is it to use a proxy whose business may not match precisely that of the company undertaking the project? Is it realistic to ignore the method of financing in the discount rate? Theory has a persuasive argument for doing this but it is often ignored (or not understood) in practice. The CAPM has many limitations. For example, one-period model, use of risk-free asset, return on the market, difficulties of tax adjustments, etc., and betas are unstable variables with wide standard deviations.

Solution 5
(a)
Year 12% p.a. discount factors If operated for 3 years Absolute cash flows Discounted cash flows Cumulative If operated for 2 years Absolute cash flows Discounted cash flows Cumulative If operated for 1 year Absolute cash flows Discounted cash flows Cumulative 0 1.000 £ (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) (10,000) 1 0.893 £ 4,200 3,751 (6,249) 4,200 3,751 (6,249) 10,400 9,287 (713) 2 0.797 £ 4,000 3,188 (3,061) 8,000 6,376 127 3 0.712 £ 3,500 2,492 (569)

NPV

127

NPV

(713)

(713)

NPV

(b) From the calculations, it can be seen that the 2-year life is preferable, and is worth more than it would appear above, because it could be repeated. If like is compared with like, for example three 2-year deals versus two 3-year deals, the former is even more positive, the latter more negative. Without allowing for the terminal value/abandonment possibilities, an incorrect assessment would be made. The possibility of abandonment adds to the flexibility of the project, thereby reducing the perceived risk.

Solution 6
(a) There are several practical limitations with the CAPM (expectations based on past returns, single period model, etc.) but it does provide a basis for understanding the nature of risk. The model is concerned only with market risk, on the assumption that specific risk is diversified away by rational investors (and managers). If managers act in the best interests of shareholders they should invest in all projects which yield above the rate of return required by investors on equivalent risk assets. If the beta is known
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and a view is taken about future returns on the market, then a cut-off point can be determined for new investments of similar risk. If the market is expecting higher returns overall than managers, then managers might invest in projects offering a return below that expected by shareholders. The subsequent fall in the share price is the mechanism whereby the market conveys to managers that the discount rate has been inappropriately determined. For the CAPM to be valid, however, it is essential that markets are at least semistrong form efficient. (b) The CAPM relies on expectations of returns on the market and past volatility of share prices to determine a discount rate to use on future projects. The APM assumes that the return on a share depends in part on macroeconomic factors and in part on issues specific to the company. As with the CAPM, the APM suggests that diversification eliminates specific risk. However, unlike the CAPM, the APM does not specify the explanatory factors, which could be the market index or many other economic variables (GDP, oil prices, etc.). Intuitively, the APM appears to be a better model because it includes many more variables. The main practical difficulties are determining what those variables might be (which the model does not specify) and forecasting their value. However, there have been few tests of the APM, probably because of the difficulties of determining which variables to include and how to weight them.

Solution 7
(a) All figures are in millions of pounds sterling. The base case NPV for ZX plc’s project is: £3.9 (£0.6/0.14) £3.90 £4.286 £0.386 The side effects of financing are: Issue costs Issue costs are £0.162. A total of £4.062 needs to be raised. Tax benefits Assuming perpetual debt, the annual tax relief on interest payments is: £4.062 10% 30% £0.122

in perpetuity. Assuming the discount rate is the interest rate, the value of this tax relief in perpetuity is: £0.122 0.1 £1.22

This also assumes continuation of unrelieved taxable profits. The APV is therefore: £0.386
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£1.22

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Adjusted discount rate First calculate the annual income/savings required to allow an NPV of zero: APV Assuming APV £4.062 £3.9 0: Annual income/0.14 0.14(£4.062 £1.22) £0.398 Annual income 0.14 £0.162 £1.22

