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Financial Management Subject Guide

Financial Management Subject Guide

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Sections

  • Introduction
  • Aims and objectives
  • Learning outcomes
  • Syllabus
  • Studying financial management
  • Reading advice
  • Online study resources
  • How to use the subject guide
  • Solutions to learning activities
  • Examination advice
  • Summary
  • Abbreviations
  • Chapter 1: Introduction to financial management
  • Aims of the chapter
  • Essential reading
  • Further reading
  • Key tasks of financial management
  • Financial environment
  • Organisational forms of business
  • Corporate objectives
  • Role of managers
  • Conflicts of interest and their resolution
  • Corporate governance
  • Financial management and risk
  • Financial management and accounting
  • Financial management and taxation
  • A reminder of your learning outcomes
  • Practise questions
  • Problems
  • Chapter 2: Basic investment appraisal methods
  • Time value of money
  • Future value and compounding
  • Present value and discounting
  • Interest rates, discount rates and real rates
  • Basic investment appraisal techniques
  • Application problems – some considerations
  • ‘What-if’ questions
  • The examination
  • Sample examination questions
  • Practise question 2.1
  • Chapter 3: Introduction to risk and return
  • Rate of return: a review
  • Calculating expected return, variance and standard deviation
  • Risk and diversification
  • Market risk versus unique risk
  • Chapter 4: Capital budgeting – risk and return
  • Measuring market risk
  • Measuring beta
  • Portfolio betas
  • Risk and return
  • Capital asset pricing model
  • Project returns and the opportunity cost of capital
  • Capital budgeting and project risk
  • Chapter 5: Sources of funds
  • Capital markets
  • Efficient market hypothesis
  • Tests of the efficient market hypothesis
  • Anomalies, fads, insider trading and doubts concerning efficiency
  • Implications of capital market efficiency
  • London capital market
  • Share capital
  • Methods of raising share capital
  • Rights issues, share prices and shareholder wealth
  • Other sources and types of equity
  • Retained earnings
  • Long-term debt finance
  • The issue of loan capital
  • Hybrid capital
  • The attitude of investors and managers to the financing decision
  • Chapter 6: Cost of capital and valuation of a business
  • The value of economic assets – debt
  • The value of economic assets – equity
  • The required return on investment
  • The capital asset pricing model (CAPM)
  • The cost of retained earnings
  • Valuation of warrants
  • The reasons for capital gearing
  • Capital gearing and risk
  • Weighted average cost of capital (WACC)
  • Valuation on the basis of the business’s earnings
  • Other approaches to share and business valuation
  • Chapter 7: Dividend policy
  • Dividend policy and shareholder wealth
  • Dividend irrelevancy argument
  • Traditional view of dividends
  • Information content of dividends
  • Clientele effect
  • Share repurchase
  • Scrip dividends
  • Determining dividend policy in practice
  • Chapter 8: Financial analysis, methods and uses, and financial planning
  • Statement analysis
  • Cash based ratios
  • Practical applications
  • Financial planning – introductory comments
  • Financial planning process
  • Technical aspects of financial planning
  • Planning outputs
  • Chapter 9: Short-term finance and asset management
  • Long- versus short-term finance
  • Trade credit
  • Debt factoring
  • Bank borrowing
  • Specialist finance
  • Leasing
  • Evaluation of sources of finance
  • Management of short-term assets
  • The management of cash
  • The management of trade debtors
  • The management of stock-in-trade
  • Working capital and the problem of overtrading
  • Calls and puts
  • What the value of a call option depends upon
  • Option valuation model
  • Using options to allow the expansion or abandonment of real assets
  • Options on financial assets
  • Why do companies hedge?
  • International financial management
  • Interrelationships between variable affecting exchange rates
  • Exchange risk exposure
  • Management of foreign exchange exposure
  • Practise question
  • Chapter 11: Mergers, corporate restructuring and off-balance sheet funding
  • Merger waves
  • Motives for individual mergers
  • Economic theories of mergers
  • Management motives
  • Takeover tactics
  • Takeover defences
  • Glamorous defence tactics
  • Company restructuring
  • Divestments
  • Off-balance sheet funding
  • Appendix 1: Review questions
  • Question 1
  • Question 2
  • Question 3
  • Question 4
  • Question 5
  • Question 6
  • Question 7
  • Question 8
  • Appendix 2: Suggested solutions to review questions
  • Solution to Question 1
  • Solution to Question 2
  • Solution to Question 3
  • Solution to Question 4
  • Solution to Question 5
  • Solution to Question 6
  • Solution to Question 7
  • Solution to Question 8
  • Appendix 3: Sample examination paper

Financial management

J. Dahya, R.E.V. Groves
AC3059, 2790059

2011

Undergraduate study in Economics, Management, Finance and the Social Sciences
This subject guide is for a Level 3 course (also known as a ‘300 course’) offered as part of the University of London International Programmes in Economics, Management, Finance and the Social Sciences. This is equivalent to Level 6 within the Framework for Higher Education Qualifications in England, Wales and Northern Ireland (FHEQ). For more information about the University of London International Programmes undergraduate study in Economics, Management, Finance and the Social Sciences, see: www.londoninternational.ac.uk

This guide was prepared for the University of London International Programmes by: J. Dahya, Bacc., Macc, Lecturer in Accounting and Business Finance, Cardiff Business School, University of Wales, Cardiff. R.E.V. Groves, B.Com., MSc, PhD, FCA, Sir Julian Hodge Professor of Accounting, Cardiff Business School, University of Wales, Cardiff. It was updated in 2008 by Professor Groves. This is one of a series of subject guides published by the University. We regret that due to pressure of work the authors are unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide.

The University of London International Programmes Publications Office Stewart House 32 Russell Square London WC1B 5DN United Kingdom Website: www.londoninternational.ac.uk

Published by: University of London © University of London 2008 Reprinted with minor revisions 2011 The University of London asserts copyright over all material in this subject guide except where otherwise indicated. All rights reserved. No part of this work may be reproduced in any form, or by any means, without permission in writing from the publisher. We make every effort to contact copyright holders. If you think we have inadvertently used your copyright material, please let us know.

Contents

Contents

Introduction ............................................................................................................ 1 Aims and objectives ....................................................................................................... 1 Learning outcomes ........................................................................................................ 2 Syllabus ........................................................................................................................ 2 Studying financial management .................................................................................... 2 Reading advice ............................................................................................................. 3 Online study resources ................................................................................................... 4 How to use the subject guide ........................................................................................ 5 Solutions to learning activities ...................................................................................... 6 Examination advice ....................................................................................................... 6 Summary ...................................................................................................................... 7 Abbreviations ............................................................................................................... 7 Chapter 1: Introduction to financial management ................................................ 9 Aims of the chapter ...................................................................................................... 9 Learning outcomes ........................................................................................................ 9 Essential reading ........................................................................................................ 10 Further reading ........................................................................................................... 10 Key tasks of financial management ............................................................................. 10 Financial environment ................................................................................................. 10 Organisational forms of business ................................................................................ 11 Corporate objectives ................................................................................................... 11 Role of managers ....................................................................................................... 12 Conflicts of interest and their resolution ...................................................................... 12 Corporate governance ................................................................................................ 13 Financial management and risk ................................................................................... 13 Financial management and accounting ....................................................................... 13 Financial management and taxation ........................................................................... 14 A reminder of your learning outcomes ......................................................................... 14 Practise questions ....................................................................................................... 14 Problems .................................................................................................................... 15 Chapter 2: Basic investment appraisal methods .................................................. 17 Aims of the chapter .................................................................................................... 17 Learning outcomes ...................................................................................................... 17 Essential reading ........................................................................................................ 17 Further reading ........................................................................................................... 17 Time value of money ................................................................................................... 18 Future value and compounding ................................................................................... 18 Present value and discounting .................................................................................... 18 Interest rates, discount rates and real rates ................................................................. 19 Basic investment appraisal techniques ........................................................................ 19 Application problems – some considerations ............................................................... 21 ‘What-if’ questions ..................................................................................................... 25 The examination ......................................................................................................... 26 A reminder of your learning outcomes ......................................................................... 26
i

.............................. 35 Practise questions ......................... 27 Chapter 3: Introduction to risk and return ... 43 Practise questions ................................................................................ 36 Chapter 4: Capital budgeting – risk and return .. 50 Methods of raising share capital ............................................................................. share prices and shareholder wealth ................................................................................................... 26 Problems . 45 Learning outcomes ................. 49 Share capital .......................................................... 54 Hybrid capital ............................................ 54 ii ................................................................................................................................................................................. 52 Retained earnings ......................................... 51 Other sources and types of equity ...................................................................................................................................................... 43 Problems .............................. 37 Further reading ... 46 Efficient market hypothesis ................................................................................................................................ 29 Essential reading .................................1 ..... 37 Essential reading .............................................................. fads................................................................................ 40 Project returns and the opportunity cost of capital ..................................... 39 Risk and return ................................................................................... 29 Introduction ............................. 43 Chapter 5: Sources of funds ........................................................................... 35 A reminder of your learning outcomes ............................................ insider trading and doubts concerning efficiency ......................................... 29 Learning outcomes ............................................................................................................................................................................ 47 Anomalies.........................................................................................................59 Financial management Sample examination questions ......... 48 Implications of capital market efficiency .................. 45 Aims of the chapter ................... 38 Portfolio betas ...................................... 29 Further reading .............................................................................................................................................................................................. 35 Problems ........................................................................................................................................................ 48 London capital market ....................................... 45 Capital markets ........................ 33 Market risk versus unique risk ....... 42 A reminder of your learning outcomes ............................................................................ 38 Measuring beta ...................................................................................................................................................................................................................................................................................................... 31 Risk and diversification ............................................................................................................................................................................................................................................................................................................................................................................................... 26 Practise question 2................ 46 Tests of the efficient market hypothesis ................................................................................................................... 41 Capital budgeting and project risk ................................................................................ 39 Capital asset pricing model ........................................................................................................................ 37 Aims of the chapter ................................................ 50 Rights issues............ 30 Calculating expected return.............................................................................................................................................................................................................. 45 Essential reading .................... 29 Aims of the chapter ............................................................................................ 37 Introduction ................................................................... 29 Rate of return: a review ........................................................................................................................................................................................................................................................................................................................................................................................................................................................... 53 The issue of loan capital ............................................................................ 37 Learning outcomes ................................................................................................................................................................................................ 53 Long-term debt finance ...................................................................... variance and standard deviation ............................... 37 Measuring market risk ..

..................................................... 70 Practise questions ........................................................................................ 81 Further reading .......................................................................................... 77 Practise questions ....................................................... 81 Essential reading ........................... 57 The value of economic assets – debt .......................................... 61 The cost of retained earnings .................................................................. 76 Determining dividend policy in practice ........................................................................................ 73 Learning outcomes ............................... 60 The capital asset pricing model (CAPM) ....... 55 Problems ........................................................ 77 A reminder of your learning outcomes .................................................................................................................................................................................................................................................. 81 Aims of the chapter ........................................................................ 75 Share repurchase .............................................. 73 Essential reading ................................................ 55 Chapter 6: Cost of capital and valuation of a business........................................................Contents The attitude of investors and managers to the financing decision ................................................................................................................. 81 iii .......... 62 The reasons for capital gearing ................................................................................................................................ 73 Aims of the chapter ...... 58 The value of economic assets – equity .................................................................................................. 81 Learning outcomes ......................... 73 Introduction ........................................................................................................................... 63 The relationship between the level of capital gearing and the cost of capital – the Modigliani and Miller view .......................................... 62 Capital gearing and risk ................................................................................................................................................................ 70 Problems ......................................................... 65 Other approaches to share and business valuation .............................................................................................. 77 Problems ............. 57 Learning outcomes ...................................................................................................................................................................... 59 The required return on investment ......... 74 Information content of dividends .................................... 76 Scrip dividends ........... 74 Dividend irrelevancy argument ............................................................................................................................................................................................................................. methods and uses............................................................................................................................. 65 Valuation on the basis of the business’s earnings ...... 73 Further reading .......... 75 Clientele effect ................... 57 Essential reading .............................................................................................................................................................................................................................................................................................................................................. 54 A reminder of your learning outcomes ........... 79 Chapter 8: Financial analysis.................................................................................................................. 55 Practise questions .............................................................................................................................................................................................. 63 The relationship between the level of capital gearing and the cost of capital – the traditional view ................................................. 73 Dividend policy and shareholder wealth .............. 57 Aims of the chapter ................................................................................................................................................................................................................................. 71 Chapter 7: Dividend policy ................................................. 64 Weighted average cost of capital (WACC) ................................... and financial planning ..................................................................................................... 57 Further reading ...................................................................................................................................................................................... 66 A reminder of your learning outcomes ......................................................................................... 81 Statement analysis ............................................................... 61 Valuation of warrants ............................................................................................................................................................. 74 Traditional view of dividends .....................................................................................

59 Financial management

Cash based ratios ....................................................................................................... 82 Practical applications .................................................................................................. 83 Financial planning – introductory comments ............................................................... 88 Financial planning process .......................................................................................... 88 Technical aspects of financial planning ........................................................................ 88 Planning outputs ........................................................................................................ 89 A reminder of your learning outcomes ......................................................................... 90 Practise questions ....................................................................................................... 91 Problems .................................................................................................................... 91 Chapter 9: Short-term finance and asset management ...................................... 93 Aims of the chapter .................................................................................................... 93 Learning outcomes ...................................................................................................... 93 Essential reading ........................................................................................................ 93 Further reading ........................................................................................................... 93 Long- versus short-term finance .................................................................................. 94 Trade credit ................................................................................................................ 94 Debt factoring ............................................................................................................ 94 Bank borrowing .......................................................................................................... 95 Specialist finance ........................................................................................................ 96 Leasing ...................................................................................................................... 96 Evaluation of sources of finance .................................................................................. 96 Management of short-term assets ............................................................................... 99 The management of cash ............................................................................................ 99 The management of trade debtors ............................................................................ 100 The management of stock-in-trade ............................................................................ 101 Working capital and the problem of overtrading ........................................................ 102 A reminder of your learning outcomes ....................................................................... 104 Practise questions ..................................................................................................... 104 Problems .................................................................................................................. 105 Chapter 10: Treasury management and international aspects of financial management ....................................................................................... 107 Aims of the chapter .................................................................................................. 107 Learning outcomes .................................................................................................... 107 Essential reading ...................................................................................................... 107 Further reading ......................................................................................................... 107 Introduction ............................................................................................................. 108 Why should financial managers of firms be concerned with options and other financial instruments? ............................................................................................... 108 Calls and puts .......................................................................................................... 108 What the value of a call option depends upon ........................................................... 109 Option valuation model ............................................................................................ 110 Using options to allow the expansion or abandonment of real assets ......................... 111 Options on financial assets ....................................................................................... 112 Why do companies hedge? ....................................................................................... 112 International financial management .......................................................................... 113 Interrelationships between variable affecting exchange rates ..................................... 114 Exchange risk exposure ............................................................................................. 116 Management of foreign exchange exposure .............................................................. 116 A reminder of your learning outcomes ....................................................................... 119 Practise question ...................................................................................................... 119 Problems .................................................................................................................. 120
iv

Contents

Chapter 11: Mergers, corporate restructuring and off-balance sheet funding .. 121 Aims of the chapter .................................................................................................. 121 Learning outcomes .................................................................................................... 121 Essential reading ...................................................................................................... 121 Further reading ......................................................................................................... 121 Introduction ............................................................................................................. 122 Merger waves ........................................................................................................... 122 Motives for individual mergers .................................................................................. 123 Economic theories of mergers ................................................................................... 123 Management motives ............................................................................................... 126 Takeover tactics ........................................................................................................ 127 Takeover defences .................................................................................................... 129 Glamorous defence tactics ........................................................................................ 129 Company restructuring ............................................................................................. 130 Divestments ............................................................................................................. 130 Off-balance sheet funding ......................................................................................... 131 Leasing .................................................................................................................... 131 A reminder of your learning outcomes ....................................................................... 132 Practise questions ..................................................................................................... 132 Problems .................................................................................................................. 133 Appendix 1: Review questions ........................................................................... 135 Question 1 ............................................................................................................... 135 Question 2 ............................................................................................................... 135 Question 3 ............................................................................................................... 136 Question 4 ............................................................................................................... 137 Question 5 ............................................................................................................... 137 Question 6 ............................................................................................................... 138 Question 7 ................................................................................................................ 138 Question 8 ............................................................................................................... 139 Appendix 2: Suggested solutions to review questions ..................................... 141 Solution to Question 1 .............................................................................................. 141 Solution to Question 2 .............................................................................................. 142 Solution to Question 3 .............................................................................................. 143 Solution to Question 4 ............................................................................................... 145 Solution to Question 5 .............................................................................................. 146 Solution to Question 6 ............................................................................................... 147 Solution to Question 7 ............................................................................................... 149 Solution to Question 8 .............................................................................................. 150 Appendix 3: Sample examination paper ........................................................... 151

v

59 Financial management

Notes

vi

It will introduce you to the concepts and theories of corporate finance that underlie the techniques which are offered as aids for the understanding. planning and control subsystems of an enterprise • provide an overview of the problems facing a financial merger in the commercial world • introduce the concepts and theories of corporate finance that underlie the techniques • which are offered as aids for the understanding. This course may not be taken with 92 Corporate finance. and • the need to understand the strategic planning processes necessary to manage the long and short term financial activities of a firm. evaluation and resolution of financial managers’ problems. Studying this course should provide you with an overview of the problems facing a financial merger in the commercial world. It incorporates: • the treasury function. Management. evaluation and resolution of financial managers’ problems. The readings and the subject guide should also help to build in your mind the ability to make critical judgements of the strengths and weaknesses of the theories. selection. This subject guide is written to supplement the Essential and Further reading listed for this course. Aims and objectives This course is designed to: • place financial management as a clear part of the decision making. planning and control subsystems of an enterprise. Finance and the Social Sciences (EMFSS) suite of programmes. The aim of the course is to provide an understanding and awareness of both the underlying concepts and practical application of the basics of financial management.Introduction Introduction 59 Financial management is a Level 3 course (also known as a ‘300’ course) offered on the Economics. course 19 Elements of accounting and finance). management and control of new capital investment opportunities • the raising and management of the long term financing of an entity • the need to understand the scope and effects of the capital markets for a company. not to replace them. 1 . Financial management is part of the decision-making. which includes the management of working capital and the implications arising from exchange rate mechanisms due to international competition • the evaluation. The management of risk in the different aspects of the financial activities undertaken is also addressed. just as it should be helping to build a critical appreciation of the uses and limitations of the same theories and their possible applications. It makes no assumptions about prior knowledge other than that you have passed the course 25 Principles of accounting (or its predecessor.

debt and their derivatives and incorporating critical consideration of their costs individually and in combination. Syllabus A critical perspective of the topic of finance. you should be able to: • discuss the theoretical models underpinning the practices in financial management • apply the techniques derived from the models and theories in financial management • explain the long and short-term financial needs of a business • describe the techniques used for the selection and management of long and short-term assets • discuss and give examples of the wider aspects of financial management so as to include international considerations and the need to communicate decisions made to other members of a management team. An introduction to risk management including hedging. Sources and methods of raising finance including venture capital. Evaluation of risk measurement theories and methods and their application to both sources of finance and to investment appraisal. Valuation methods for costing the different elements of capital such as the Capital Asset Pricing Model and the Arbitrage Pricing Model. Consideration of theories and techniques for management of short term funds including treasury and currency management. models and methods. options and derivatives and their uses in both long and short term situations. The above provides a broad checklist for you to refer to as you work through the guide. Investment appraisal techniques in the certain and uncertain world. Theories of capital gearing. and having completed the Essential reading and activities. Strategic considerations of financial planning and control. Topics will be set in both national and international contexts. Mergers and acquisitions. Analytical tools. techniques and methods for analysing financial reports incorporating an assessment of their relevance for evaluation and planning purposes. dividend policy and corporate restructuring and refinancing. A critical review of the different forms of finance such as equity. The topics to be covered in this subject can be divided into six elements: • the theories and techniques of appraisal and management of long-term investments under conditions of both certainty and risk 2 . Studying financial management This subject guide highlights the key theoretical and practical issues relating to financial management.59 Financial management Learning outcomes At the end of this course. for management of corporate liabilities and assets. the role of financial managers and the place of financial markets within the business environment in developed and developing economies. private placements and project finance. futures. public offerings. with and without constraints.

Introduction • the various sources of long-term funds. Also check the virtual learning environment (VLE) regularly for updated guidance on readings. the financial manager must then fulfil the control function of this role thus ensuring that the planning goals are achieved. Having decided upon the capital mix on the one hand.. Myers and A.C. incorporating theoretical and empirical aspects of investors’ behaviour both individually and as a capital market. why. You can use a more recent edition of any of the books. allocation and control of a business’s financial resources to enable it to achieve its objectives. valuation. Detailed reading references in this subject guide refer to the editions of the set textbooks listed above. prediction and planning • short-term funds. risk management. their sources and management. From the practical viewpoint. 2007) fifth edition (Intl) [ISBN 9780073012384]. (McGraw-Hill Inc. New editions of one or more of these textbooks may have been published by the time you study this course. Marcus Fundamentals of Corporate Finance. treasury management using the currency and futures markets. This textbook gives a good introduction to the subject. R. To do this. Where. It is therefore necessary to read the appropriate chapters in one of the additional texts listed below to provide this depth. The financial manager must be able to identify and quantify the amount of capital required for investment. both nationally and internationally • general elements of corporate financial activity such as mergers and acquisitions. In the text it will be referred to in this subject guide as BMM. these elements of financial management can be condensed to the three broad areas of the provision. Overall. but on its own is insufficient since it does not provide the depth of discussion and analysis required for an undergraduate degree course. the methods used to raise them. and the selection of the investments on the other. the manager will use financial planning models to determine the quantity of funds required. whether this is in fixed or current assets.J.A. the financial manager has a wide and very important role. S. use the detailed chapter and section headings and the index to identify relevant readings. and how the funds are obtained is all part of the financial manager’s function just as deciding to what use the funds should be put. noting differences in capital market operations and effects between developed and developing capital markets • the analytical tools necessary for corporate evaluation. 3 . their individual costs and the effect of gearing in the corporate financial mix • the valuation models used to derive capital costs. These texts tend to be reflective of the corporate finance perception of the subject matter rather than the more applied view of financial management. Reading advice Essential reading You need to purchase or have regular access to the following textbook: Brealey. This has to be born in mind.

work collaboratively to solve problems and discuss subject material. You will need to support your learning by reading as widely as possible and by thinking about how these principles apply in the real world. paper or online resource. The VLE provides a range of resources for EMFSS courses: • Self-testing activities: Doing these allows you to test your own understanding of subject material. interviews and debates and. To help you read extensively.uk quoting your student number. • Electronic study materials: The printed materials that you receive from the University of London are available to download. audio-visual tutorials and conclusions. please email: uolia. The VLE The VLE. 4 . seek support from your peers. it is crucial that you take advantage of the study resources that are available online for this course.support@ london.ac. including updated reading lists and references. R. • Past examination papers and Examiners’ commentaries: These provide advice on how each examination question might best be answered.uk You should have received your login details for the Student Portal with your official offer. which complements this subject guide. has been designed to enhance your learning experience. Other useful texts for this course include: Brealey. (McGraw-Hill. you will automatically have been granted access to the VLE.londoninternational. the Online Library and your University of London email account via the Student Portal at: http://my. Allen Principles of Corporate Finance. providing additional support and a sense of community. you have free access to the VLE and University of London Online Library (see below). including the VLE and the Online Library. P Financial Management for Decision makers.A. Myers and F. For those of you who are studying on your own who find difficulty with the recommended basic text of BMM another text is offered. but note that it does not cover the subjects to the same depth and rigour required.59 Financial management Further reading Please note that as long as you read the Essential reading you are then free to read around the subject area in any text. • Videos: There are recorded academic introductions to the subject. for some courses. Online Library and your fully functional University of London email account. S. You have probably already logged in to the Student Portal in order to register! As soon as you registered. Europe. 2008) ninth edition (Intl) [ISBN 9780073368696]. 2005) fourth edition [ISBN 9780273702498].. • A student discussion forum: This is an open space for you to discuss interests and experiences. This supplementary primer is: Atrill. It forms an important part of your study experience with the University of London and you should access it regularly. Online study resources In addition to the subject guide and the Essential reading.C. which was emailed to the address that you gave on your application form. (FT Prentice Hall . If you forget your login details at any point.ac. You can access the VLE.

please see the online help pages: www. with the aim of gaining an initial understanding of the topics. Myers and Marcus and then from any other books you should have obtained the necessary material for your understanding.uk/summon/about. For further advice. • Ensure you have achieved the listed learning outcomes. Some chapters in the subject guide are self-contained. but we are expanding our provision all the time and you should check the VLE regularly for updates. Myers and Allen. Myers and Marcus. • Carefully read the suggested chapters in Brealey.Introduction • Recorded lectures: For some courses.com/ollathens The easiest way to locate relevant content and journal articles in the Online Library is to use the Summon search engine. plus appendicies.lon.php How to use the subject guide This subject guide is divided into 11 chapters. question marks and colons. Complete whichever chapter you are studying and the associated work before moving on. application and later revision. • The subject guide material is aimed to identify the scope of your studying of this topic as well as attempting to reinforce the basic messages set out in Brealey. If you are having trouble finding an article listed in a reading list.external. • Read the remainder of the chapter in the subject guide. others lead into one or more following chapters. Making use of the Online Library The Online Library contains a huge array of journal articles and other resources to help you read widely and extensively. The material covered in the examples and in working through the exercises is both complementary to the textbook and important in your preparation for the examination. where appropriate. • Feedback forms. such as single quotation marks. By taking notes from Brealey. • Pay particular attention to the practise questions and the examples given in the subject guide. or you will be required to register and use an Athens login: http://tinyurl. You may then approach the Further reading suggested in Brealey. read the aims and/or introduction and the learning objectives to appreciate the scope of the material to be covered.shl. Myers and Marcus.ac. To access the majority of resources via the Online Library you will either need to use your University of London Student Portal login details. try removing any punctuation from the title. Some of these resources are available for certain courses only. A suggested order for your studying is as follows: • For each chapter. 5 . Therefore you should pay careful attention to the examples in both the texts and the subject guide to ensure you achieve that basic understanding. • Study skills: Expert advice on preparing for examinations and developing your digital literacy skills. the sessions from previous years’ Study Weekends have been recorded and made available.

Solutions to learning activities Solutions to certain learning activities is provided online in the VLE at http://emfss. Each question will also have a small section requiring a written answer which may be a discussion of the theory used in the application. remember that the numerical type questions on this paper take some time to read through and digest. throughout. Remember when sitting the examination to maximise the time spent on each question and although. which are always placed at the end of a question. the subject guide will give you advice on tackling your examinations. You will need to answer four questions with a minimum of one question from each section. by reading the requirements first. • Check you have mastered each topic before moving on to the next. In the question selection process at the start of the examination. and if you have the time attempt those at the end of the Brealey. since the guide is trying to cover all possible angles in the answer. but do remember that they may well include more information than the Examiner would expect in an examination paper. Myers and Marcus chapters. Because of this we strongly advise you to always check both the current Regulations for relevant information about the examination. therefore speeding up the analysis and saving time. by reading only the requirements. Please note that subject guides may be used for several years. or a request for interpretation of your results or something related to the problem or theory used.elearning.uk/ This is indicated in the subject guide as: See VLE for solution Examination advice Important: the information and advice given here are based on the examination structure used at the time this guide was written. One section will include data handling and numerical analysis type questions each requiring analysis. The examination paper will normally be made up of two sections each containing four questions. Therefore try to remember and practise the following approach. your mind is focused on the sort of information it should be looking for in order to answer the question. you do not waste time reading material you are not going to answer.london. or when you are reading the question in preparation for your answer. attempt the Sample examination questions at the end of the subject guide. Secondly. composition and presentation. Always read the requirement(s) of a question first before reading the body of the question. The other section will contain essay or report-style questions requiring written answers. 6 . You should also carefully check the rubric/instructions on the paper you actually sit and follow those instructions. a luxury you do not usually have time for in an examination.ac. Then compare your answers with the suggested solutions.59 Financial management • Attempt the problems at the end of each chapter. and the VLE where you should be advised of any forthcoming changes. • At the end of your preparations. This is appropriate whether you are making your selection of questions to answer. you then only read material relevant to your choice.

Summary Remember this introduction is only a complementary study tool in your efforts with this subject guide. Systematically study the next eleven chapters along with the listed texts for your desired success. Good luck and enjoy the subject! Abbreviations AIM APM ARR BMA BMM CAPM CME EMH EPS IRR ISE NPV MM MPT PA PE PI PP WACC Alternative Investment Market Arbitrage Pricing model Accounting rate of return Brealey. Its aim is to give you a clear understanding of what is in the subject guide and how to study successfully. it is important to check the VLE for: • up-to-date information on examination and assessment arrangements for this course • where available.Introduction Remember. Myers and Marcus Capital asset pricing model Capital market efficiency Efficient market hypothesis Earnings per share Internal rate of return International Stock Exchange of the UK and the Republic of Ireland Net present value Modigliani and Miller Modem portfolio theory Peter Atrill Price earnings ratio Profitability index Payback period Weighted average cost of capital 7 . past examination papers and Examiners’ commentaries for the course which give advice on how each question might best be answered. Myers and Allen Brealey.

59 Financial management Notes 8 .

is important as it helps to put everything learnt later into appropriate perspective. One area of major interest is the corporate governance debate on how the relationship between owners and controllers should be systemised to maximise the corporate gain. the environment to which the subject relates. Since knowledge of the financial environment is vital to managers this comes next before the review of the differing organisational forms of business that are in use. the appraisal and selection. a knowledge of the background. An outline of corporate objectives follows because these form the basis of much of the theory that is covered in this subject. then a more detailed and careful review of your prerequisite course may be needed. If that is true. The course 25 Principles of accounting. and how accounting is linked in with financial management. Brief descriptions of how risk is treated in financial management theory. As with any subject area. and having completed the Essential reading and activities. 9 . Learning outcomes By the end of this chapter. if studied carefully and fully. The roles of financial managers come next. but if the practise questions and problem(s) here and in the Essential text cause you any problems. you should be able to: • describe the general financial environment in which corporations operate • explain the importance and roles of financial markets • list/outline the roles financial managers can have within an organisation • outline such things as taxation. to be followed by a discussion of some of their conflicts of interest and how they might be resolved. the changes suggested. and the control methods used. accounting information and form of business and their implications for financial management • give examples of the various objectives a company may have and why the main objective is deemed to be shareholder wealth maximisation • explain and give examples of how the influence of risk will permeate all aspects of financial management. should have meant you already have all this background knowledge. the theories presented. The chapter starts by looking at the key tasks of financial management. Without a clear understanding of the fundamentals the remainder of this subject will not be easy to grasp.Chapter 1: Introduction to financial management Chapter 1: Introduction to financial management Aims of the chapter This chapter is clearly one of the most important in the subject guide because it deals with the fundamentals of financial management. then perhaps only a quick review of this subject matter is necessary. are included and the chapter is concluded with a note of the direction and importance of taxation in today’s financial decisions.

Part of the finance function is dealing with the capital market since a large part of the finance is obtained through the capital market. The financing decisions involve the identification and choice of the sources of funds which will provide the cash to be invested into the selected projects. P Financial Management for Decision makers. S. S. Allen Principles of Corporate Finance. Marcus Fundamentals of Corporate Finance. as the two most important tasks. 2 and 3. the ordinary shareholders. Countries that are still developing may not have a public market place (i. to evaluate the proposed courses of action. R. The quality and amount of that return. will be one of the elements influencing the price at which the share is quoted in the market. In the capitalist economies of developed countries where there are stockmarkets.. Financial environment The economic and social background of a country is a major influence on a firm. through plans and projections. The next two tasks. investment project appraisal and financing decisions are seen by some. Further reading Brealey. 2005) Chapters 1 and 2.A. Similarly financial control deals with the ways and means by which the plans are achieved. Financial planning provides the means. Key tasks of financial management There are five key tasks undertaken in financial management: • financial planning • investment project appraisal • financial decisions • capital market operations • financial control. R.A. Potential owners of shares as well as existing 10 . on its structure and on its objectives and operations. Different phases of the trade cycle have different implications for financial operations. interest rates payable on loans will be higher.. (McGraw-Hill Inc. . 2007) Chapters 1. 2008) Chapter 1. Atrill. the owners of the shares in trading companies will expect returns on those shares. This function does not just deal with the raising of funds but also with the ongoing relationship between the company and the market place. Myers and F.C. including Brealey and Myers.59 Financial management Essential reading Brealey. trading conditions much more risky and so returns to shareholders may be lower or non-existent. a stock market) in which the shares in a company can be traded. (McGrawHill. Myers and A.C. information disseminated to the capital markets affects the market’s perception of the company and the price of the company’s shares. In depressed times.e. and thus wealth of the shareholder. Firms in socialist or communist countries have different structures and objectives from those that operate in capitalist economies.J. (FT Prentice Hall Europe. Investment project appraisal is the assessment and evaluation of the relative strengths of a company’s investment propositions. not least those funds provided by the equity owners. the dividend.

very sophisticated. but much of what is covered is also relevant to the unincorporated business. while the unincorporated are either proprietorships or partnerships. Corporate objectives are determined by a relatively small group of senior management. Organisational forms of business Businesses established for profit-making purposes generally are organised into one of two forms: incorporated and un-incorporated. The incorporated firm are the companies or corporations. These businesses are generally sole proprietorships or partnerships. vary enormously from the very large. ownership and management are likely to be separate. We also assume that all managers act to further that objective. These can 11 . a company has many stakeholders. Shareholder wealth maximisation is the normative objective of a company that underlies financial management theory. Each country has its own sets of laws and regulations which provide the parameters for the structure of the entity and how it can operate on a daily basis. unless of course managers are also major shareholders. very structured markets such as London and New York to some of the very small nascent markets in some developing countries in Africa and the Middle East. With ownership usually comes some form of control through voting rights. As groups they have their objectives for the company and as individuals they have their own objectives for their stake in the company. in theory. If the owner/partners want the entity to continue to grow then usually a change in form for the entity will be necessary. Corporate objectives Generally we assume that a company’s objective is to increase the value of the shareholders’ investment in the firm. its shareholders. customers. How and why those returns and share prices can be influenced will be covered later. though not the majority in terms of value or employment. lenders as well as shareholders. In this subject guide we will be viewing financial management from the perspective of a corporate entity. government. The owners of a company. employees. but this does not extend to managerial control of day to day operations. For that. The unincorporated form of business make up the majority of the numbers of businesses. independent of its owners. Some of these individual objectives may be at slight variance with the others. customers want the company to provide the product with the highest quality and lowest price. The corporation or company is a legal entity of unlimited life. have to be appointed to act as the shareholders’ agents. In practice. They are managed by the owners and do not have a separate legal entity even though they may have a separate trading name. Ownership and management risks are intertwined which makes raising very large sums of capital almost impossible. for example. by way of directors. The extent of a country’s capital markets. probably the directors. The liability being limited to the par or nominal value of the shares or equity held. but this may not result in high profits and share price maximisation. creditors. management. have limited liability for the debts and obligation of the company. Therefore. The liability of the owners of these entities is unlimited. of which the stockmarket is but a part.Chapter 1: Introduction to financial management owners of shares are interested in the quoted price of a company’s share and in the return obtainable from that investment.

and in particular directors. This separation can create costs which have been called the costs of agency since management is deemed to be the agent of the owners (the principals). share option schemes). planning and control techniques and systems. will attempt to maximise the return from the optimal selection of investments so as to satisfy the providers of finance from whom (s)he has obtained the cheapest and best combination of funds via the capital markets. Systems should be used to monitor and ensure control of agents. It is often argued in the UK financial press that though companies may be trying to increase shareholder wealth it is not with a long-term perspective but is only short-term oriented. See VLE for solution Role of managers A company is a complex organisation made up of many employees each with their own objectives. as well as possible ways in which the costs of any such conflict can be minimised. 12 . Conflicts of interest and their resolution One of the major disadvantages of the corporate form is the separation of management and ownership. and do not forget the power of the financial market place in steering you towards your final selection.59 Financial management be influenced by a number of things with an outcome which may not be shareholder wealth maximisation. Activity 1. • Then try to rank each group’s objectives in order of importance. However. minimises and hopefully enables the removal of management. Therefore incentives should be provided to try to ensure convergence of goals between principal and agent (e. the greater the agency costs. who abuse their powers and who are therefore not attempting to ensure the company achieves its goals. the manager. • Now draft your reasons for your rankings.g. Do not be surprised by the differences and variations. • Which one(s) would you list and why? Do they all directly or indirectly lead to shareholder wealth maximisation? Your lists could be based upon the company(s) you know or work for. Agency theory attempts to explain this situation and how conflicts between principal and agent can arise. • Try to list what you believe are the major objectives of each group. That is. • Next assume you are the Board of Directors and you are required to publish the company’s objective(s). the manager is expected to act in furtherance of the goals of the owners. It is argued that agents will tend to pursue their own goals and the greater the deviation of those goals from the corporate goals. for example use of annual reports.1 Consider the stakeholders of a business as described earlier. using the evaluation. three or more for each group. In theory. managers may not be owners. and which can be allowed to vary with circumstances and over time. There may be two. The financial manager is expected to act as the intermediary who will undertake the tasks of financial management. the setting up of an appropriate governance structure which restricts.

Accounting has been defined as: the process of identifying. business. The greater the separation between the two. 13 . the greater the potential for abuse and also the greater the possibility of suboptimal behaviour by managers as viewed by shareholders. and decision making is concerned with the future and the future is uncertain. All this is important because it highlights the differences between the normative theory and the practical application. The framework has evolved through.Chapter 1: Introduction to financial management Corporate governance The essence of the corporate governance debate is the effects of the particular relationship between directors and shareholders. there is no risk. The various recommendations of these reports have been incorporated into the combined code which is included in the Listing Rules of the London Stock Exchange as an appendix. or been impacted upon. Though not legally enforceable. risk must be a major factor in all aspects of financial management. (e. projecting next year’s sales budget or evaluating a new investment proposal). See VLE for solution Financial management and accounting Financial management is not the same as. If there is only one single possible outcome. • Try to identify the causes of that riskiness.2 • Choose a few practical situations where a business faces the effect of risk. the regulations require compliance and provide for penalties. If there are many possible outcomes and many of them are very different from our estimate of the outcome. Activity 1. Risk may be defined as the extent to which what we estimate will happen in the future may or may not happen. The rules require a company to make a disclosure statement in its annual report about its compliance with the combined code. Broadly speaking. by six key reports starting with the Cadbury report in 1992. At present in the UK there is a voluntary system of governance in place.g. Different corporate structures. an investment in government securities). Where we perceive little risk (e. both theory and practice show us that risk and return are correlated.g. then there is a lot of risk. we are prepared to accept relatively small returns. legal and social environments require different governance requirements and systems. We seek higher expected returns for investing in riskier projects. or even a branch of. measuring and communicating economic information to permit informed judgements and decisions by users of the information. (American Accounting Association). Financial management and risk Since financial management is concerned with making decisions. • Then think of ways to try to measure it and ways to control it. accounting.