£1.22

Annual income

The minimum IRR is therefore: £0.398 0.098 or 9.8%. £4.062 Thus, the ADR is 9.8 per cent. This ADR may be used to evaluate future investments only if the business risk of the new venture is identical to the one being evaluated here, and the project is to be financed by the same method and on the same terms. This is unlikely, and the effect on the company’s cost of capital of introducing debt into the capital structure cannot be ignored. (b) The relevant calculations are as follows:
Initial investment £m Project 1 Project 2 Project 3 3.85 4.25 2.95 NPV £m 0.85 0.90 0.68 Profitability index % 22.08 21.18 23.05 EAA £m 0.366 0.309 0.413 0.85 2.322 0.90 2.914 0.68 1.647

Notes: ● The profitability index is the NPV expressed as a percentage of the initial investment (the ‘net’ method). The GPV method (the ‘gross’ method) would be equally acceptable. ● The equivalent annual annuity approach (EAA) seeks to determine the constant annual cash flow that offers the same present value as the project’s NPV. This is found by dividing the project’s NPV by the relevant annuity discount factor. As all three projects cannot be undertaken given the company’s capital expenditure limit of £7.5 million, it is necessary to look at combinations of any two projects:
Initial investment £m 8.10 7.20 6.80 NPV £m 1.75 1.58 1.53 Profitability index % 21.60 21.94 22.50

Projects 1 Projects 2 Projects 3

2 3 1

The combination of Projects 1 2 gives the highest NPV, but this would exceed the company’s investment limit. The combination of Projects 2 3 is the preferred option on the highest NPV criteria. The combination of Projects 3 1 is the preferred option
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on the other two criteria. In theory, Projects 2 3 should be preferred unless other investment opportunities can be identified to utilise the unspent capital. Other factors to consider:

If the projects yield positive NPVs at 14 per cent, could the company consider borrowing to fund all three; in theory it should borrow. Investing in the money market is not a sensible option other than for very short-term deposits as the yield is below the shareholders’ required cost of capital. In the long run, this would result in a fall in the company’s share price. The company has used the same cost of capital for all three projects. Have the relative risks of the projects been considered? Taking PI as the criterion we would get:
Investment £m 2.95 3.85 0.70 7.50 NPV £m 0.68 0.85 0.15 1.68

Project 3 Project 1 Project 2

We should invest in Projects 3 and 1 with the balance in Project 2.

Solution 8
(i) The five variables are as follows: Share price or value. The current market price of a share. Exercise price. Also known as the ‘strike’ price – the price the holder of the option wishes to buy or sell the share at. Risk free rate. As with the CAPM, the rate typically paid on 3-month treasury bills. Time to expiry. The number of days/months to the expiry of the option. Share price volatility. This is the variability of the share price over a period of time measured by the variance. Author’s Note: This part of the answer uses share options as required in part (ii) of the answer. The use of currency options in this part of the question would be equally valid. (ii) As applied to capital investments, the variable could relate as follows: Share price. Present value of expected cash flows. Exercise price. Initial outlay on the investment. Risk free interest rate. Risk free interest rate. Time to expiry. Time until the investment opportunity disappears (not the time to the end of the investment). Share price volatility. Project value uncertainty.
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Financing and Appraisal of Overseas Operations

9

LEARNING OUTCOMES
After completing this chapter, you should be able to: identify and evaluate optimal strategies for the satisfaction of international longer-term financing requirements; evaluate international investment projects taking account of potential variations in business and economic factors.

9.1 Introduction
The topics covered in this chapter are:
● ● ● ● ● ●

methods of financing overseas operations; the euromarkets; international capital budgeting using NPV; international capital budgeting using APV; the effect of taxation, including differential tax rates and double tax relief; restrictions on remittances.