Practise questions 1. the theories presented. Financial management and taxation Virtually all decisions taken by financial managers have tax effects. it is clear that financial managers will be major users of accounting information. and the control methods used. that you have a broad appreciation of the major aspects of the UK tax system. Therefore the decision between raising funds from shareholders and from lenders has tax implications. Describe these objectives and show how there may or may not be consistency between the different objectives.59 Financial management Given this definition. Discuss the implications of your findings. 2. accounting information and form of business and their implications for financial management • give examples of the various objectives a company may have and why the main objective is deemed to be shareholder wealth maximisation • explain and give examples of how the influence of risk will permeate all aspects of financial management. Those who work as financial managers may very well have a background in accounting. Consider what objectives might be important to a company other than shareholder wealth maximisation. It is important. How might a manager’s objectives differ from those of the company? What are the implications for corporate policies in order to ensure congruence between the sets of objectives? 14 . for example. Are there any major differences in the corporate taxation system? A reminder of your learning outcomes By the end of this chapter. profits) are taxed. Despite these facts. In many small businesses one person combines the roles of accountant and financial manager. however. the changes suggested.e. the tax treatment of loan interest is different from that of dividends paid to shareholders. the appraisal and selection. It is not one of the objectives of this course to turn you into an expert on the UK tax system.3 Think of similarities and differences between the UK tax systems and another country you are familiar with. you should be able to: • describe the general financial environment in which corporations operate • explain the importance and roles of financial markets • list/outline the roles financial managers can have within an organisation • outline such things as taxation. Activity 1. The accountant is concerned with the provision of information: financial managers use information supplied by the business’s accounting system and other sources to help them to make financing and investment decisions. the role of the accountant and that of financial manager are distinctly different. and having completed the Essential reading and activities. In the UK. Returns from investments made by the business (i. which has much in common with the tax systems which prevail in other of the world’s countries.

pp.44 and 45. p. p. 3 and 4. numbers 2.23. numbers 4. attempt the following problems: • Chapter 1. 15 . 7. 8 and 9 • Chapter 2. 5. numbers 2.65.Chapter 1: Introduction to financial management Problems In BMM. 10 and 17 • Chapter 3.

59 Financial management Notes 16 .

(FT Prentice Hall Europe. P Financial Management for Decision makers. valuing monetary assets.. This chapter defines and explains the time value of money concept and applies it to problems of investment appraisal in a certain world. Different sets of circumstances are introduced to show how the NPV approach can cope with the situations met in an imperfect world.C. The major problem of an imperfect world and uncertain outcomes is dealt with later in Chapters three and four. mutually exclusive investments. 7. S. Alternative methods of appraisal are also described. Myers and F. Atrill. So carefully learn these concepts. capital rationing). Marcus Fundamentals of Corporate Finance. 8 and 9 Further reading Brealey. Allen Principles of Corporate Finance. We start by describing the time value of money and then explain the concept and approach to the computational methodology used in a practical example of investment appraisal and selection. 3. inflation. R. The net present value (NPV) is described very fully both in principle and application and in how the decision rules are derived. the topics in this chapter are integral to the subject as a whole since these basic techniques of time value of money and discounting are used in numerous other aspects of financial management. Here we concentrate on the basics since the technique can be and is used in long-term and short-term investment appraisal. such as internal rate of return and pay-back.J. whether it be future or present value oriented • defend the use of NPV as the method of appraisal against other suggested methods • prepare evaluations of investment proposals and state which decision rule is appropriate in the specific set of circumstances. risk management etc. Myers and A. Essential reading Brealey. 17 . The relaxation of the assumption of certainty occurs in the following two chapters. different interest rates. 2007) Chapters 4. (e.Chapter 2: Basic investment appraisal methods Chapter 2: Basic investment appraisal methods Aims of the chapter Like the topics in the first chapter of this guide. and the process as well as the principles and the pros and cons concerning them.A. 6 and 7. R. S. 2008) Chapters 2. (McGraw-Hill Inc. 2005) Chapters 4 and 5. Learning outcomes By the end of this chapter and having completed the Essential reading and activities.A. . taxation. (McGrawHill.C. you should he able to: • describe and apply the time value of money in project evaluation. repeat investments. in evaluation of financing methods.g..

So if we predict receiving £F in t years time during which r is rate of interest then £P is the present value of £F. Apply this knowledge to annuity payments or receipts. today’s amount) which. You should familiarise yourself with the compounding and discounting formulae and procedures and where they are used. The present value of a future amount is also known as the discounted value.e. Remember an annuity is a constant annual amount and so the annuity factor for any year is the sum of the annual discount factors up to and including that year.e. but as these predictions are all in money terms of differing values they must all be converted into a value at a common date (i. the recipient would be indifferent between the future receipt and today’s receipt. the greater the interest compensation required. If the interest earned is reinvested rather than withdrawn then the total amount invested grows at a compound rate. Future value and compounding Whenever someone makes an investment. would achieve the future value predicted. holders of money can either spend the money on consumption now or delay the consumption by investing the money until it is required for consumption. The difference between the two receipts is the time value. By receiving today an amount of cash equal to the present value. which we call the present value. 18 . today’s values.e. This uses as its basis the sane algebraic relationship but in the opposite way. So if one knows of a certain future receipt of cash then there must be a certain value today. he or she expects to earn a return which can take the form of interest when the investment is in some form of monetary asset. The further into the future a consumer has to wait. If P is the amount invested today at r% with compound interest for t years then the future value will be F. derived thus: P = Note F (1 + r ) 1 (1 + r) t t = F× 1 (1 + r ) t is the discount factor. the compensation for the passage of time. F = P(1 + r) t Present value and discounting The converse of compounding is discounting. a table of discount factors for all combinations of r and t has already been prepared. cash) has a different value over time. The aim of discounting is to determine the present value of a future amount (i. This can be found at the back of all reputable texts. if invested at the rate of interest r. The amount of interest is dependent upon the amount of time and the rate of interest. With prospective new investments we can predict the incremental cash flows which will occur because of the investment. At the end of the life of the investment (at maturity) it will have a value F – the future or maturity value. which will be its equivalent. Using a computer. Therefore we need to convert all cash flows into present values. The reward for the delay in spending is the interest received by investing.59 Financial management Time value of money Money (i. the day of the investment). today.

when undertaking an investment appraisal. (1 + real rate)(1+ inflation rate) = (1 + nominal rate) (1+ r)(1+ i) = (1+ n) N.2. The expression discount rate is often used synonymously with interest rates because the discount factor is derived using an interest rate. as well as an investment’s internal rate of return (IRR). The discount factor used should only incorporate the inflation rate relevant to the capital providers who have to be serviced and repaid from the investment. You must learn the difference between real and nominal interest rates. The nominal rate is the rate to be found in the market place. We can use the expressions cost of capital. 4. See BMM sections 7. 19 . Remember that different items of operating expenditure and revenues may have their own specific inflation rates and.1.14.4. 4.Chapter 2: Basic investment appraisal methods Interest rates.5. the degree of inflation may have been different from year to year or between say wages and materials). a company’s investment or the required return a company has to pay on its loan etc. all cash flows prior to discounting should be quoted in actual or money flows for the specific period. numbers 4. So it could be the return on a bond.B. are also used to mean nominal rate). that mixture has an average cost which the company has to service. Similarly. because companies use a mixture of capital types to fund their investments. selection between mutually exclusive projects and so on. Activity 2. 4. as alternatives to discount rate since the discounting factor is derived using the cost of capital. 4.g.8 and 4. (The terms. Note the short cut sometimes used to derive the nominal rate (r + i) = n. simple go/no go.3. Likewise learn how to compute the payback period (PP) and the accounting rate of return (ARR).2 Solve self-tests in BMM. discount rates and real rates An interest rate is the proportionate return on an investment appropriate for the risk level of the investment. opportunity cost of funds. The decision rules for each appraisal method should be learnt for the range of different types of decisions a manager might face. Activity 2. Any investments made from that mix of capital must generate flows and in the evaluation of those flows we use the discounting process. All individual and specific inflation rates will have been separately accounted for (e. money and actual interest rates. The real rate is the rate of interest that would persist if there were no inflation or deflation.1 What is the time value of money? How is it different from the real and actual rates of interest of a risky investment? See VLE for solution Basic investment appraisal techniques Using BMM learn how to compute the net present value (NPV) for an investment.1 and 7. Do remember this is only an approximation and will usually lead to over-valuing the present value of the future flows.

000 3 12.251 22 24* 2. Using the NPV approach A will have an NPV of £4.140–43. Each method has its own set of decision rules. Profit flows will need adjustment to cash if only profit estimates are given. Project Time periods (years) 0 A B (25. The amount and timing of the net cash flows of a project are crucial to the viability of an investment. Assuming an annual cost of capital of 15% and estimated net actual annual cash flows as stated. analysing and estimating the investment flows. PP and ARR. exceed the estimated outflows.000 5. then A is preferred since it has the higher rate.202 and PA pp.6 1.166 and B an NPV of £1.500 £4.000) NPV(£) 1 5.500 - Total £17. See BMM p. If one only used ARR.5* 35* 26.000 Payback (Years) ARR(%) A B 4.500 (1.000 IRR (%) 2 12. A and B. the time value of the cashflows). It is marked with an asterisk (*) in each case. are considerable. unless ARR is being used. The main reason for disregarding the outcomes under these two methods is that neither payback nor ARR take into account the pattern of flows (i. in practice. You should learn the process of identifying. 20 . in the case of A. Using the payback approach would suggest B is preferred as it has the shorter payback period. Also payback does not take into account the post payback flows which.7 Separately using each evaluation method the pairs of values for projects A and B are shown above. remembering the projections should be in cash not profit flows.000) 4 12. then the four methods will give conflicting results.e.000) (10. also discounted to the present • that the theory in this section assumes certainty of knowledge and forecasting – this is relaxed in the next chapter • that.251.59 Financial management You must remember: • that long term projects under consideration should be consistent with the long term corporate plan • that the estimated cash inflows from the project when discounted to a common date. Given below is an example of two mutually exclusive investments. it is by chance one gives us the appropriate selection. You should learn the theory behind the four main analytical techniques with emphasis on why NPV is superior to IRR. The decision rule is to select the investment with the higher NPV regardless of the size of the original investment.166* 1.500 10. Therefore A will be preferred to B. From the textbooks note the rationales presented for the still considerable use of payback by managers in practice. which is why it is marked with an asterisk (*). the present. while for B they are less so and it even has a net outflow in one period. with an explanation of why only NPV will give the correct signal to management. Since neither method is the correct one. Under each of the evaluation methods and using the appropriate decision rule the preferred choice can be made. businesses do not wholeheartedly follow the theoretically correct route of using the net present value approach (NPV) all the time.

Many businesses are faced with decisions regarding projects that may require repetition on a known cyclical basis. For example. the other being a negative value. Another problem is that IRR’s reinvestment assumption for the fourth year of B is that the funds have been reinvested at 24% to enable comparison with A. means two roots to the equation (i. The cost of capital is the average rate payable to the providers of the capital for the company.000 is not as good as 24% of £25. raw material prices etc. it is important to ensure that all flows are dealt with on an after tax basis. This is because of one of the technical problems of using IRR that are exemplified in B. It is important to identify an optimum replacement period for them. you should prepare all estimates of flows in actual or money terms and then discount the net flows using the actual or money cost of capital. take a business with a fleet of vehicles. For example. may be affected by different rates of price changes. 24% of £10.000. The post-audit process should involve the comparison of actual results with the predictions for the project and provoke explanations of whatever differences have occurred. as in B. we must use the general or average rate of inflation since it is assumed that all providers of funds have the ‘average’ spending pattern used to compute a retail price index. when making estimates of cash flows. For each change in sign in the sequence of cash flows. This is not necessarily true. businesses have to take investment decisions when their financial resources are limited. It is called the hurdle rate because it is the minimum that has to be achieved and the opportunity cost because each element of capital has got its own opportunity cost. you should learn the capital budgeting process and. Thus two sign changes. Also the IRR does not indicate the difference in the size of the projects. Therefore. The cost of capital is also called the hurdle rate and the opportunity cost of funds (capital). Finally. though B has the higher IRR. the IRR shown is only one of the two IRRs for that project. the specific rates of price increases must be incorporated in the analysis. 21 .g. Similarly. The type and make of vehicle to be used by the group can be identified on cost grounds by use of the net perpetuity value and annual equivalent annuity methods. B has multiple rates of return because the sign of the annual cash flows changes more than once in the sequence. Wages. Note it is possible that one or more root could be the square root of a negative number which is of no practical value.197–99). Where the capital restriction will only last for one time period (normally one year) the profitability index (PI) should be used to identify the optimal selection of projects. thus enabling improved forecasting in the future and improved operations too. in particular. two IRRs). space or personnel) then linear or integer programming models can be used which maximise the NPV of the portfolio of projects subject to the constraint introduced.e. Application problems – some considerations When considering applications of the NPV analysis to practical situations. If the restrictions are multi-period and/or multi-faceted (e. In compiling the cost of capital or opportunity cost of funds. in an inflationary world.Chapter 2: Basic investment appraisal methods In the example. the benefits from the post audit procedure. From a practical viewpoint. there will be a root to the solution of the equation which produces the IRR. Different groups of vehicles in the fleet will need replacement on a regular basis. These are all derived from the NPV approach and can be learnt from BMM (see pp.

Worked example 1 A business is considering an investment in equipment which requires an initial outlay of £10 million.a. increases) Materials (20% p.5% p. during the five years and the business’s real after tax opportunity cost of capital is 10% p.59 Financial management An alternative way of acquiring the services of an asset is to lease it rather than buy it.5 1 4 49 5 (2. Writing down allowance computation (straight line) Tax allowance Outlay Year 1 (20%) Year 2 (20%) Year 3 (20%) Year 4 Sale Year 4 10 2 8 2 6 2 4 3 1 2 2 2 Loss on sale 1 (The same approach can be used for reducing balance based allowances. or paid on a gain.0) The business estimates that the average annual inflation rate will be 4. increases) Book depreciation Net trading surplus Increases in working capital 10 7 10 2 30 11 13 11 29 1 1 2 40 15 17 12 37 3 0.a.5 2 50 16 19 13 46 4 0. Payback and ARR for the project. IRR. arising from the sale of the equipment would occur in the fifth year.) Then compute the tax payments or receipts based upon the taxable profits. The corporate tax rate for each of the five years is 30% payable a year in arrears. increases) Other costs (5% p. The investment will be allowed a 20% writing down allowance (depreciation) on a straight line basis for tax purposes. The incremental revenues and costs and the annual price rises incorporated in the estimates arising from the investment are as follows: £million Years 1 2 3 4 Sales Wages (4% p. Required: Compute the NPV. The same principles of evaluation should be applied to the incremental cash flows arising as a result of taking out a lease in order to see whether it is a better way of funding the asset as opposed to buying it.a. 22 . It is estimated the equipment will be sold at the end of the project. Any tax received on a loss. Obviously one uses the tax regime requirements appropriate to the country in which one is investing. Solution to Worked example 1 First compute the depreciation for tax purposes. This may require a transfer of tax depreciation for book depreciation (in this case they are similar).a. the end of the fourth year for £3 million.a.

025 0. Here: 10% + 4.3 2 3 2 5 2 3 £0.4768 3. Then: (1+i) = = Thus i = (1 + 0. You should use the theoretically correct method given above unless an approximation is called for.3725 (0.604 0.0 3.5718 (0.9 3 4 2 6 2 4 £1.5 Tax is paid in year following the year in which the profits were earned.8696 3.6575 5.0 1.0) (0.0 6.5% = 15%.1495) 0.0 (3.5) 2.0) (28%) (10.1 0.8 0.437) – 3. All cash flows are assumed to arise at the end of the year concerned except for the initial outlay on equipment.5% = 14.3) 4.3 paid at end of year 2.6 0.2 0. (The last point depends on the individual country’s tax regime).6104 2. Cost of capital (discount rate) (i) The actual or money rate is the rate to use.798 million shown above in the Total column.e.739 1.5) (0.) To calculate the NPV £’million Year Outlay Trading surplus (adjusted) Working capital change Sale of equipment Tax payments Net cash flows Discount factors Discounted flows Discount factors Discounted flows – (10.5) (1.0 1.0) The NPV at 15% cost of capital is therefore the aggregate discounted flows of £2.4972 2.0 0 (10. that the average actual cost of capital had to be calculated and used.0) (15%) (10.7813 2.564 (0.179 (1.045) (1 + 0.2 4 5 1 6 1 5 £1. The annual discounted flows are computed from the 23 .746) 0.9) 4.0 (1. e.798 0.Chapter 2: Basic investment appraisal methods Tax computation (£million) Years 1 Net trading surplus Add book depreciation Trading surplus (adjusted) Less tax depreciation Taxable profit Tax (30%) 1 2 3 2 1 £0. that in arriving at the annual flows the specific price changes were used in estimating the wages.563 (0.2) 9. To obtain the NPV note that the accrued profits have been converted into cash flows by the changes in the working capital.0 6. tax on year 1’s profits of £0.9) 9.0) 1 2 3 4 5 Total (10.176 0.5) 0.7561 3. 15%) (Some authors and businesses use the quick way and get an approximate value by summing the real and inflation rates. The discount factors came from the present value tables and are based on a cost of capital of 15%.0 5.2910 (0. that the tax shield is provided by the writing down allowance (tax depreciation) and that tax is paid a year in arrears.0) 2.1)(1 + 0.15 (i.651 (1.0 1. i.480) 3. materials etc.0 20.

Payback Taking the net cash flows: Year 0 1 2 3 Surplus Payback = 2 + 3.798 from £2.66% using an extrapolation procedure (check your understanding of the method by doing your own calculation and check with the answer given).775/5) ×100 = 95.1 and £2. 24 . Thus the IRR is   2. but more approximate value could have been obtained by using the NPVs of £9.2 (3. If the four projects were mutually exclusive.00 = (4. The reduction in NPV by £2. By increasing the discount rate from 15% to 8% – an increase of 13%.6 0. the NPV declined from £2.8696 = 1.1 + 15 = 26. Calculation of IRR Using the two discount rates 15% and 28% we have obtained two different NPVs. one positive and one negative. so the rate must lie somewhere between 15% and 28%.00) ARR = Average inflow/Average outlay Profitability Index (PI) NPV PI = Initial investment = 2. The IRR is the rate which gives an NPV equal to zero.480)    = 11.798 to 3.6 = 2.8) 4. Their characteristics are given below in the table along with those of the project just evaluated.798 10.278 reduction in NPV.798 − (−0.1% Note: A quicker. then the asterisk indicates the preferred choice under that evaluation method.798 (28 − 15)  + 15 2. The row of discounted flows are summed to give the NPV in the final column.798 to a negative £0.8 Flows (£ million) (10.775 =5 2.83 years Accounting rate of return (ARR) Average inflow Average outlay = Total inflow/Project life = Outlay/2 = 19.1/4 = 10/2 = 4. a total decline of £3.59 Financial management product of the actual net cash flow for a year times its discount factor.0 4. So if the interest rate is increased by an amount equal to the proportion of 2. This approach would have given a much less accurate estimate of 21.798 at 0% and 15% respectively.798 to zero will require increasing the interest rate from 15%.278.8/4. The 13% increase in interest rate produced a £3.5% = 0. (2 × 0.28 Now assume that the business has three other projects it has evaluated.2 6.180.739).278 of the 13% it should move from 15% to the appropriate rate which is the IRR.

25 . the following combinations of projects are possible. so the project with the next best PI is included that does not exceed the outlay limit. The first is by the use of sensitivity analysis. Managers need to evaluate the effects of these possibilities in their initial prediction.8 7.5 million.00 2.280* 0.50 Try and understand the applied type problems and examples used in the texts.180 0. one by one. Understand the conceptual weaknesses and strengths of theoretical methods used and learn how to critique your methods and results.8 7. relax that assumption and consider that in the real world. Here the addition of project D to A used the two highest ranked projects and had a £25 million outlay. fewer things will actually occur than might have been predicted.3 7.0 yrs ARR 96%* 50% 60% 80% PI 0. though some combinations seem to have higher PIs (e.180 0. starting with project A.200 Conceptually B is the preferred project from amongst the four evaluated because it has the highest NPV of £4. then if the business has a maximum of £40 million to invest. AD).2125 Outlay 10 15 3/5 × 25 40 NPV 2. ‘What-if’ questions Now that you’ve learnt the basic techniques for the analysis of investment proposals.g. Using the same data and assuming now that all four projects are available for selection and are not mutually exclusive. derived as follows by using the PI ranking: Project A AD 3/5B PI 0.5 Average PI 0.0% 20.83 yrs 2.5m* £2.0m IRR 26.4%* Payback 2. Combination (£million) Combination AD AB ADC DB Outlay 25 35 40 40 NPV 5. thus giving a lower corrected average PI of 0. This requires an estimate of the effect on the predicted outcome. on the assumption of operating in a world of certainty.188 The objective is to maximise the NPV of the portfolio of investments. then the combination would have been A.5 yrs 1.Chapter 2: Basic investment appraisal methods Project evaluation table Project A B C D Outlay £10m £25m £15m £15m NPV £2.195 0. However that is a false comparison because the balance of unused funds of £15 million should be included with its zero NPV.145.0% 26. The combination of ADC provides the highest NPV.232 0. in descending order of PI.70 8. in particular those in BMM. If it is assumed that all projects could be undertaken fractionally if necessary. D and 3/5 of B. Third ranked project is B but combining its outlay to A and Ds exceeds the limit.133 0. The PI is used to indicate the order of selection.209 0.200 0.1% 18. Here it is assumed that each project is discrete and cannot be split up. continuing to combine those projects that satisfy the limit placed on available funds. There are various ways of doing this.322 0.0m £3.8m £4. The process is to go through the projects.9 yrs* 3.80 3. usually NPV .

for example. you should be able to: • describe and apply the time value of money in project evaluation. calling for a more sophisticated knowledge of probability distributions of outcomes. is a large proposal requiring an initial investment of £13 million in plant and equipment which at the end of the project’s life of 4 years will have a resale value of £4. Discuss the pros and cons of NPV IRR and payback period as methods . of appraising investments. Sample examination questions 1. The first proposal. whether it be future or present value oriented • defend the use of NPV as the method of appraisal against other suggested methods • prepare evaluations of investment proposals and state which decision rule is appropriate in the specific set of circumstances. Effects of changes of combinations of variables can also be evaluated. Practise question 2. The company has £100. What is the time value of money? 2. Arising out of that identification. The examination Extracts from discount and annuity tables will be supplied in the examination for 59 Financial management if these are relevant for any question. one is the set of the most optimistic outcomes. This is sometimes called threepoint estimates. the set of the most pessimistic outcomes. another the set of most likely and the third. managers can assess the likelihood of the variable change. An extension of this approach.59 Financial management of changes in each variable. The overall impact on the final outcome of the potential changes can be evaluated and aid the decision as to whether or not the proposal can be accepted. This is called scenario analysis. Make a case to support the reported managerial preference for the use of IRR and payback methods in real world situations.0 million.1 Snowdon plc has a fund of £15 million to invest in new projects. and having completed the Essential reading and activities. When a number of variables are interrelated. and whether it can be influenced by managerial efforts. then the different combinations can be reviewed as separate possible scenarios.000 still to pay to the consultants 26 . A. It can be identified from this evaluation those variables whose changes might influence the outcome the most. An extension of sensitivity analysis is breakeven analysis which can be used to assess the magnitude of change that will reduce the originally predicted NPV to zero separately for each variable. A reminder of your learning outcomes By the end of this chapter. managers may call for three different but consistent combinations of variables. is called simulation analysis. You can however use your own calculator to generate the factors if you so wish. It has a number of proposals to consider. 3.

The contractual obligation will be met in 3 months time.8 million will be recovered when stocks of the product are rundown and debtors pay up. The life cycle predictions for sales volumes. A working capital fund of £2 million will be needed immediately to finance the build up of stock and debtors.15 million p.20 million p. Calculate the payback period and accounting rate of return for project A.a. numbers 15. p. In calculating these fixed overheads the accountant had included £3.a. and administration and selling were £8. 25. 27 . 20.25 million p.Chapter 2: Basic investment appraisal methods under the research and development contract for this project of £3 million. prices and variable costs are as follows: Years Sales volume (‘000) Sales price/unit (£) Variable cost/unit(£) 1 1200 20 4 2 1920 20 4 3 960 18 4 4 600 13 4 The incremental fixed costs were forecast to remain constant over the product’s life which for the annual production fixed overheads were £4.234. REQUIRED a. p.204–7. Calculate the net present value to the company of project A. At the end of the project’s life only £1.a.. numbers 18 and 25 • Chapter 9.258. pp. The company has a cost of capital of 15%. for the annual depreciation write off of the new equipment. numbers 5 and 6. b. 19. 27 and 30 • Chapter 8. See VLE for solution Problems In BMM attempt the following problems: • Chapter 7.

59 Financial management Notes 28 .

.A. and having completed the Essential reading and activities. Further reading Brealey. R. how this risk associated with a project can be measured. It measures the return the firm must earn on its assets to meet the requirements of investors. and explaining the concepts and techniques of. 2007) Chapter 10. variance and standard deviation for both a single investment and also for a portfolio of investments • explain why a strategy of diversification reduces risk • distinguish between unique risk and market risk. or as they are often referred to. 2008) Chapter 8. Myers and F. and it provides a benchmarking for the return from existing business activities. here is a word of advice: The cost of capital is the link between a firm’s financing and its investment. R. S. This is followed by an explanation of how to distinguish between market and unique risk.C. Allen Principles of Corporate Finance.A.C. We will then show how to calculate share returns. risk and return.Chapter 3: Introduction to risk and return Chapter 3: Introduction to risk and return Aims of the chapter This chapter will start by looking at. Essential reading Brealey.. (FT Prentice Hall Europe. Before you start reading the recommended textbook. S. systematic and unsystematic risk. you should be able to: • estimate the opportunity cost of capital for a project using shares that have the same risk as the project • calculate the expected return. Marcus Fundamentals of Corporate Finance. (McGraw-Hill. 2005) pp. P Financial Management for Decision makers. Learning outcomes By the end of this chapter.J. Myers and A. So the cost of capital provides the discount rate for evaluation of new projects and for valuing the firm as a whole. 170–208. (McGrawHill. In this chapter you are required to confront the issue of the relationship between the cost of capital and risk and. . The significance of using diversification to achieve risk reduction will then be considered. 29 . Introduction So far in your studies of financial management you have overlooked the issues that are associated with project specific risk and you have assumed that the cost of capital for a project will depend upon the risky nature of the project undertaken. Atrill.

the capital gain would be £100 – £80 = £20 gain. 30 . and by 20X6. when they were valued at £80 a share. one way in which you could estimate the cost of capital is to find shares that have the same risk as the project and then estimate the expected return on those shares. during the year. the return you will expect from the share will come in two forms: • a dividend (a special form of cash interest payment to shareholders as a return for their investment in the firm) • a capital gain or loss (which will depend upon whether the price of the share has increased or decreased relative to the purchase price).e. For instance. These concepts can at first be difficult to understand but persevere through the chapter and re-read the introductory section again after you have read the whole chapter. British Airways paid a dividend of £10 per share. shares are riskier than corporate bonds which are in turn riskier than treasury bills. In addition. the value of the share had increased to £100 per share. this is also the basis for the Gordon Dividend model used to estimate a company’s cost equity (see Chapter 5). and shares have tended to provide the highest returns in the past. far more than either bonds or treasury bills). provides a useful but detailed history of capital markets and also points out that certain assets which are associated with a high degree of risk offer high returns relative to assets which offer low returns at a lower level of risk (i. it is important to concentrate on the concepts and techniques used to measure risk. As this chapter is only an introduction to risk and return. the London Stock Exchange. then process to understand why the diversification of securities reduces unique risk and not market risk. Rate of return: a review When a share is purchased from say. if you purchased a British Airways share in 20X5. Therefore.50% (which is the nominal rate of return) nominal rate of return = (capital gain or loss + dividend) initial price paid You already know that the cost of capital will depend upon the risk of the project and you could simply define the cost of capital to be the rate of return shareholders could expect to earn if they invested in equally risky shares. Total return = (20 + 10)/ 80 = 37. Brealey and Myers (2007) adopt a detailed approach to risk and return which may not be suited to students who are new to the subject.59 Financial management The introductory section to Chapter 10 of BMM. Then the return on your investment would be: Total return = (capital gain or loss + dividend) initial price paid for the share Incidentally.

Therefore. 31 .Chapter 3: Introduction to risk and return Activity 3. so the more widely spread the returns were and are around the average will imply a greater investment risk.) Dividends as returns Cash returns for investment Ordinary shareholders Company Projects Cash to buy shares Cash to undertake projects See VLE for solution Calculating expected return. Standard deviation is the square root of the variance and is also a measure of volatility. You also need to be aware that the higher the uncertainty of the average return. you need to know that risk is related to the spread of the outcomes. the higher will be the risk associated with the share. Variance is the average value of the squared deviations from the mean and is therefore a measure of volatility.1 Who ultimately bears the risk of projects undertaken by a company? (Use the diagram below as a guide to your answer. any objective measure of dispersion will provide a reasonable measure of risk and dispersion and that is why variance and standard deviation are able to be used in this context. you need to appreciate how far returns may differ from their average (which is usually determined by analysing the performance of the share over a long period of time). variance and standard deviation To understand the concept of the business of investing in shares. Thus.

Variance = = 0. which has a current market value of £10 and you expect that the future possible value of the share and the dividends at the end of the period are those set out below.6 × (0.2 × (0.3)2 + 0. Its use in this context assumes constant marginal utility. this is the co-efficient of variation.2 × (0. For instance.30 = 0. 32 . that other things being equal.5 – 10. investors will prefer an investment giving the highest expected return for a given level of risk or one that has the lowest risk for a given level of expected return. It should be clear at this point.65 – 0. if you were told that the return on a share is expected to be 20% and you have been given three risk ratings. which measures how much each individual outcome differs from the average (measures dispersion and volatility) is calculated by multiplying each end period return Ri minus the expected return by R the probability Pi associated with the market condition and summing. the total return will be 65%.30 (i. under normal market conditions 35% and under unfavourable market conditions −20%.50 7. 30%) The Variance. 15% and 10%.50 1.6 × (0.00 0.e.e. let us consider a simple example: Worked example 2 Suppose you own a single share in company A.0) (8.3)2 = 0. There is also a measure of risk per unit of return which is helpful when choosing between two independent risky assets.6%) Standard Deviation = σ = √ variance = 0.92 Thus a rational investor when choosing between two heterogeneous investments will prefer the one with the lower co-efficient of variation – the lower risk per unit of return.2) = 0.276 / 0.35) + 0. then you will select this level of risk for the given level of return. To best illustrate how the expected return.276 The Standard Deviation is simply calculated as the square root of the variance.5 – 10.00 12.2 – 0. assuming that the 10% risk rating is associated with the lowest risk.0 – 10. 30%.35 – 0.3)2 + 0.2 × (–0. Market conditions Favourable Normal Unfavourable Probability end share price 0.076 (i.2 × (−0. which may be acceptable over a short range.2 End dividend 15. Co-efficient of Variation = standard deviation / R = 0.0) 65% 35% -20% You will notice that under favourable market conditions. Expected Return = R = P1 R1 + P2 R2+ P3 R3 = 0.6 0. The Expected Return R is calculated by multiplying each total period end outcome Ri by the probability Pi associated with its market condition and summing. the variance and the standard deviation are calculated.50 Total end return 1.65) + 0.2 0. 7.50 (16.59 Financial management Equations Expected return = Variance = Standard deviation = variance.0) (13.

you would notice that: The standard deviation of individual shares is generally higher than it is for a group of shares. Compare the expected returns and the standard deviations for both scenarios. under favourable market conditions the total end period return will be 30%. you will notice that both the variance and the standard deviation for the portfolio are much lower than the mean return and standard deviation for each individual share. (Brealey. Myers and Marcus. 2007. By adding additional shares to the one(s) you already have.50 4. Market portfolio is the group of shares that make up the overall market. 33 .288) Diversification is a strategy designed to reduce risk by spreading the portfolio risk across many investments. the variance and the standard deviation for a single share. under normal conditions 10% and under unfavourable market conditions −10%. Should you be given the opportunity to calculate the standard deviations for a group of shares (such as that of a market portfolio).50 Total end period return % 30 10 –10 Therefore.2 You are now required to re-work the example for company A with the probability of the end share price equally likely for the three market conditions. which has a current market value of £5 and you expect that the total end period returns for the share will be as set out below for the three market conditions already identified when analysing company A: Market condition Favourable Normal Unfavourable End period return (Gain + Dividend) £ 6. Suppose. you have decided to purchase a share in company B.Chapter 3: Introduction to risk and return Activity 3. you are not exposing yourself by having ‘all your eggs in one basket’. such as the market portfolio. See VLE for solution Risk and diversification In the previous worked example you calculated the expected return. This is mainly due to the reduction in the volatility associated with the greater number of shares you add to than the single share that you started with. Worked example 3 We can now extend our initial analysis of only a single share in worked example (1) to examining more than one share and thus see the effects of diversification. The risk is spread amongst a large number of shares whose returns do not move in exactly the same direction and magnitude all the time. If you now compare the individual total end period returns for both company A and company B with their combined (portfolio) returns.50 5. p.

5(−20) + 0.5(10) = 47.R ) / σ σ AB A B A B 34 .92 30 10 −10 10 160 12. The lower the risk the lower the return.6 0.5(35) + 0. they are more likely to be concerned with the risk and returns associated with their portfolio.6 1. The choice of investment between the three alternatives by an individual will depend on the risk and return parameters of the utility curve of the individual. See VLE for solution r = cov(R . but on a constant returns to risk. The correlation co-efficient measures the extent to which the returns of pairs of shares vary with one another.2 65 35 −20 30 760 27. B and the portfolio of A and B indicates share A for the higher level of risk gives a disproportionately higher return than the portfolio of A and B.0 You must remember that investors with a portfolio of investments will not necessarily be concerned with the returns and standard deviation of the individual shares.5(65) 0.5(30) + 0.3 You are now required to re-work the example above for a portfolio of 60% invested in company A and 40% in company B. share A is better than B or the 50/50 combination. Notice how the addition of a lower return in share B to share A reduces the overall portfolio return and how the standard deviation of the portfolio has been reduced too.R ) = ∑P (R – R )(R – R ) A B R A A B B When you calculate the portfolio variance you also need to consider not only the individual variances of the shares but also the way in which their returns vary as measured by the covariance (usually termed the covariance effect). Covariances can be negative as well as positive.26 0.5 Favourable Normal Unfavourable Expected return Variance Standard deviation Co-efficient of variation 0.5 = 22. Note that the correlation coefficient between the returns of A and B is 1.59 Financial management Market condition Probability Return on share % Share A Share B Portfolio return (50% in share A and 50% in share B) 0. Correlation co-efficient: Activity 3. Calculating the co-efficient of variation for shares A. It is important at this point to emphasise the effect of a negative covariance which is usually influenced by a negative correlation coefficient.5(–10) = −15. You will also be expected to learn and be able to apply the formulae used to calculate the expected return and the variance of the two share portfolio.6 0. in this question assume all other factors remain the same as in the example above.2 0. Two share portfolio Expected return: Variance: Covariance: R = XR + (1 – X)R p 2 2 A 2 p A σ = X σ + (1 – X) σ + 2X(1 – X) r σ σ B B 2 2 AB A B cov(R .0 20 400 20 1.

50 0 20 11 0 Suppose. A reminder of your learning outcomes By the end of this chapter and having completed the Essential reading and activities. if the company is faced with unfavourable market conditions it will go out of business.00. You are required to calculate the expected return and standard deviation of the returns to the shareholders of Carbs Ltd. Practise questions 1. 3. which has a current market value of £12.00 1. The shares for Carbs Ltd are currently trading at £10.00 and the standard deviation 2. your strategy of diversification is likely to have almost eliminated unique risk and thus leave you to handle only the risk born by every share in the marketplace – market risk. Assume that the three possible market conditions are equally likely. Suppose you have now decided to purchase a share in Bards Ltd. See VLE for solution 35 . the portfolio variance. 2. a chain of fashion retail outlets. The shares of Carbs Ltd.Chapter 3: Introduction to risk and return Market risk versus unique risk The risk that you will be able to eliminate by the diversification of your investments is known as unique risk or unsystematic risk. a chain of bookstores. the variance will be 4. but once you have a portfolio of 20 or more shares.00 and you expect that the expected return for this share will be 2. Discuss what would happen to the opportunity cost of capital if investors suddenly became especially prudent and generally less willing to bear investment risk. Market risk occurs as a direct result of economy-wide perils that threaten all businesses.00. You are required to calculate the combined portfolio returns for Carbs Ltd and Bards Ltd (assuming 50% in each share). The risk that you will not be able to diversify away regardless of the different investments you add to your portfolio is generally referred to as market risk or systematic risk. You are now required to extend the analysis performed in Question 1 to examining more than one share and note the effects of diversification. you should be able to: • estimate the opportunity cost of capital for a project using shares that have the same risk as the project • calculate the expected return.8. both unique risk and market risk will be very important. It is worth reiterating that if you only hold one share.00 per share. the portfolio standard deviation. will generate the following payoffs to shareholders in the following year: Market condition Favourable Normal Unfavourable Dividend Share price 3. variance and standard deviation for both a single investment and also for a portfolio of investments • explain why a strategy of diversification reduces risk • distinguish between unique risk and market risk. the portfolio covariance and assuming the portfolio correlation coefficient between the two shares is −0.