9.2 Financing overseas operations – a global strategy
In times past a business would, in its early days, tend to be concentrated in one geographical area and in the regulated environment which used to obtain, even quite large companies would define themselves in national terms, and raise capital and invest in facilities where their market was. If asked about competition, they would naturally think of other enterprises based in the same country.
359
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But that was then. Now, it is feasible – and in some instances vital – for enterprises to raise capital in one country, invest it in another, and produce goods which are to be marketed in a third. Moreover, they need to think about competition on a worldwide basis. As a result of this, companies have developed global strategies, perhaps to exploit new markets or secure supplies of raw materials that are essential for its UK or other worldwide operations. The financing of these ventures is obviously of key importance if the risks outlined below are to be minimised. A number of different methods can be used to finance companies overseas. Retained earnings The subsidiary could rely upon its own internally generated funds. This would avoid many of the problems of financing overseas, but is unlikely to result in the necessary level of expansion to meet high growth objectives, and is obviously not suitable for new overseas ventures. Finance from the UK Funds can be raised by the parent company within the UK and transferred overseas to subsidiary companies by way of a combination of equity and loans. The main advantage of this method is that the company will probably be familiar with the UK capital markets and therefore be capable of raising finance quickly and cost effectively. However, if exchange controls exist this method can become difficult and expensive. Another disadvantage of using sterling-denominated finance for an overseas asset is that it will in no way reduce foreign-exchange risk through matching. The company will also be more exposed to political risks. If the investment is lost, perhaps through a war or expropriation by a foreign government, the UK liability will still remain intact. Also, if the overseas investment is a subsidiary company, failure of the subsidiary would leave the holding company with the liability in the same way. Finance in the overseas country The main advantage of this method is that it will result in reductions in risk. Foreignexchange risk will be reduced, since any losses in the value of the overseas asset will be offset by gains on the liability, and vice versa. The complete elimination of risk is, however, unlikely since it would require the exact matching of cash flows on the asset and liability. Political risk can also be reduced since, if the investment is lost, the liability will be eliminated as well. Difficulties may be experienced with this method of finance if the country concerned does not have a well-developed capital market. On the other hand, financing in the overseas country can make such investments more acceptable to that country since it is then seen that not all of the profits made are sent abroad. Alternatively, it could also be argued that financing overseas limits the methods by which profits from the overseas investment can be repatriated – heavy reliance being placed on the payment of dividends. When finance is raised in the UK it may be easier to get money out of the country as a combination of dividends, interest, management charges, etc. Most governments take steps to encourage overseas investors since they are beneficial to that country’s economy, creating employment and wealth. Such encouragement often takes the form of grants, subsidies and cheap or guaranteed finance. These incentives should be taken into account when considering overseas investments and their financing. Financing from other capital markets Finance can today be raised from a variety of capital markets. A multinational company based in the UK could quite easily raise finance in Germany via a subsidiary in that country
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and use the money to finance an investment in a different country, or even in the UK. One possible incentive in raising money in other countries is that interest rates may be substantially lower than in the UK or in the country where an investment is intended. However, if the interest cost is lower, then it is likely that the currency borrowed is strong, and will therefore appreciate with respect to sterling and other currencies. The expected exchange loss on the borrowings would therefore offset any benefit through a lower interest rate. Dealing with risk and individuals’ attitudes to risk is vital to any decision-making process, and when multinationals look to evaluate investments overseas they have to compare the risks with the rewards.

9.3 The effect of restrictions on remittances
When a foreign subsidiary makes a profit, that profit will be included in the total profits generated by the multinational group. Investors in the parent company will be concerned to see not just how much profit is made, but how much cash is available for distribution as dividends. This will require the subsidiary company remitting cash to the parent company. There are various ways by which the parent may obtain a cash return from its foreign subsidiary:

● ●

capital flows comprising dividends and monies to servicing debt capital provided by the parent; payments for merchandise supplied, and management charges.