289. Attempt the following problems in BMA: • Chapter 8. 17 and 18. 36 . numbers 8. 14. 4 and 8. p.1.59 Financial management Problems Attempt the following problems in BMM: • Chapter 10. p. numbers 3. selftest 10.268.

As unique risk can be diversified away by holding a large portfolio of shares. and how risk associated with a particular project could be measured.C.A. will be described and calculated and its application in capital budgeting and project risk derivation shown.J. Marcus Fundamentals of Corporate Finance. As this chapter is a logical extension of the previous chapter (Introduction to risk and return). The relationship of market risk and the risk of a share to the rate of return that investors require will be explained. Introduction In Chapter 3 you were required to confront the basic relationship between the cost of capital and risk. Learning outcomes By the end of this chapter and having completed the Essential reading and activities. (McGrawHill. R. R. 2008) Chapters 8. 2007) Chapter 11. S. This required return. Further reading Brealey. you should be able to: • calculate and interpret the risk associated with macroeconomic factors (market risk) for a share • compare the rate of return that investors demand and the market risk of a share • calculate the opportunity cost of capital for a project and be able to explain its relationship to the company cost of capital. investors will need to earn a higher rate of return to persuade them to take on market risk. through the use of beta. it is important that you concentrate on the concepts and techniques used to measure and interpret the market risk of a security and then proceed to relate the market risk of a share to the rate of return that investors demand and finally.. show how the opportunity cost of capital of a project can be calculated. applied to the concept of risk and the measurement of market and investment risk. or opportunity cost of capital. In the final section of Chapter 3 you were required to understand why the diversification of shares reduces unique risk (firm-specific risk) and not market risk (associated with macroeconomic events faced by all firms). The capital asset pricing model (CAPM for short) will be introduced and..C. Before you start reading Chapter 11 in BMM 37 .A. (McGraw-Hill Inc. 9 and 10. Essential reading Brealey. S. Myers and F.Chapter 4: Capital budgeting – risk and return Chapter 4: Capital budgeting – risk and return Aims of the chapter In this chapter the concepts of market risk and beta will be described and this will include how each can be measured. Allen Principles of Corporate Finance. Myers and A.

The part of total risk which cannot be diversified away requires a risk premium to compensate investors for bearing it. As risk depends upon exposure to macroeconomic events. some shares will be less affected than others by market fluctuations. This sensitivity is termed as the share’s beta (ß). a substitute such as the FT All Share Index is used as a proxy for the market portfolio. etc. Beta is a measure of movements of a shares return to the return on the market portfolio. This risk premium relates to the extent to which the particular share is affected by the macroeconomic factors associated with systematic risk. and the second section of this chapter extends your understanding of the basic risk and return relationship by introducing the capital asset pricing model and the security market line. Risk premium is the difference between market return and the return from the risk free asset. This is because this part of the risk relates to factors which affect all businesses and their returns. it can be measured as the sensitivity of a share’s return to fluctuations in returns on the market portfolio – as a total market portfolio consisting of all types of investments is difficult to establish. Total risk of investing in a particular share involves: • Unsystematic risk (or project specific risk) which is diversifiable by holding a large portfolio of shares. Measuring market risk By holding a portfolio of investments comprising shares in different businesses. it is caused by macroeconomic factors like changes in interest rates. changes in oil prices. Measuring beta As you will have already worked out. • Systematic risk (or market risk) which is risk borne by all companies. both these sections may seem to be very technical and the language used by the authors may prove to be difficult to understand at first but we recommend that you persevere through the entire chapter and then revisit the earlier sections for a fuller understanding.59 Financial management here is a word of advice. it is possible to diversify away quite a lot of the risk. 38 . At a glance. We thoroughly recommend that you also follow-up this chapter in BMM by reading the corresponding chapters in BMA. The first section to this chapter introduces you to measuring market risk and the beta of shares (which is mainly empirical in nature). in different industries. Investment managers generally refer to these as follows: • where shares are not very sensitive to market fluctuations and therefore have a beta less than one – defensive shares – and • where shares are sensitive to market changes and therefore have a beta value greater than one – aggressive shares. part of the risk of share ownership cannot be diversified away. Obviously investors will want to hold a portfolio of aggressive shares should they expect the market to rise in the near future and hold a portfolio of defensive shares should they anticipate the market will fall in the near future. This part of risk is known as market risk or systematic risk. However.

Solution to Worked example 4 The portfolio beta is calculated as follows: (0.0%. 4. usually a proxy is adopted for the market return such as the FTSE 100 all share index (in the UK) or the S & P 500 index (in the US) and the return on the risk free asset is the interest payable on treasury bills issued by the government.8.95 Risk and return The market risk premium can be defined as the difference between the market return and the return on risk-free treasury bills. 1.0) + (0. and their respective betas are 1.2) + (0. Portfolio betas The diversification of shares decreases the variability from unique risk but not from market risk.4 0.0% and the return on the market portfolio is 13.25 + 0.3 + 0.0 − 4. Activity 4. the company share returns on the y-axis and the proxy for the market returns over the same period on the x-axis).e.0% then the risk premium is 13. if the return on the risk-free asset is 4. The beta of a portfolio of shares is just an average of the betas of the individual shares in the portfolio. Worked example 4 Calculate the portfolio beta if you have invested 25% in ICI shares. Amazon. as illustrated below. 2. you should be able to plot the expected return against the beta.com and Exxon Mobil. if you are told that the return on treasury bills is 4% and the return on the market portfolio is 13%.25 × 1. 25% in British Airways shares and 50% in British Petroleum shares. You must remember that the risk-free treasury bills will have a zero beta and the fully diversified market portfolio will have a beta of one. therefore.0 = 9. Plot the observations (i. weighted by the investment in each share. 3.2.25 × 1. For example. Beta of the share will be the slope of the fitted line (usually calculated in practice using a technique known as regression analysis). usually monthly/weekly returns over a particular time period and also track the returns for a proxy of the market index such as the FT All Share Index over the same period. 39 .5 × 0.Chapter 4: Capital budgeting – risk and return Procedure for measuring real ’companies’ betas (in the UK): 1.8) = = 0. The bold line represents the security market line which shows the relationship between expected return and beta.0 and 0. Follow the rates of return for a particular UK company.1 At this point you may find it useful to go through how BMM calculate the betas for Turbot-Charged Seafood. Fit a line of best fit showing the average returns for the share at different market returns.

if you have a portfolio split evenly between risk-free assets (which offer an interest rate of 4%) and the market portfolio (which offers an expected return of 13%) the expected return for the portfolio will be: (0. Risk premium of an investment = β(rm – rf) You multiply (i) by beta as beta measures risk relative to the market on any asset. iii) Risk premium of an investment with beta of 0.5 and market risk premium of 9% = β(rm – rf) = 0.59 Financial management Figure 4.5 × 4%) = 8.5 × 13%) + (0.5 × 9% = 4. 40 .5% You can also calculate the expected return for this example more formally by using the following formulae: i. you will be able to calculate the expected return for any asset which has a beta between zero and one.5% Capital asset pricing model ri = rf + β(rm – rf) where: ri is the required rate of return on a particular investment i rf is the risk-free rate β is a measure of the extent to which investment i is affected by macroeconomic factors rm is the expected average return from investing in the market portfolio of shares. you will notice that given the expected return for riskfree treasury bills (zero beta asset) and the expected return for the market portfolio (unitary beta asset). Market risk premium = (rm – rf) = 13% − 4% = 9% ii.1 Plot of expected return against beta From this figure. For example.5% iv) Total expected return (r) = risk-free rate + risk premium of investment = rf + β(rm – rf) = 8.

9. you can expect to gain an extra return or risk premium. say 4%. if the interest on treasury bills is 4% and the market risk premium is 10% and the beta for Company Z shares is 0. expected rates of return for all securities and all portfolios lie on the security market line as illustrated above. Then discuss how the beta for a company may be calculated in practice.65 then the expected return on Company Z shares will be: Expected return = risk-free rate + (beta × market risk premium) = 4% + (0.87. Calculate whether the project is feasible if a. Worked example 5 Company Y has forecasted the cash flows on a project and estimate that the internally required rate of return on this project (internal rate of return) is 10%. the CAPM is only a model of risk and return. the CAPM does capture two simple but fundamental ideas useful to investment managers. For example. the beta is zero) b.4 c. First. Secondly. almost everyone agrees that investors require some extra return for taking on risk. The basic idea behind the CAPM is that investors expect a reward for waiting and taking on risk. the project is a sure thing (i. According to the CAPM.Chapter 4: Capital budgeting – risk and return This formula is commonly used to calculate expected returns and states the basic risk-return relationship called the Capital Asset Pricing Model or CAPM. the beta for company Y is 0.65 × 10%) = 10. The riskier the investment. Risk-free treasury bills offer a return of 4% and the expected risk premium is 7%.5% Activity 4.e. whereas if you invest in risky shares. 41 . CAPM is the theory of the relationship between risk and return which states that the expected risk premium on any share equals the share’s beta multiplied by the market risk premium. you require – the risk-free rate. say 9% for the increased risk you take on by investing in shares. if you invest in a risk-free asset. However. β = 2) then the risk premium is doubled. So if you invest in something twice as risky as the market (i. Remember. Therefore.e. investors are principally concerned with the market risk (the risk which they cannot diversify away). To calculate the returns that investors are expecting from particular shares. the greater the expected return.2 Calculate the expected return for a share if the risk-free rate of return is 8% and the market premium is 12% and the beta for the company share is 0. you just receive the rate of interest. the beta for company Y is 0. See VLE for solution Project returns and the opportunity cost of capital The opportunity cost of capital is the return that investors give up by investing in the project rather than in securities of equivalent risk. the expected market risk premium. and beta.

If the company has a zero beta then r = 4% + (0 × 7%) = 4% If the company has a beta of 0.9%? See VLE for solution c i Capital budgeting and project risk Long before the risk-return relationship was established financial managers realised that.59 Financial management Solution to Worked example 5 To answer this question you need to calculate the opportunity cost of capital. then the return is higher than investors can expect to get by investing in the capital market.3% Company Y would only consider the project if the beta was either zero or 0. When we are analysing whether a project is feasible the selection of an individual project beta (or individual area of business beta) will be preferred to the company’s cost of capital as the latter will be a weighted average of all project betas for the company (the average of the betas for all business areas).9 × 7%) = 10.3 Should the company accept a project (for the worked example above) if the beta for the project was (i) 7.4 × 7%) = 6.e. Thus if a company presently had assets with risk class β of 0. the security market line is a good indicator for project acceptance.7% or (iii) 8. risky projects were not as desirable as those which were considered to be safe projects. high-risk firms will have a higher company or asset cost of capital and they will therefore set a higher discount rate for their new investment opportunities.3% is more than 10%).8%. other things being equal.90 then the hurdle rate is 10.5%.9 then r = 4% + (0.30%. Activity 4. 0.8% If the company has a beta of 0.4 then r = 4% + (0. If the return on the project lies above the security market line. Therefore.4. Since investors will require a higher rate of return from a high-risk company than from a low-risk company. and thus would require a higher rate of return. but if faced with a new riskier area of business with β of 0. The corporate cost of capital is based on a portfolio of assets with individual beta’s β = ∑β ii. If the beta is 0. In this way the company cost of capital equated to the expected rate of return demanded by investors. The project cost of capital may differ from the company cost of capital as it will depend upon the use to which the company’s capital is put. (ii) 4. i.40 – the required return – the hurdle rate in the calculation below is 6.9 then company Y should not take on the project as the project is riskier than the internal rate of return required by the firm (i. In practice. 42 . the project cost of capital will depend upon the risk of the project and not upon the risk of the company’s existing business. which was determined by the average risk of the company’s assets and operations. Since we have already established in an earlier chapter that NPV is the best criterion for project selection we need to note in this question that the selected hurdle rate (cost of capital) is the relevant rate for a particular risk level.

Discuss whether. which projects have a higher cost of capital than the firm’s? b.2 Expected return 13% 12% 19% 18% a. 10 and 13. and the expected returns calculated by the way of IRR’s are as follows: Project A B C D Beta 0. 3. Share A had a beta of 0. according to the CAPM. the expected rate of return of a share with a beta less than zero would be more or less than the riskfree rate? Why would investors be willing to invest in such a security? 2. If the firm has a current single cost of capital as 16%. The risk free rate is 4% and the market return is 16%.313–16). 8 and 11 (pp.Chapter 4: Capital budgeting – risk and return A reminder of your learning outcomes By the end of this chapter and having completed the Essential reading and activities. numbers 5 and 8 • Chapter 10. pp. you should be able to: • calculate and interpret the risk associated with macroeconomic factors (market risk) for a share • compare the rate of return that investors demand and the market risk of a share • calculate the opportunity cost of capital for a project and be able to explain its relationship to the company cost of capital.260–61.8 0.5 and investors expect it will provide a return of 5 per cent. numbers 9. Use the CAPM to find the market risk premium and the expected rate of return on the market.6 1. 43 .5 and investors expect it to give a return of 13 per cent.231.5 1. Which projects should be accepted? See VLE for solutions Problems Attempt the following problems in BMM: • Numbers 1. Practise questions 1. Attempt the following problems in BMA: • Chapter 9. p. A firm is considering the following projects. Share B has a beta of 1.

59 Financial management Notes 44 .

you should be able to: • describe the nature and types of capital markets • explain the efficient market hypothesis. Atrill. 2005) Chapters 6 and 7. It considers the concept of an efficient capital market with its implications for the raising of capital and the assurances for a fair game situation for the transfer of funds between investors. Myers and A.Chapter 5: Sources of funds Chapter 5: Sources of funds Aims of the chapter The first part of this chapter introduces you to the theory and practice of capital markets. 15 and 16.8. (McGraw-Hill Inc. 2007) Chapters 6.g. Brealey.A. ..A. The former adds the necessary depth of required background knowledge to that provided in the latter text. its different levels. Learning outcomes By the end of this chapter. 13 and 14.1.J. The efficient market hypothesis has important implications for all market operators and their agents. and having completed the Essential reading and activities.C. (McGrawHill.2. 6. the anomalies and deviations between theory and practice as well as the ability to summarise the evidence that has been produced as support both for and against the hypothesis • explain the implications of market efficiency for the various operators who use the markets or provide information regarding them (e. P Financial Management for Decision makers. investors. Myers and F. 6. companies raising funds and financial analysts) • discuss how the financial markets operate particularly with respect to the provision of funds for companies • list/outline the range of securities used to generate funds for companies including a more in-depth insight of the main forms of debt and equity. 45 . S. Allen Principles of Corporate Finance. S.6–6. Implications. The types and the degrees of efficiency have been tested in many and various ways with more recent research findings highlighting certain anomalies which give support to those who have questioned the concept.C. benefits and costs of the alternative methods of funding and raising the funds are considered due to their importance to a company. Essential reading The chapters in PA and BMA are included as Essential reading here as well as those in BMM. Marcus Fundamentals of Corporate Finance. (FT Prentice Hall Europe. 2008) Chapters 14. Discrepancies in types and degrees of efficiency between different international markets also have been identified.. R. Brealey. as well as including details of the characteristics and costs of using them. R. The second part deals descriptively with the main methods of raising equity and debt funds.

CME does not require that the market is a perfect one in the sense that perfect markets are referred to by economists. means that one cannot consistently earn better-thanaverage investment returns as a result of studying past patterns of prices for particular securities. through their management. CME requires that the price at which that security is traded today rationally reflects all of the information which is available today. Note. thus people who draw charts of past share price movements. few people or institutions would be prepared to make investment funds available. and try to detect patterns of share price 46 . functions. Efficient market hypothesis There are three forms or levels of efficiency: weak. It is to this that the Efficient Market Hypothesis (EMH) relates. Thus this marketplace is providing the needed interface for investors to interact with the companies. See VLE for solution There are three types of efficiency: • allocational • pricing • operational The majority of the research findings in the literature when discussing efficiency are related to pricing efficiency. semi-strong and strong: • weak form.1 Write out the economists’ assumptions for a perfect market and corporate finance’s assumption for an efficient capital market. a description of the typical capital market found in most of the world’s developed countries. Neither does CME require that any investors have perfect knowledge of the future. without the facility to exit from an investment. Note that this latter function is a vitally important one because. with the advantage of information which may subsequently come to light. Show the links between the two lists. This description of London is. and a secondary one which provides the opportunity for the providers of funds to liquidate their investments. CME is concerned with the extent to which the knowledge which does exist about a particular security is fully taken account of in its market price. respectively. that wish to raise funds as well as other investors who may wish to buy or sell existing financial assets. Learn the assumptions underpinning the definition of a perfect capital market and how the economist’s perfect market becomes the financial manager’s efficient capital market and the sufficient conditions for that. Activity 5. Note carefully what is meant by capital market efficiency (CME). It is important to note how capital markets have two separate. but linked.59 Financial management Capital markets In Chapter 7 of PA and Chapter 16 of BMA these are examinations of the workings of the London Stock Market in the UK and the Securities and Exchange Commission (SEC) in the USA. be above or below the true worth of the security. in principle. use and understand how the notion of being involved in a fair game proves the basis for discussion here. These are a primary one for fund raising. Thus the price at which a security is traded today may.

Is your explanation drawn from the weak. This randomness could be seen as a market which is irrational. thus. if a market is efficient in the semi-strong form. over different time periods. In other words.2 Take a local paper which quotes daily share prices. however. tends to suggest that the world’s capital markets are efficient in the weak and semi-strong form. rather than following repeating patterns. semi-strong or strong form? It is important to understand that. By reading the paper about Monday’s market activities try to explain why the plot for Monday’s price is where it is. perhaps because they work for a particular business. Similarly. Activity 5. These distinctions are useful. for example serial correlation and run tests. would not gain as a result. Select a company and plot the closing share prices for the 5 days in one week with time on the x axis. sub-martingale. it must also be efficient in the semi-strong form and the weak form. The differences in results can be explained by many features – developed country markets versus developing country markets. 47 . bearing in mind that CME means that all information is reflected in share prices. So somehow. This is because evidence. The results have not been uniform in outcome. monthly versus daily versus weekly prices. upward versus downward price trends etc. which consists of the results of a large number of research studies. can expect to earn better than average investment returns. Tests have looked for data patterns that might have particular properties similar to different frequency distributions – random-walk. etc. simple sequences of increases or declines – all with the aim of being able to derive a trading rule which would enable the investor to out-perform the market using a simple buy and hold strategy. This correctly suggests that share prices move in an apparently random way. but not in the strong form.Chapter 5: Sources of funds movements. because the market is efficient. Draw a line of best fit through those five points. if a market is efficient in the strong form. You should be able to summarise the outcome of these tests which have used a variety of statistical techniques. Tests of the efficient market hypothesis Researchers have conducted the greatest number of tests on the weak form of the hypothesis. Since the emergence of new information will not follow a pattern. for example the published accounting reports of companies. would not be expected to be advantageous • strong form. The tests have been performed on numerous different markets. this has the effect that share prices follow an apparently ‘random walk’ • semi-strong form. those who have relevant information which is not generally known. people who have unpublished information. Then plot the next Monday’s closing price. on. above or below the trend line you have drawn. where better than average returns cannot be consistently earned by studying publicly available information about the enterprise. it must also be efficient in the weak form. where better than average returns cannot be earned as a result of having access to information which is not available to the public. would not expect to gain as a result. only relevant new information will affect them. it prevents people from consistently earning better-than-average returns. this study of public information.