The ability to convert these cash flows from local currency into the parent’s currency will depend on local legislation. Some countries place restrictions on the remittance of profits overseas as part of a policy designed to protect the strength of their currency. Such restrictions work against the long-term interests of the country concerned as freedom to withdraw funds is a key determinant of investors’ willingness to commit in the first place. For dividends there may be a requirement to reinvest a certain proportion of the profit, which limits dividends. Loan servicing should be less restricted subject to the reasonableness of interest rates. Payments for merchandise will usually be permitted subject to transfer pricing restrictions, which will ensure that goods sold between the parent company and a subsidiary are priced at ‘arm’s length’, and not so as to minimise the profits of the subsidiary to manipulate how the total profit of the group is divided between the parent and subsidiaries. Management charges are usually restricted to avoid them being used as a way of avoiding dividend restrictions and it will often be necessary to justify them to the authorities. In all cases there is a risk that all foreign currency remittances will be placed under severe restriction and this possibility should be carefully considered before an investment decision is undertaken, as should the tax implications of various systems of remitting profits back to the parent company.

9.4 The Euromarkets
The ‘euro’ term is a catch-all tag used to refer to an investment in a currency held outside its country of origin. It does not imply that the investment is in Europe, or that the currency is European. For example, US dollars deposited in a Japanese bank would be referred to as eurodollars.
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9.4.1 Eurocurrency markets
Eurodollars: US dollars deposited with, or borrowed from, a bank outside the USA. The increase in international trade has meant that significant amounts of currencies such as US dollars, Japanese yen and UK sterling are held on deposit outside their home countries. These deposits are then loaned out by the banks. Eurocurrencies are effectively ‘stateless’ money, so any transactions are not subject to the domestic rules and regulations of any financial centre. London has become the main centre for eurocurrency transactions, although the eurocurrency market is not a domestic UK market and most eurocurrency transactions are carried out by overseas banks based there. Eurocurrencies can be deposited or borrowed for relatively short periods – typically 3 months – or for a number of years. The syndicated loan market developed from the short-term eurocurrency market. A syndicate of banks is brought together by a lead bank to provide medium- to long-term currency loans to large multinational companies. These loans may run to the equivalent of hundreds of millions of pounds. By arranging a syndicate of banks to provide the loan, the lead bank reduces its risk exposure.

9.4.2 Eurobonds
Eurobond: A bearer bond, issued in a euro-currency, usually eurodollars. Eurobonds are bonds issued in a currency outside its country of origin. Large companies, banks and some governments raise money through issuing bonds in the eurobond market, in a similar way that companies and governments issue bonds in their domestic markets. The main difference is that borrowers are tapping the ‘euro’ pool of stateless money. This means that the eurobond market is not totally accountable to any particular government, which leads to fewer controls or regulation. Eurobonds are usually issued in bearer, rather than registered form, which means that the bondholder does not have to declare his identity. Possession of the bond is sufficient to prove ownership. Interest is paid gross, allowing investors to pay their own domestic tax, although the eurobond market has been criticised as being a haven for tax-shy investors.

9.5 The effect of taxation
Tax planning for global organisations is complex, and beyond the scope of this study system. Most countries have a system of tax credits for taxes on income paid to the host country to avoid the same income being taxed twice.

9.5.1 Double taxation relief
Double taxation occurs when income is taxed both by the taxpayer’s country of residence and in another country where the income crises. The purpose of double taxation relief is to remove or reduce the disincentive that this double taxation represents to outward investment. Another important objective is to try to ensure that taxpayers do not exploit the terms of double taxation agreements and differing tax systems in each country for tax avoidance purposes.
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UK domestic legislation generally provides that (a) all income which arises in the UK, whether derived by a UK resident or not, and (b) income derived from abroad by a UK resident, is chargeable to UK tax. Many foreign countries have taxation systems based on similar principles so that income which arises in one country and flows to the other country is taxed twice, once in the country of its origin and again in the country in which the recipient resides. Double taxation of income could discourage residents of one country from investing and expanding their business activities in other countries. In order to ease the burdon of double taxation many countries provide for relief. This is achieved either by virtue of the provisions of a double taxation agreement or under the country’s own domestic legislation. There are two main methods: (a) exemption. Income or gains are exempted from tax in the country where the income or gains arise; exemption may also be given in the country of the recipient’s residence. (b) credit. Where the income or gains are taxed in both countries, the country in which the recipient is resident gives credit for the other country’s tax against its own tax. Where income remains taxable in both countries, the country in which it arises may agree, under a double taxation agreement, to tax it at a lower rate than its normal domestic rate. That is usually the case with dividends, interest, and royalties. The country in which the recipient is resident gives credit against its own tax for the reduced amount of tax paid in the other country.