The major implications are: • Accounting misinformation will not fool investors generally. even month of the year. fads. Again. There are numerous reasons why management wants financial information presented in a particular way (e. day of the week effect. so if shares look cheap it is illusory – all that will happen is that the investor will waste time and money seeking out the ‘cheap’ shares. size anomalies and small company effect). Anomalies.59 Financial management The tests on the semi-strong form have also been numerous and again produced results lacking in consistency. insider trading). 48 . The strong form tests have been least successful in their proof of the strong form of efficiency in the markets. then spend money on agents’ fees etc. this is provided that the facts concerning the alterations to the accounting bases are made public. • Investors are best advised to buy a portfolio of shares and to hold those shares rather than looking for opportunities to buy ‘cheap’ shares – this is because securities reliably reflect all known information about a business. to indicate that theory and practice are not quite in line.e. to figures published in annual accounts which have the effect of giving a changed view of the profit for a period or the assets on the balance sheet. • There is no need for the large body of analysts and others in the securities and investment industry. This is in spite of legislation in some countries in the markets outlawing particular operations (e. being caught for insider training etc.g. Results from developing market studies have been much fewer and have tended to suggest a lower degree of efficiency. These anomalies help to explain why the anecdotal evidence quoted by interested parties of abnormal profits can be explained. There is a body of evidence which suggests that attempts by corporate managers to make alterations to the accounting bases. to publicly available information). trading hours of the day effect. insider trading and doubts concerning efficiency There are now many published articles on the anomalies in the evidence investigated for proof of EMH (e. earn above average profits. to sell part of the existing portfolio and replace it with the ‘cheap’ shares. income smoothing because of the link with a management remuneration scheme).g.g. these implications are the reason why CME is included in the syllabus. and do. Clearly there are still circumstances that exist where investors under the strong form could. it is fair to say that there is sufficient anecdotal evidence of investor behaviour of following fads. Implications of capital market efficiency You should particularly note the implications of CME for financial managers. efficiently. However not everything may be made public and in any case some manipulation may be possible within the guidelines and thus not published. Reality is different due in part to human nature. The tests using data from developed country markets have tended to support the conclusion that the market adjusts quickly (i. will not affect the market price of the business’s shares. Even so there is not evidence of consistent above average gains accruing to groups of investors who have based their trading upon those results. Not surprisingly.

Market efficiency means that all known (strong form) or all publicly known (semi-strong form) information is rapidly and rationally reflected in security prices. Only where the businesses managers have economic information about the business. It seems that corporate managers are frequently concerned not to issue shares at a point where share prices are historically low. since in order for the issue to be successful the new issue would have to be at a low price. This is a very bad time for our business to make an issue of new shares to the public. ‘The stock market is depressed at the moment. Review question Critically comment on each of the following statements: a.’ Solution to review question a. As all relevant information relates to the future. this is irrational if current share prices reflect all that is known about the business.’ b. There is no reason to believe that share prices will rise again. Again anecdotal evidence can show in specific instances where during a particular short period businesses did lose out by having to issue at the wrong time. If the share issue is to be a rights issue. c. London capital market This is a generic title given to a considerable number of specific and specialist markets. the Alternative Investment Market (AIM). For efficiency to exist it is not necessary for all investors to have the relevant information. it means that all investors have complete information about all of the shares quoted in that market.’ c. fairly values it. 49 . Possibly it reflects the use of more sophisticated research techniques in recent studies. ‘The stock market cannot be semi-strong efficient. the International Stock Exchange of the UK and the Republic of Ireland. It includes such markets as the ISE. It certainly does not mean that what investors know is ‘correct’. A paradox of capital market efficiency is that it is as a result of people looking for inefficiencies and exploiting them that the market forces drive prices rationally. European Association of Security Dealers Automated Quotation (EASDAQ) and so on. which are leading to a truer view of things. simply for investors to have it between them. perhaps caused by an effective decline in the number of individual investors active in the market. Possibly the shift in research findings is reflecting a genuine lessening of CME over recent times.Chapter 5: Sources of funds • The timing of issues of new shares by businesses is not an important question. which says that the current price rationally reflects all information about the business and. This implies that the current issue price will make the existing shareholders worse off because the new shares will be sold for less than they are really worth. in any case. the issue price will not affect the wealth of the shareholders. This is inconsistent with efficient capital market theory. that they have yet to release into the public domain would delay be justified. it is not possible to know it for certain. b. Stock market efficiency does not mean what the quote says. therefore. otherwise you wouldn’t have all those well paid analysts spending most of their working day poring over business reports and other published information. ‘If stock market prices are efficient.

From a business viewpoint. a public issue entails greater risk as the public may not wish to subscribe for the shares offered. The method of issue could be an offer for sale or a public issue. it is a less popular method of raising equity finance. offers the shares to the general public whereas in the latter case a company will make a direct offer of its shares to the public. Note the distinction between an offer for sale and a public issue of shares. Such uncertainty may be due to such factors as stock market volatility or the unique nature of the business. In the former case. All the above methods of issue do not place restrictions upon the company as to whom it can offer the shares. many investors find it difficult to decide on an appropriate tender price and so prefer a fixed price share issue. Consequently. A rights issue offers existing shareholders the opportunity to participate in any new share issue and to maintain control of the business. which would use the tender approach to identify the striking price at which the issue would take place. 50 .3 Write out and learn the outline of the processes of the main exchange and the rationale and difficulties concerned with the other markets and their requirements. The advantages and disadvantages of this form of issue should be carefully noted. See VLE for solution Share capital Much of the content of the introductory sections concerning the characteristics of limited companies and the main forms of share capital have been dealt with in your earlier studies and so should be familiar to you. or overpricing. It is important to appreciate that a tender issue is not a method of issuing shares but rather a method of determining the price at which shares are issued.59 Financial management Activity 5. in turn. When dealing with the main forms of share capital you should note the decline in recent years of the popularity of preference shares and the likely reasons for this. A tender issue has distinct advantages for a business where uncertainty surrounds the appropriate price at which to price the shares. shares to be issued are sold to an issuing house which. A tender issue will help avoid underpricing the share. which means the business may experience an unsuccessful share issue. A company wishing to extend its share capital may wish to place restrictions and an example of how it can do it is by use of a rights issue. which means the investor will lose potential profits on the issue. Methods of raising share capital You must study carefully the various methods of raising share capital. However.

50) 2. The investor can take up the rights issue.50/6 = £1.50 £10.000 share investment prior to announcement of rights issue: 1. b. Calculate: i.e.000 @ £1. or let the rights offer lapse (i.560 The ordinary shares are currently being traded on the stock exchange at £1.000 ordinary shares in the company upon receipt of the one-for-five rights offer.200 @ £1.50 £0. do nothing). share prices and shareholder wealth It is also important to appreciate the effect of a rights issue on both share prices and shareholder wealth. sell the rights.800 51 . Identify and evaluate the options available to an investor holding 1.800 Take up rights issue (i.00 1.e.75 1. the price at which the rights are likely to be traded. acquires 200 more shares @ £1.Chapter 5: Sources of funds Rights issues.000 4. Worked example 6 Mulberry Chemicals plc has the following capital structure: £000 25p ordinary shares Share premium account Retained profit 15. the theoretical ex-rights price of a share ii.560 21. Required: a. Each of these options may be evaluated as follows: Value of original 1.25 b.80 = £1.80 each. At a recent board of directors’ meeting it was decided to undertake an ambitious expansion programme and to finance this with a one-for-five rights issue at £1. Solution to Worked example 6 a.000 2.100 300 £1. Study the worked example below. The theoretical ex-nights price is: £ 5 ordinary shares @£1.50) £ Value of investment following rights issue (1.50 Value of a single share following the rights 10.50 per share.75 The value of the rights may be calculated as follows £ Value of one share following the rights issue: Less cost of rights share Value of the rights 1.75) Less cost of acquiring rights shares (200 × £1.80 1 rights share 9.

4 Write a brief paragraph explaining the advantages and disadvantages of the different forms of equity.000 @ £1. It is. However. of financing in the text. 100.50 per share.25) Do nothing £ Value of investment following rights issue (1.59 Financial management Sell rights £ Value of investment following rights issue (1.000 @ £1.800 Thus. others made up of local groups of individuals with some money and expertise to offer who are called ‘business angels’. The efficiency and effectiveness of the market place for such funds depends very much on the quality of the network between such providers. both large and small gaps have been identified since it is much more difficult for them to raise risk capital when required. Allowing the rights offer to lapse will place the investor in a worse financial position than the other options.750 1. important to ensure the offer price is below the market price of the shares for the rights issue to be successful. With private companies. From the viewpoint of a business. for example. It is possible. You will find details of their aims. Other sources and types of equity You should be able to explain the difference between preference shares and ordinary shares along with the variety of each sort and the advantages and disadvantages for each. The providers of risk capital. the business may sell the rights on behalf of the investor and pass on the proceeds thereby putting the investor in the same financial position as if he had sold the rights. some funded by financial institutions like pension funds. Within the general title. given that a business wishes to raise a specific amount of money. the investor should be in the same financial position whether he sells the rights or takes up the rights issue. the smaller the needs and provisions the poorer it gets. See VLE for solution 52 . The larger and thus more public the company the easier it is to raise funds through the market.75) 1.75) Add sale of rights (200 × £0. However. Clearly the business wishes to issue as few shares as possible when raising its funds. venture capitalists.000 shares are issued @ £1. that fixed interest borrowing is no longer available because a company may have borrowed to their limit.000 shares are issued @ £3 per share or 200. so it will not tend to make a rights issue when the market is at a low. Similarly. needs. are known as venture capitalists. in theory. style etc. can be found various subgroups of fund providers.750 50 £1. but rather to do it in a buoyant share market. The value of the underlying assets held by the business and the proportion of those assets to which each shareholder has a claim will be the same. however. say. the price at which a rights issue is offered is important but not critical. so these smaller companies have to turn elsewhere. you should note the gaps in the capital market for providing equity funds. it is not really important whether. Activity 5. in practice.

interest on loan capital is viewed as an allowable business expense which can be offset against profits for taxation purposes – this is not the case for dividend payments. Moreover. • In the UK. The use of loan capital to finance a business. the returns to equity shareholders will increase providing the returns from the funds invested exceed the cost of servicing the loan. however. as capital gains are only normally taxed when the gain is realised. 53 .Chapter 5: Sources of funds Retained earnings A business may prefer to use retained earnings rather than a new issue of shares as a source of equity funds. Examples of these new types are junk bonds. These advantages include: • By employing loan capital to help finance the business. the investor has some control over the timing of their tax liability. However. mezzanine finance. also brings certain disadvantages: • The higher the level of borrowing the higher the level of financial risk associated with the business. • Loan capital is normally perceived as being less risky by investors than equity shares as loan interest is payable before share dividends and security is normally provided by the business for the loan – this lower level of risk results in lower expected returns by lender than equity shareholders. • New shares issues are usually subject to a great deal more scrutiny by investors and their advisers than profit retentions. This higher level of risk is likely to mean that equity shareholders will seek higher returns in compensation. interest-rate swaps and debt-equity swaps. deep discounted bonds. Interest must be paid irrespective of the profit level and capital must be repaid on maturity of the debt. The level of borrowing is also known as the amount of gearing. • The degree of sophistication and variety now available in bond or quasi-bond securities has grown enormously over the recent past through the increasing competitiveness within the financial markets. The issue of loan capital can bring certain advantages to a business and its shareholders. A policy of retention may also be preferred by investors. • There is no risk of failure to obtain the necessary funds or existing shareholders suffering some dilution of control. Some investors may prefer to receive returns from their shares in the fore of capital gains rather than dividends. • It is easier to secure funds in this way as retained profits will already be held by the business in some form or other. these characteristics are dealt with in rather more detail than before. Long-term debt finance The early sections in the readings describing the main characteristics of long-term debt should again be familiar to you as a result of your earlier studies. This policy would have the following advantages: • Issue costs and delays in receiving the new injection of funds are avoided.

g. However the level of borrowing. conversely in times of declining profits the higher the gearing the faster the decline in earnings per share. including the likely risks and returns arising from the equity option and the effect of the investment on the investors’ consumption pattern. • The existing level of gearing is fairly low for the particular business sector.) Most forms can be evaluated in similar ways to warrants and options. simplistically. • Adequate security for the debt exists. in growth and high profit periods it is better for the company to be highly geared.) which will restrict management’s freedom of action. which are covered in a later chapter. Existing lenders will be concerned that any new debt issued by the business does not undermine their status or increase the level of risk borne. there can be occasions when the returns on loan capital are higher than those on equity capital. The higher the gearing the greater the gains in earnings for shareholders in times of increasing profits.59 Financial management • The business may also be required to accept loan covenants as part of the loan agreement (e. it is better to be low geared in low profit or declining profit periods. gearing.) 54 . The issue of loan capital Long-term debt is likely to be issued by a business where some of the following conditions prevail: • Earnings are relatively stable over time or on an increasing trend.(See BMA Chapter 15 or PA Chapter 7. • There is a risk of a change in the pattern of control from the issue of new equity shares. The attitude of existing equity shareholders is likely to be influenced by: • the perceived benefits and costs of gearing (the mix of debt and equity) • the potential problem of dilution of control through a reduction in the proportion of voting equity held • financial implications of additional calls for funds. seeking permission from existing lenders before raising new loan capital etc. Hybrid capital A clear distinction between share and loan capital is not always possible and so you should cover carefully the sections on the major forms of hybrids in order to understand their characteristics and objectives. will also be influenced by the company’s profitability and the present and future underlying economic conditions. Thus. (Often their position will be protected by restricting loan covenants and so permission may have to be sought before the business can issue a new class of debtor. The attitude of investors and managers to the financing decision When new finance is sought from the issue of either long-term debt or equity shares the views of existing investors and the management of the business are important. • Although interest rates are generally lower than equity returns. maintaining a certain level of liquidity.

55 . (e. p. Practise questions 1.368 number 8. investors.386 numbers 15 and 17. its different levels. A reminder of your learning outcomes By the end of this chapter. numbers 7 and 8. Discuss reasons why.g. you should be able to: • describe the nature and types of capital markets • explain the efficient market hypothesis.406. the stock markets of the world will never achieve the ‘strong form’ of the efficient market hypothesis.433. in your view.Chapter 5: Sources of funds Managers are employed to act in the best interests of the shareholders although they may feel that a high level of gearing increases their own level of risk. p. They may be more willing to take on higher levels of gearing where their remuneration is linked closely to profits generated.171.381–82. the anomalies and deviations between theory and practice as well as the ability to summarise the evidence that has been produced as support both for and against the hypothesis • explain the implications of market efficiency for the various operators who use the markets or provide information regarding them. and having completed the Essential reading and activities. p. number 8. companies raising funds and financial analysts) • discuss how the financial markets operate particularly with respect to the provision of funds for companies • list/outline the range of securities used to generate funds for companies including a more in-depth insight of the main forms of debt and equity. number 10. See VLE for solution Problems Attempt the following problems in BMM • p. Attempt the following problems in BMA • pp. p. number 9 and 19.

59 Financial management Notes 56 .

Myers and F. R.. Investments will only be made when it can be shown that they will at least overcome the hurdle of achieving the cost of capital. Allen Principles of Corporate Finance. Atrill. As the level of gearing varies. the cost of the funds injected. (McGraw-Hill Inc. 12 and 15. R. each with their individual cost and quantity. 2007) Chapters 5. This cost of capital comes from the particular combination of funds and their costs. Further reading Brealey. (FT Prentice Hall Europe.Chapter 6: Cost of capital and valuation of a business Chapter 6: Cost of capital and valuation of a business Aims of the chapter In this chapter we start by investigating the costs of the main capital components. both in theory and practice. P Financial Management for Decision makers. (McGrawHill. 2008) Chapters 4. We show the various models suggested to derive these costs. equity and business valuations • explain the influence of gearing on capital structure both in a conceptual framework and in applications such as raising new capital • derive and calculate the weighted cost of capital for a company • compute the valuation of a business • provide a reasoned evaluation of the best way a company should raise new capital.A. It is a weighted average cost because the total funds have a number of different types of funds.C.J. . 18 and 20. 9. Gearing is the name given to the degree or level of debt used in the total capital of a firm. 11. 10.C. 6. it will influence a company’s average cost of capital and so this will be discussed for its implications. debt and equity. Money raised from these different sources is then invested by the company and its managers to obtain maximum return. S. So this chapter covers the rationale and derivation of a company’s cost of capital. Marcus Fundamentals of Corporate Finance. The valuation models described and discussed relate to activities of investors and managers in the market place. Learning outcomes By the end of this chapter. you should be able to: • calculate the value of debt and equity and their respective costs using alternative approaches • describe and give an evaluation of the strengths and weaknesses of the different approaches to the derivation of the estimation of debt. Approaches to valuing shares and business from a practical viewpoint will be covered since they will be dependent upon the theories which can provide guidance for a company’s financing methods and costs. S. 5. Myers and A. Essential reading Brealey. and having completed the Essential reading and activities. 2005) Chapter 8. 57 ..A.

59 Financial management The value of economic assets – debt The value of an economic asset is determined by the economic benefits which are expected to be generated by that asset. and cost of debt Kd the present value of the cash flows L0 is given below: This is the discounted cash flow the lender will receive over the outstanding life of the loan. Introducing taxation adds minor complications to the formula. Kd. The maturity value M is usually the same as the nominal value. So using Kd = £ 99. the yield to maturity and cost of debt. partially or completely. for sentimental reasons. The corporation tax rate is 33%. Required: What is the cost of the perpetual loan stock? Using this cost calculate what the market value of the second type should be Solution to Worked example 7 = 5. annual interest payment of it. At the end of the maturity period the nominal value of £100 will be repaid. will exceed the nominal interest rate it /100 when the present price of the loan L0 is less than the nominal value of the loan. The first type is a perpetual loan stock and is quoted at £93 per £100 nominal value. a share in a business has value only because it is expected to generate future economic benefits. The second type has the same yield (cost) and interest rate but is quoted at a different market price because it only has a two-year life. to the typical shareholder. This contrasts with an asset that has value. ultimately in the form of cash. The interest rate for each type (based on the nominal value) is 7.e. they are not scheduled to be redeemed). Assuming a loan with market value today of L0. or debt. Thus an economic asset is something that has value to the owner only because it is expected to generate economic benefits.5% per annum. Where this is not the case the redemption cash flow must also be taken into account. will be the present value of a combination of the interest payments and capital repayment(s). a term of years n.31 58 . repayment at maturity of M. Worked example 7 Solo plc has some loan stocks which are quoted at rates per £100 nominal value. There is no capital gains tax. Therefore the market value of a debenture.4% This example considers loan stocks which are ‘perpetual’ (i. Thus.

the value of a share will be a function of the expected future economic benefits (dividends) from owning it. and Ke is the required rate of return. This is known as the Gordon Dividend model. year two because the benefit will not occur until two years later. the prospective dividend yield plus the predicted capital growth in share price. D2 etc. are the dividends which will be received in respect of the share after one year. Learn it and its strengths and weaknesses. Logically. 59 . It is a simple way deriving a company’s cost of equity. Though each of these approaches can be criticised as being oversimplifications in real life. Required: Calculate the value of an ordinary share in Apex plc. Another is to assume a constant growth rate. it is the opportunity cost of finance to the shareholder).25 per share. It will also be a function of the required rate of return from owning the share. in real life. Obviously. One solution is to assume that dividends will remain constant at the current level. Given the level of interest rates in the economy and the risk associated with the dividends investors require a return of 17% per annum. estimating the dividend which will be paid on the shares in future years is problematic. a. assuming a constant level of dividends. they do provide helpful starting points in the valuation process. Thus: (This assumes dividends are payable annually and that the current year’s dividend has already been paid and the company continues forever so t equals infinity).e. Thus the dividend for year four is more heavily discounted than that of. assuming a constant level of growth of dividends of 6% per annum. Worked example 8 Apex plc has just paid a dividend for this year on its ordinary shares. say.Chapter 6: Cost of capital and valuation of a business The value of economic assets – equity Likewise. the value (P0) of a share at any particular point in time is the sum of the discounted values of expected future dividends. named after the author who derived it many years ago. This in turn will depend upon the levels of return available from investments in the same risk class (i. Where a constant level of dividends is envisaged: Where a constant rate of increase in the size of dividend of g is envisaged: By rearrangement of this equation we get which is the equity cost of capital. where Dl. Next year’s dividend is expected to be £0. and b. two years etc.