9.6 International capital budgeting
Evaluation of an overseas project should be similar to the evaluation of a UK project. There are a few more complications, but the appraisal method that best deals with risk and uncertainty is net present value. For overseas project evaluation, net present value is often referred to as international capital budgeting. An overseas project will generate a stream of net cash flows in the currency of its host country. There are two possible approaches to evaluating overseas projects using an NPV analysis which should both lead to the same outcome, assuming that interest-rate parity theory holds (interest-rate parity theory is covered in Management Accounting: Risk and Control Strategy). Assuming a UK investing company, these approaches are: (i) convert the currency cash flows from the project into sterling, then discount at a sterling discount rate to generate a sterling NPV; (ii) discount the currency cash flows from the project at a discount rate appropriate to that currency. Then convert the currency NPV into a sterling NPV by converting at the spot rate of exchange. Both approaches start with the currency net cash flows, and finish with a sterling NPV. The approach to be used will depend on what information is available and the reliability of forecasts for information that is not available.
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Assuming a UK company investing in the USA, the relationship between the sterling discount rate and the dollar discount rate can be found using the interest-rate parity theory: 1 1 annual discount rate$ annual discount rate£ Exchange rate in 12 months’ time$/£ Spot rate$/£

Example 9.A
Butler plc is considering undertaking a new project in Australia. The project would require immediate capital expenditure of A$10m, plus A$5m of working capital which would be recovered at the end of the project’s 4-year life. The net cash flows expected to be generated from the project are A$13m before tax. Straight-line depreciation over the life of the project is an allowable expense against company tax in Australia, which is charged at the rate of 50 per cent, payable at each year-end without delay. The project will have zero scrap value. Butler plc will not have to pay any UK tax on the project due to a double-taxation agreement. The A$/£ spot rate is 2.0 and the A$ is expected to depreciate against the £ by 10 per cent per year. A similar risk, UK-based project would be expected to generate a minimum return of 20 per cent after tax.

Solution
Year 0 1 2 3 4 Investment A$m (15) Cont’n A$m 13 13 13 13 Tax A$m (5.25) (5.25) (5.25) (5.25) Net cash flow A$m (15.00) 7.75 7.75 7.75 12.75 Ex rate 2.00 2.20 2.42 2.66 2.93 Net cash flow £m (7.50) 3.52 3.20 2.91 4.35 DF @ 20% 1.000 0.833 0.694 0.579 0.482 NPV £m (7.50) 2.93 2.22 1.68 2.10 1.43 Taxation workings Contribution Depreciation (10/4) A$m 13.0 2(2.5) 10.5 2

5

@ 50%

A$5.25m

The solution above converts the currency cash flows into sterling, and discounts the sterling cash flows at a sterling discount rate. An alternative method is as follows. Using interest rate parity: 1 1 1 annual discount rate$ annual discount rate£ annual discount rate$ 1.20 Annual discount rate$ Exchange rate in 12 months’ time$/£ Spot rate$/£ 2.20 2.00 2.20 1.20 2.00

1

32%

Discounting the currency cash flows at this discount rate: Net cash flow A$m (15.00) 7.75 7.75 7.75 12.75 NPV A$m (15.00) 5.87 4.45 3.37 (14.19) (12.88)

Year 0 1 2 3 4

DF @ 32% 1.000 0.758 0.574 0.435 0.329

A$2.88m 2 £1.44m, which shows that both approaches to appraising investments lead to the same outcome as long as interest-rate parity holds.

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Taxation In Example 9.A, there was a double-taxation agreement between UK and Australia which meant that Butler plc did not have to pay any UK tax on the project. Many countries give a tax credit for any taxation paid to the host country, in order to prevent the same income being taxed twice.

Exercise 9.1
PG plc is considering investing in a new project in Canada which will have a life of 4 years. The initial investment is C$150,000, including working capital. The net after-tax cash flows which the project will generate are C$60,000 per annum for years 1, 2 and 3 and C$45,000 in year 4. The terminal value of the project is estimated at C$50,000, net of tax. The current spot rate for C$ against sterling is 1.7. Economic forecasters expect sterling to strengthen against the Canadian dollar by 5 per cent per annum over the next 4 years. The company evaluates UK projects of similar risk at 14 per cent.

Requirements
(a) Calculate the NPV of the Canadian project using the following two methods: (i) convert the currency cash flows into sterling and discount the sterling cash flows at a sterling discount rate; (ii) discount the cash flows in C$ using an adjusted discount rate which incorporates the 12-month forecast spot rate; and explain briefly the theories and/or assumptions which underlie the use of the adjusted discount rate approach in (ii). (12 marks) (b) The company had originally planned to finance the project with internal funds generated in the UK. However, the finance director has suggested that there would be advantages in raising debt finance in Canada. You are required to discuss the advantages and disadvantages of matching investment and borrowing overseas as compared with UK-sourced debt or equity. Wherever possible, relate your answer to the details given in this question for PG plc. (8 marks) (Total marks 20)

Solution
(a) Calculations
Year (i) Method 1 C$ Initial investment Other cash flows Net cash flows C$ per £ £ 14% p.a. discount factors Discounted £ Cumulative discount £ 0 1 2 3 4

(150,000) (150,000) (150,000) 1.700 (88,235) 1.000 (88,235) 1(88,235)

60,000 60,000 1.785 33,613 0.877 29,479 (58,756)

60,000 60,000 1.874 32,017 0.769 24,621 (34,135)

60,000 60,000 1.968 30,488 0.675 20,579 (13,556)

50,000 45,000 95,000 2.066 45,983 0.592 27,222 13,666

2005.1

366 FINANCING AND APPRAISAL OF OVERSEAS OPERATIONS

STUDY MATERIAL P9 (ii) Method 2 C$ net cash flows as above 19.7% p.a. discount factors Discounted C$ Discounted £ (@ C$ 1.700 per £) Cumulative discounted £

(150,000) 1.000 (150,000) (88,235) 1(88,235)

60,000 0.835 50,100 29,479 (58,756)

60,000 0.698 41,888 24,621 (34,135)

60,000 0.583 34,980 20,579 (13,556)

95,000 0.487 46,265 27,222 13,666

For the two approaches to yield the same net present value, the discount rate applied to the Canadian $ cash flows needs to be the combination of the sterling discount rate (14 per cent p.a.) and the projected strengthening of the pound (5 per cent p.a.), i.e. 19.7 per cent p.a. (1.14 1.05 being 1.197). A forecast of a 5 per cent per annum strengthening of the pound against the dollar will, generally, be associated with UK inflation rates/interest rates being 5 percentage points per annum below the corresponding Canadian figures. It is surprising, therefore, to see that the Canadian cash flows are expected to be constant. It would be worth checking that they are nominal, and not inadvertently real. (b) As the barriers to international trade come down, and globalisation becomes a reality, exchange rate risk management becomes a higher priority in financial management. This particular project looks viable given the assumptions as regards future exchange rates. However, they are only forecasts and the actuals could turn out to be significantly different. If the pound were to strengthen by more than forecast, the value of the project to PG plc’s shareholders would fall – and could even become negative. If PG plc’s managers are sufficiently risk averse, they may wish to protect the company’s