The basic tenet of MPT is that it is easy and cheap to avoid much of the risk of investing in shares. part of the risk of share ownership which cannot be diversified away. however. Thus: Total risk of investing in a particular share equals specific risk (diversifiable) plus systematic risk (undiversifiable). This is because this part of the risk relates to factors which affect all businesses and their returns.06) = £2.17 − 0. Assuming a constant rate of increase in the size of dividend: P0 = D1/(Ke − g) = £0. Assuming a constant level of dividends: P0 = D1/ Ke = £0. It is caused by macroeconomic factors like changes in interest rates. investors will not be able to obtain a risk premium for bearing this part of the risk. In other words it is that which the investor could earn from a similar investment. in real life.59 Financial management Solution to Worked example 8 a. 60 . This is simply achieved by not putting all of your eggs in one basket. changes in fuel prices etc. we find that the shares of businesses which are seen as having good growth prospects are valued more highly compared with those whose future is seen as more static. So. There is. Thus: The required return equals a risk free rate of interest (perhaps the return from UK government short term securities) plus a risk premium (related to the level of risk associated with the particular investment). Consequently. Both BMM and BMA give good descriptions of the theory and derivation of the debt and equity valuation models which are based on the application of the NPV concept.25/(0. This explains why. This part of the risk is known as systematic or market risk.25/17% = £1. the investor needs to be compensated for having the money tied up (delaying consumption) and for bearing the risk.47 b. this should be the opportunity cost of finance.27 Note how much more valuable a share is when it is expected that the annual dividend will increase each year. which is known as specific (or unsystematic) risk. By ‘similar’ is meant over the same time scale and with a similar level of risk. The required return on investment A question which needs to be addressed is how do we select the required rate of return from a share? As has already been said. By holding a portfolio of investments comprising shares in different businesses in different industries it is possible to diversify away quite a lot of the risk. There is a model for deducing the appropriate risk premium which is based on modern portfolio theory (MPT).

61 . F2 etc. This risk premium relates to the extent to which the particular share concerned is affected by the macroeconomic factors associated with systematic risk. βi Rm The second term on the right hand side of CAPM is the average risk premium for all shares (Rm – Rf). Thus some of the increase in the assets to which the profit gave rise typically remains in the business and is reinvested or ‘ploughed back’. and F1. Empirical testing of this model is still ongoing. The formal statement of the relationship between the required rate of return from a share and the level of risk is given by CAPM.) This model like all others has its weaknesses. The cost of retained earnings It is normal practice for businesses to pay dividends of an amount less than their after tax earnings for the year. and e is the random unexplained unrelated element in the return of the (i)th security. The capital asset pricing model (CAPM) This has been dealt with earlier. It argues that return is linearly related to a number of risk factors for which factor indices can be found and used and thus give a truer relationship. This is not true. Ri = Rf + β1F1 + ß2F2 + … + e where Rf is the riskless rate. There are no solid results yet proving or disproving this theory. the shareholders would obviously have more cash than if part of the profit is retained. which you should learn. and is only included here as a refresher and introduction to the capital asset pricing model which will be used to derive a company’s cost of equity. the cost to the shareholders of their money being reinvested by the business is the same as the original investment.the sensitivity of the share’s return to those factors. β2 etc. is cost free to the business. in Chapter 3. Logically. It is tempting to believe that this source of finance costs the shareholder nothing and.are the indices for the various risk factors influencing the return with β1. (In the previous section we used Ke for cost of equity. this is: Ri = Rf + βi (Rm – Rf) where: Ri Rf is the required rate of return on a particular investment (i) is the risk-free rate of interest is the measure of the extent to which the investment i is affected by macroeconomic factors which cause systematic risk is the expected average return from investing in shares generally. It has a potential successor which is called the Arbitrage Pricing Model (APM). multiplied by the risk factor (βi ) of the particular share (i) concerned. Were all of the profits paid to shareholders by way of dividend. its equivalent in the CAPM model above is Ri which can be replaced by Ke in that equation when estimating a company’s cost of equity.Chapter 6: Cost of capital and valuation of a business The part of the risk which cannot be diversified away requires a risk premium to compensate investors for bearing it. βs for most businesses which are traded on the International Stock Exchange are published and are readily available. The same level of interest rates and risk apply to the reinvested profits as apply to the original investment. therefore. however.

In theory the value of a warrant in the market is (P0 − E) N. It is not necessary to learn the various formulae needed in order to derive a warrants price since risk has to be incorporated. preference shares) the risk is much greater. What is important is to learn the main conceptual approach to valuing the different types of capital. incentives to help induce lenders make the loan to the company. Raising equity can be achieved when the warrant is taken up by its holder at the due date. 10% less tax at 33%). present value of the cost of exercising the warrant at the end of its life. assuming a Corporation tax rate of 33%. So a loan with an interest rate of 10% per annum would cost only 6. where P0 is the market price of the ordinary share today. where the business is well established in a stable industry and the finance is secured on a quality asset) the risk is very small indeed.1 Describe and evaluate various methods of calculating the costs of debt and equity.g. In such cases the business would not need to offer much above the rate of interest currently available on government securities. E is the exercise price of the warrant and N the number of shares each warrant allows the holder to buy. and therefore to shareholders.e. 62 .7% (i. whereas the reward of shareholders (i. The thrust of the model is: M0 − Pw = VD + Vw where M0 Pw VD Vw price of share(s) today for which the warrant can be exchanged price of the warrant today present value of the-after-tax dividends receivable over remaining life of warrant. Since providers of fixed return capital are not exposed to as much risk as are the equity holders. but it is still likely to be significantly less than the ordinary shares of the same business. The expectation is that the share price will rise and be well above the exercise price on that future date. See VLE for solution Valuation of warrants A warrant is a right to purchase a given number of shares. This means that the net cost to the business. at a stated price on a given date(s) in the future. is the amount of interest less the tax rate. All of this means that fixed return capital is relatively cheap and this is its attraction. is cost. in the present context. Explain with reasons the differences between the types of costs and between the different methods of computation. profit) is fully taxed.59 Financial management Activity 6. A further reason for the cheapness of most forms of fixed return capital is the fact that interest payments are tax deductible. they are prepared to accept relatively low returns. In other cases (e. The reasons for capital gearing What distinguishes fixed return capital from equity capital. In some cases (e.e. Since there may be some considerable time between the present day and the exercise date then a more sophisticated model is necessary to value a warrant.g. Generally warrants are issued as sweeteners.

These higher levels of return demanded by ordinary shareholders are not sufficient. Though not shown in the example it is possible that the markets perception of the differences in financial risk may produce different Price Earnings ratios (PE ratio) at different levels. gearing up to moderate levels would be beneficial. The greater the level of capital gearing (i. Since ordinary shareholders do not know for certain. At high levels of profit the benefits to the shareholders are good. This increased uncertainty will make the ordinary shareholders place less value on their shares than they otherwise would. as the level of capital gearing increases. If you examine Tables 15. As the level of gearing increases. This is because of the increasing proportion of the significantly cheaper fixed return finance. The obligation to make fixed interest payments exposes the shareholders to increased risk. WACC falls. Note also in Table 15. as a consequence. however. This would have a beneficial effect on the shareholders because the lower the WACC.398–9 of BMM you will see this point clearly illustrated. however.11 on p. from the shareholder’s point of view. Thus the expectation would be that the net effect of capital gearing would be beneficial to ordinary shareholders.E. the greater the risk to which the ordinary shareholders are exposed. whether the effect of capital gearing will be beneficial or detrimental is not certain. The traditional view is illustrated in Figure 8. to outweigh the advantage of the much cheaper fixed return capital. The relationship between the level of capital gearing and the cost of capital – the traditional view The view of capital gearing that broadly prevailed until 1958 was that there were clear benefits to the ordinary shareholders because the weighted average cost of capital (WACC) would tend to fall as the capital gearing level was increased.2 and 15. the ordinary shareholders perceive a higher level of risk and. It is not necessarily quite as good as it seems.335 of PA or Figure 15. too good to be true.3 on pp. the effect of alterations in the level of (pre-interest) operating profit is multiplied. anticipated under each financing alternative. where the business is earning a rate of return on its assets which is greater than the cost of the fixed return finance.6 of BMM. at lower levels of gearing.2 Work through the review question at the end of this chapter. Where the return on assets is below the cost of the fixed return finance ordinary shareholders suffer. Activity 6. what level of profits will be earned in future. At low levels of profit the shareholder’s returns are hit heavily by the need to make interest payments. Since increases in the value of the business accrue to the ordinary shareholders. at least up to moderate levels of capital gearing. the higher the proportion of total finance which is raised from fixed return sources). Naturally. Essentially. A problem with capital gearing is risk. Multiplying the EPS’s by the P ratios will give the possible share price . gearing is beneficial to shareholders. This shows that. At 63 .e. the more the business would be worth.Chapter 6: Cost of capital and valuation of a business Capital gearing and risk On the face of it capital gearing seems. no business will raise fixed return finance at a cost which is above the estimated future rate of return on the business’s assets. require higher returns to compensate for this.3 that the level of cover for interest payments becomes less at higher levels of gearing. When there is capital gearing.

may not fetch this value if they have to be sold piecemeal. and other costs of selling off the business’s assets to meet financial obligations. relates to the effective cost to the ordinary shareholders of the business getting into financial distress (going into liquidation).13 on p. the ordinary shareholders will start to see their returns as being more and more risky and they will require much higher returns. that it is illogical to argue that the value of a business is related to how that business is financed. at high levels of gearing. Another of the MM assumptions. seriously flaws the MM logic. these will not alter with the method of financing. the value of the business as a result of this tax deductibility. however.59 Financial management higher levels. In 1963 MM dropped their no-taxes assumption and concluded that the higher the level of capital gearing. however. The MM analysis was based on several assumptions. the lower the WACC and the higher the value of the business and of each ordinary share. The relationships are shown graphically in Figure 8. One of them. The relationship between the level of capital gearing and the cost of capital – the Modigliani and Miller view Modigliani and Miller (MM). The problem with financial distress is that it costs money. The higher the level of gearing. This means that there is significant effect on the business’s net cash flows and. with the support of some rigorous analysis.337 of PA. whose lack of reality could seriously call their conclusion into question. place in jeopardy the business’s ability to meet all of these obligations. Thus WACC will initially decline as the gearing level is increased. published a paper in 1958 which fundamentally challenged the traditional view. The value of the business is based on the future cash flows which are expected to be generated by that business’s operations. would be incurred. Similarly. as gearing levels increase. who both went on to win Nobel prizes. At some level of gearing it will reach a minimum value after which it will increase again. Thus: 64 . therefore. the higher the probability of financial collapse. the likelihood of it being unable to meet its contractual financial commitments is increased. the providers of the fixed return finance start to perceive an increase in the riskiness of their own returns. There is therefore an ‘optimal’ level of gearing at which WACC is at a minimum and the value of the business (and each ordinary share) is at a maximum. two US economists. There is also the cost that assets which may have a particular value to the business. because the demands of the ordinary shareholders will precisely counteract the effect of the cheaper fixed return finance. but they argued that introducing fixed return finance into the business’s capital structure will not lower WACC. It is quite reasonable to argue that the lack of reality of most of the assumptions does not seriously undermine the broad conclusions of MM. This is because legal fees. Thus the business will only be able to raise more fixed return capital by offering increasingly higher rates of interest and preference dividend. MM argued. The higher amount of interest and preference share dividend that the business is committed to paying will. At some point the increased requirements of both groups of providers of finance will drive up WACC. the assumption of no taxes. Thus the cost of capital is independent of the level of gearing. If a business has capital gearing. This is because loan interest is tax deductible. most of which do not strictly hold in real life. MM conceded that fixed return finance is cheaper than equity finance because it is less risky.

from a valuation point of view. Show how the relaxation of the assumptions affects the propositions. WACC is often used as the yardstick by which the business’s own investments are judged. A review question which utilises the MM theories is given in Chapter 12. market values. whether we base the valuation on 65 . Activity 6. See VLE for solution Weighted average cost of capital (WACC) The overall cost of capital for the business is the average for the various sources. in theory. past or present weights. Learn the different approaches to the weights used in the formula. to give the asset or project beta risk for the company as a whole. It can be written as Ka – the after-tax weighted average cost of capital: where Ke and Kd are the costs of equity and debt respectively. Thus. Ensure that you are able to discuss why. average or marginal or target debt/equity levels. the corporate tax rate. weighted according to each one’s importance to the business. Similarly. if a business pays out all of its profits as dividend this should lead to a constant dividend each year. thanks to agency costs and a pecking order theory.3 Describe the assumptions underpinning MM’s original propositions concerning a company’s cost of capital. Assuming that the rate of return on the investment is constant. If the business retains a fixed proportion of each year’s profit for reinvestment (broadly what seems to happen in real life) then dividends will grow by a steady rate each year. Valuation on the basis of the business’s earnings In principle it should not matter whether a business pays out all of its earnings as dividend. It is shown thus: β a = βe Ve + Vd Ve + βd (Ve + Vd) Vd Remember too that the corporate asset beta just so defined is also the weighted average of the individual project betas of the investments being undertaken by the company at the time. book values.Chapter 6: Cost of capital and valuation of a business the value of the geared business equals the value of the equivalent ungeared business plus the value of the tax advantage minus the value of the cost of financial distress. found from empirical study. management may not be found to fully follow a target debt/equity approach in spite of the arguments in its favour. Ve and Vd the market values of equity and debt respectively and tc. we must remember to combine the weighted β’s of equity and debt.

in theory. In theory all valuation methods. Another possibility is to value each of the businesses assets and deduct the amounts owed to creditors to deduce the net value of the business.e. So from whatever valuation method we use we can work back. correctly applied. amounts falling due after more than one year Long term loan 74 53 21 108 32 76 Capital and reserves Called up share capital – 160 million ordinary shares of £0. Share valuation is very difficult and is completely surrounded by the need to make assumptions about various aspects of the future. One of the assets might be goodwill (i. In practice this is unlikely to occur. Other approaches to share and business valuation There are various other approaches to valuing shares. lead to a different value being placed on the shares. or whole businesses and also deriving the resultant cost of equity. and derive a company’s cost of equity. Review question – selection of a source of capital Bycraft plc. the asset which arises from the expectation that the business will earn higher than ‘normal’ profits in future). The value of a company’s equity and its cost are intertwined. should give the same result. a business whose most recent published accounts are summarised as follows: Balance sheet as at 31 August 2007 £ million Fixed assets Current assets Less: creditors. amounts falling due within one year Net current assets Total assets less current liabilities Creditors. These approaches include estimating the future cash flow which the business will generate from its commercial activities and discounting these to arrive at their net present value.59 Financial management dividends or on earnings should not. if necessary. By ‘normal’ is meant the level of profits which the average business in the same line of business might be expected to earn.25 each Profit and loss account balance 40 36 76 Profit and loss account for the year ended 31 August 2007 £ Turnover Profit on ordinary activities before taxation Taxation on profit on ordinary activities Profit on ordinary activities after taxation Dividends paid Retained profit 66 £ million 87 143 24 6 18 9 9 .

The real world may be different. at a price of £0. Required: a. before interest and tax. only the tax gain will benefit shareholders. c. Future levels of profit are expected to remain at the 2007 level and corporation tax is expected to be levied at the rate of 25% of the profit after interest.0 10. Alternatively.50 per share.4 22.0 4. starting in the year ending 31 August 2008. will exactly cancel the effect of the lower cost of debt.106 The EPS is higher for the debt financing option. According to Modigliani and Miller.2 £0. Deduce the level of total profit. sufficient to raise the £40 million.0 34.5/240) Debt finance option £ million Existing profit before tax Additional profit Less: Interest Corporation tax @ 25% Profit after tax Earnings per share (22. This would require an immediate cash outlay of £40 million.4 29. This is due to the tax relief on the interest and the lower cost of debt relative to equity due to lower risk. by £10 million each year. The increased risk caused by increasing the capital gearing. b. This could be done by making a rights issue.2/160) 24. The expansion programme is expected to generate increased profit.5 160 80 240 £0.0 8. State what factors should the directors take into account regarding the choice between the two financing options? Solution to review question a.0 34. before interest and tax.Chapter 6: Cost of capital and valuation of a business The directors are keen to undertake an expansion programme for the business.0 10. Compute the earnings per share figures for 2008 under each of the two financing options and comment on reasons for the difference between the two EPS figures.6 7. at which the earnings per share figure is the same under each of the two financing options. 67 .5 25. Equity finance option £ million Existing profit before tax Additional profit Corporation tax @ 25% Profit after tax Existing shares (millions) Rights issue (£40 million/£0.138 24. the business could borrow the money at an annual interest rate of 11%.50) New total (millions) Earnings per share (25.

68 .4 5.) caused by debt financing.3 You have found a business. Advance Corporation Tax is 20/80 of the dividends paid.0 1.50 each Revaluation reserve Profit and loss account balance 5.1 2.25) 160 million £13. amounts falling due within one year Net current assets Total assets less current liabilities Creditors.7 Profit and loss account for the year ended 30 September 2007 £ million Turnover Profit on ordinary activities before taxation Taxation on profit on ordinary activities Profit on ordinary activities after taxation Dividends paid Retained profit 31. amounts falling due after more than one year Long term loan Capital and reserves Called up share capital – 10 million ordinary shares of £0. similar to Allemby Ltd in terms of type of activity.4)(1 − 0.2 million c.6.2 5. This business has a dividend yield of 3.2 11.25) 240 million p = = = EPS debt option (p − 4. whose most recent published accounts are summarised as follows: Balance sheet as at 30 September 2007 £ million Fixed assets Current assets: Less: creditors.59 Financial management b.7 11.5 1.6 1.7 15.7 3. which is quoted on the Stock Exchange.3 10.1 1.4 £ 12.5 5.1 17. rating of the company current and future interest rates returns on equity expected by the shareholders effects on share price restrictions (covenants etc. Let p be the profit at equal EPS EPS equity option p(1 − 0. Review question – valuation of a share and/or business Allemby Ltd is a small unquoted company.89% and a price earnings ratio of 21.E. The main factors which should be considered in making the choice of financing include: • • • • • • • • • the volatility and growth pattern predicted for the business’s earnings the rate and certainty of corporation tax potential liquidation cost attitudes of the shareholders and directors to risk possible market changes to P.

Chapter 6: Cost of capital and valuation of a business

Required: Calculate the price of Allemby Ltd’s shares on each of the following bases: • earnings yield • dividend yield • net assets. What reservations would you have about the quality of each of these valuations? Solution to review question Earnings yield approach (Using data from comparable company combined with Allenby’s data.) EPS of Allemby Ltd = £2.5m/10m = £0.25 per share. PE ratio of the other business is 21.6 therefore the price per share of Allemby Ltd is estimated at 21.6 × £0.25 = £5.40. The problems with this basis of valuation include: • How appropriate is the other business for valuation purposes – how similar is it to Allemby Ltd? It might be better to use the average for a range of businesses rather than base the valuation on just one quoted busines Particular differences between the two businesses which may cause problems relate to capital gearing and the tax positions. • How typical of Allemby Ltd are the 2007 profits? It may well be inappropriate to base the valuation on just one year’s profit. Values are based on expected future events, not the past, in any case. • The lack of marketability of unquoted shares tends to make them less valuable than those of their quoted counterparts. Dividend yield approach Dividend (gross) per share of Allemby Ltd = (£1.1m × 100/80)/10m = £0.1375 per share. DY of the other business is 3.89%, therefore the price per share of Allemby Ltd is £0.1375/0.0389 = £3.53. The problems with this basis of valuation include: • As with the earnings yield method, how appropriate is the other business data for valuation purposes? An obvious area of dissimilarity might be the dividend policy of the other business. • How typical of Allemby Ltd is the 2007 dividend? Future dividends should, in any case, be the basis of the valuation. • To what extent are dividends the determinants of value? There is more than one school of thought on this point. • The lack of marketability of unquoted shares tends to make them less valuable than those of their quoted counterparts. Net assets approach According to the balance sheet, the net assets stand at £11.7m or £1.17 (i.e. £11.7m/ 10m) per share. This is completely out of line with the other two valuations. Apart from the weaknesses of those valuation bases, the following points are relevant: • Balance sheet values are not the same, nor are they intended to be the same, as market values. Broadly speaking fixed assets are valued at cost, less an allowance for depreciation where relevant; current assets tend to be valued at the lower of cost and net realisable value. This tends to mean that balance sheet values understate assets relative to their economic value.
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59 Financial management

• The existence of a revaluation reserve implies that the business has not strictly followed the normal rule for valuing fixed assets in the balance sheet. • It appears that the assets are undervalued relative to their economic value or that goodwill exists but does not appear on the balance sheet. This point is based on the fact that the business made a pre tax return on book capital of 31% (i.e. £3.6m/11.7m × 100) in 2007 – this is a very high return.

A reminder of your learning outcomes
By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • calculate the value of debt and equity and their respective costs using alternative approaches • describe and give an evaluation of the strengths and weaknesses of the different approaches to the derivation of the estimation of debt, equity and business valuations • explain the influence of gearing on capital structure both in a conceptual framework and in applications such as raising new capital • derive and calculate the weighted cost of capital for a company • compute the valuation of a business • provide a reasoned evaluation of the best way a company should raise new capital.

Practise questions
1. Berks plc has been told by its bankers that it has reached its overdraft limit of £100million and that it would be a good time to go to the long term capital market and raise funds. The bank suggested that £210million be raised by one of two methods, either by a 15year debenture which could cost £18million interest (gross) per annum, or by a rights issue @£1.50 per share in proportion of 7 to 15 shares. Berks plc recently published its last Balance Sheet which is: £million Non-Current Assets Current Assets Less Current Liabilities* Represented by Ordinary Share Capital (200 million £/shares) Retained Earnings 200 250 450 * Where Current Liabilities include bank overdraft of £100million. Note this would be repaid out of the £210million raised. Post balance sheet publication, but prior to raising of any long-term capital, the Company announced a 1 for 2 bonus issue of ordinary shares. The founding family of Berks still own 60% of the equity and wish to remain the majority shareholding group. The company’s profit after interest but before tax for the past year amounted to £140million. The corporate tax rate is 50%. 300 250 50 450 400

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Chapter 6: Cost of capital and valuation of a business

If £210million is raised by either of the two methods it is predicted that the net profit, before charging any interest on loans or debentures, for the next three years will be £186million, £130million and £210million respectively. If the rights issue method is used the Price Earnings (PE) ratio will remain as it is at 10x, but if funds are raised by long term debentures, the PE ratio will fall to 9x. If the total debt to total assets ratio rises to above 50% then the P .E. ratio will be reduced by a further unit. REQUIRED a. For each of the two capital raising methods, provide a table that shows what the company’s share price will be for the next three years, assuming the issue of shares or debentures is successful. Show what the balance sheet of the company will be like under each method after the capital raising. (14 marks) b. What is the minimum number of shares the family must subscribe for under a rights issue in order to retain their voting majority? (2 marks) c. Calculate the amount of net profit before interest expense and taxation for the shareholders to be equally well off under either method. (4 marks) d. Write a short report to the family shareholders giving your views and recommendations for the raising of the £210million. (5 marks) 2. Describe and discuss what considerations have to be taken into account when selecting the next installment of finance a company is considering to undertake. See VLE for solution

Problems
Attempt the following problems in BMM: • Chapter 5, numbers 4 and 5; Chapter 6, number 4; Chapter 12, numbers 2 and 11. Attempt the following problems in BMA: • p.80, numbers 2 and 4; p.109 numbers 5 and 6; pp.491–93, numbers 1, 2 and 8; pp.554–55, numbers 1 and 7.

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59 Financial management Notes 72 .

2007) Chapter 16. such as what is and whether to pay non-cash dividends are covered. 2008) Chapter 17.C. It starts by mentioning the irrelevancy argument before discussing and describing other theories such as the traditionalist approach. Some practical aspects concerning the determination of the policy in practice. We will present opposing views on the effects of dividend policy on the valuation of shares and discuss the significance of the traditional view of dividends. (McGraw-Hill Inc. and having completed the Essential reading and activities. We also consider alternatives to dividend payments which a business might consider.J. P Financial Management for Decision makers. . Essential reading Brealey. the information content of dividends.C. Atrill.A. Dividend policy has been the source of some controversy over the years.Chapter 7: Dividend policy Chapter 7: Dividend policy Aims of the chapter Corporate dividend policy or how companies can provide a return to share holders by way of a cash distribution or other means is one of the more important financial decisions management has to make. The general intention of this chapter is to provide an in-depth discussion on the controversial question of how dividend policy affects firm value. 2005) Chapter 9 Introduction In Chapter 16 of BMM you will be exposed to the theory and practices associated with corporate dividend policy. R. Further reading Brealey. S. 73 . It also addresses informational aspects concerning dividend payments and potential clientele effects and how dividend payments are set in practice. Myers and F.. Marcus Fundamentals of Corporate Finance. Myers and A.. (McGrawHill. Non-cash dividends would include scrip dividends and share repurchases. you should be able to: • explain how companies decide on dividend payments • describe and critique the theory and practice of corporate dividend policy • describe and discuss alternative views on the effect of dividend policy • explain the informational aspects of dividend payments • explain the impact of tax on the dividend decision. the clientele effect. S. Allen Principles of Corporate Finance. Learning outcomes By the end of this chapter. In this chapter we consider the nature surrounding that controversy and the factors which influence dividend policy in practice. So this chapter will cover how a firm’s value can or cannot be affected by the chosen dividend policy.A. (FT Prentice Hall Europe. R.

as the risk of dividend payment in the future is associated with a higher firm risk. dividend policy is irrelevant for identical businesses). the differential treatment of capital gains and dividends is less pronounced today than in the past. it may at first seem that the interests of shareholders would be best served by the business adopting the highest dividend policy it is able to sustain. 74 . Dividend irrelevancy argument The argument put forward by Modigliani and Miller (MM) concerning the irrelevance of dividends is particularly important and you should study it carefully. Furthermore. Traditional view of dividends The traditional view of dividends. This idea therefore suggests that. is that dividends are important in determining share value as £1. Risk arising from an investment will already have been taken into account when determining the appropriate discount rate. therefore to deflate future dividends because of this risk is in fact. The most important aspect of their argument concerns the notion that share values are not influenced by the particular dividend policy of the firm. the notion that MM challenged. investors who are registered as holding the firm’s shares before this date are entitled to the dividend. double counting. Many proponents of the MM irrelevancy argument believe that the most serious imperfection is the different treatment of dividends and capital gains for taxation purposes. Note the restrictive assumptions upon which the MM position is based.00 retained by the firm. managers of the firm can reduce this risk by adopting a strategy of a high dividend payout policy. we will illustrate that this may not necessarily be the case. However. As dividends normally represent the cash flows received from holding shares. However. this is illogical as risk is associated with the type of business operations undertaken by the firm and not as a result of whether the return from shares occurs now or at a later date. If the firm still has surplus liquid funds after undertaking all positive NPV projects then this surplus should be paid to the shareholders as a dividend payment. This basic idea is based upon the argument that investors apply a lower discount rate to current dividends than they do to future dividends on the grounds that future dividends have a higher level of risk associated with them. However. Therefore. MM point out that shareholders can create their own dividend policy by selling or cancelling dividends by buying shares in the firm.59 Financial management Ex-dividend date determines whether a shareholder is entitled to receive a dividend payment. Much of the controversy concerning dividend policy is based on the extent to which imperfections and inefficiencies in the real world destroy the hypothetically derived MM case. it would be illogical for share values of identical firms to be different because of differences in their dividend policies (i. in the UK. MM suggested that firms should only invest in all projects which are likely to yield a positive NPV when discounted at the appropriate cost of capital. Dividend policy and shareholder wealth A share is similar to any other economic asset insofar as its value is related to the future cash flows which it generates.e.00 received as a cash dividend today is worth more than £1.

which was not expected by the stock market. MM view the concept of the information content of dividends as only a temporary phenomenon. Clientele effect It is often argued that different investors are attracted to the shares of different businesses on the basis of the particular dividend policy being pursued by the firm. the preference for a regular stream of income may be a further important factor which may encourage investors to choose a particular business to invest in. When firms are likely to dramatically veer away from their target payout. 75 . You will notice when reading the relevant sections that it is the difference between the size of the dividend payment announced and the expectations of the market concerning the size of the dividend which is important. Often investors will be concerned about their tax position when deciding which business to invest in. Such volatility can create a feeling of uncertainty which is likely to lead investors to invest in firms where the dividend policy is more stable and which may have a dividend policy which may meet their needs more closely. Therefore. However. Discuss how it can be said that dividend policy is irrelevant? See VLE for solution Information content of dividends As the board of directors of a firm will know more about the financial position and the prospects of the firm than others. In light of the arguments presented above concerning the information contents of dividend payouts. The shares are deemed to be riskier and thus a higher return is required. the change in share price due to the unexpected size/magnitude/direction of the dividend announced would occur anyway. which causes the price to fall. A relatively volatile dividend payout pattern is likely to be unpopular with most investors. They respond to a higher than expected market reaction to dividends as suggesting that. many academic writers and critics advocate firms to adopt a stable dividend policy based on a target payout ratio.Chapter 7: Dividend policy Activity 7. An individual with a high marginal rate of income tax. may prefer to invest in a firm which has a low dividend payout policy. a higher than expected dividend payment may convey to investors that the board of directors has a level of confidence in the firm’s future. This is because of the different treatment of capital gains and dividend income for tax purposes in the UK. Thus. This feeling of uncertainty in firms which have a volatile dividend policy may command a lower share price and a higher cost of capital for the firm.1 It is well documented in academic circles that share prices tend to rise when firms raise their dividend payout and drop when firms cut their target payout ratio. dividends can be used by them to signal information about the future prospects of the firm to investors. as more information becomes available to the stock market. pension funds (which in the UK are exempt from taxation) may prefer their financial managers to invest in firms which offer the highest dividend payment policies particularly as the pension fund will require a stream of relatively liquid funds to meet the payments due to its pensioners. the market should be given as much warning and information as possible concerning the probable change in the dividend policy. A number of academic writers have highlighted the role of dividends in sending signals to the capital market. for example.

When reading the relevant sections in the books note the possible motives for share re-purchase and also remember that in an MM world. a share re-purchase can have certain tax advantages and also provide investors with the choice of whether to sell or to hold on to their shares. In addition. Obviously. as the effect on shareholder wealth from both these events would be the same. a scrip dividend is no different from the firm deciding to retain the profits from the financial year and not to pay shareholders any cash dividends. Therefore. you must remember that transaction costs will be incurred when shares are sold. Share repurchase In the UK. there is a risk that the re-purchase will either overprice the shares (to the detriment of the shareholders who decide to hold on to their shares) or underprice the shares (to the detriment of shareholders who wish to sell their shares). Following a scrip dividend. other practical issues such as the lack of a ready market for the shares. although a greater number of shares will be in issue following the scrip dividend.59 Financial management Activity 7. share re-purchase can create greater uncertainty for investors than a stable dividend policy. Those who opt for the scrip dividend will benefit by having an increased share in the value of the firm while those choosing a cash dividend will benefit from receiving an immediate payment. This provides an alternative method of cash payment to investors in preference to dividend payments. investors would be indifferent as between a share re-purchase and a cash dividend. companies are permitted to re-purchase their own shares under company law. should investors prefer. In essence. From an investor’s point of view. the value of the business will remain unchanged and. which is a dividend paid in the form of new shares instead of cash.2 Outline the main points which should be considered when deciding upon corporate dividend policy. In addition. However. they may create a dividend for themselves by selling shares if cash is required and they may also find that there may be certain tax advantages in receiving a scrip dividend rather than a cash dividend. See VLE for solution Firms usually have a long-run target dividend payout ratios. This ratio is the fraction of earnings paid out as dividends. should the shares of a particular firm not be actively traded (commonly referred to as the phenomenon of thin trading). Scrip dividends As another alternative to a cash dividend firms may decide to pay a scrip dividend to its shareholders. the total value of shares issued will still remain the same. 76 . the problem of indivisibility (whereby shareholders may be unable to dispose of the precise number of shares necessary for their cash needs) and also the inconvenience involved in making changes to investment portfolios may make the issuing of a scrip dividend an unattractive choice. In many instances investors will have a choice of receiving either a scrip dividend or a cash dividend.

a.Chapter 7: Dividend policy Activity 7. the chairman believes that annual dividends should be a constant proportion of the annual reported profits (ie a constant payout ratio). you should be able to: • explain how companies decide on dividend payments • describe and critique the theory and practice of corporate dividend policy • describe and discuss alternative views on the effect of dividend policy • explain the informational aspects of dividend payments • explain the impact of tax on the dividend decision. Describe what is meant by the term ‘the information content of dividends’. The financial director has made the following predictions for profits and dividends for the next five payments under the three alternative views. A reminder of your learning outcomes By the end of this chapter. Firstly. 3. in your reading you will also come across other factors which may guide the directors of a firm in determining the dividend policy in practice. and it is important that you understand how these factors impact on the dividend decision. There is also evidence to suggest that directors of a firm consider the firm’s level of earnings to be the most important influence on the dividend decision. Similarly.3 Explain the importance of share repurchase and scrip dividends. 2. The past year’s profits (year 0) and the dividend paid there from will be the same regardless of the dividend policy chosen. regardless of the level of profit achieved. Practise questions 1. there is usually a reluctance for firms to cut dividends because of the (adverse) signals which such an action may elicit. In what circumstances are they likely to be preferred to cash dividends? See VLE for solution Determining dividend policy in practice Both empirical evidence and casual observation seem to suggest that the directors of businesses consider the dividend decision to be very important and that the maintenance of a stable dividend policy is preferred over time. There seems to be a high degree of reluctance in firms to raise dividend levels unless the directors of the firm are confident that the higher payout ratio can be sustained over a long time period. Explain the ‘clientele effect’ and its impact on setting corporate dividend policy.. 77 . and having completed the Essential reading and activities. The financial director of Sugary plc is preparing for a forthcoming Board meeting at which the corporate dividend policy for the next four years will be decided. secondly a group led by a non-executive director believes that dividends should increase annually at a constant rate of 15% p. However. The financial director’s own view is that dividends are the residual payment from earnings after retaining all that is needed for the next year’s re-investment. He has been advised he must cover three points of view in his briefing paper.

) Profit after tax Investment proposed Dividend proposed 100 (50) 50 125 (70) 162 (50) 157 (60) 203 (50) At the end of year four it is predicted that the ‘ex div’ market value of the company is 14 times the after-tax profits. Corporation tax is 30%. It is financed by 70% equity and 30% debt based on market values. The pre-tax rate of return for the market as a whole is 8% and the risk free rate is 4%.7. REQUIRED i) Prepare a schedule for the Board Meeting showing ‘value to the shareholder’ under each of the three alternatives using the information given above and assuming that the presentation is from the viewpoint of a shareholder with 1% of the total equity of Sugary Plc. has decided to extend its business by acquiring Chicki Ltd which is in a very different business risk class and has an asset β of 0. as Arras with a total market value of £25 million.59 Financial management Alternative views 1 and 2 (Constant dividend payout ratio (50%) and constant dividend growth (15%)) Year Profit after tax Dividend proposed 0 100 50 1 120 2 (£ millions) 150 140 180 3 4 Alternative View 3 (NB Profit shown incorporates the additional profit arising from the extra investment made compared to Alternatives 1 and 2. Arras is an all-equity financed company with a market value of £12 million. whilst its debt has a zero β value. c. Compute the weighted average cost of capital for Arras. The company’s cost of equity is 12% net per annum. a recently listed company. discussing the theories and rationales of each of the three alternatives proposed and end with your recommendation for the preferred alternative. b. To improve the potential for returns to the shareholders it has decided to borrow £6 million @ 5% (gross) over a long term and use the money to repurchase £6 million of its equity (at market value).5 million and it will be financed in the same proportions of debt and equity as the existing capital structure. The β value of its equity is given at 1.4 times. Bonn plc is in the same industry. The total value of the investment in Chicki is £12. Compute the asset β for Arras plc. Bonn plc. It expected future profits to be roughly in line with this year’s amount. (3 marks) (6 marks) (6 marks) 78 . and thus same business risk class. Compute the debt and equity β values for Arras plc. has just announced its annual results. REQUIRED a. Arras plc.0 million. (15 marks) ii) Write a discussion paper for the Board meeting using the information calculated in i) above. stating that its profit before interest and tax was £2. (10 marks) 4. subsequent to Arras’ share repurchase.

numbers 6. 14 and 15. numbers 6 and 18. 467–69. (6 marks) e. Attempt the following problems in BMA: • pp. 11. Compute the revised weighted average cost of capital for Bonn and the new asset β for Bonn after it has taken over Chicki.Chapter 7: Dividend policy d. Briefly describe what discount rate Bonn should use in future investment appraisals giving reasons for your suggestion(s). 79 . (4 marks) See VLE for solution Problems Attempt the following problems in BMM: • pp. 447–48.

59 Financial management Notes 80 .

ratio analysis and financial budgeting. Alternative names are often used for each of these parts. and for review and critical assessment of performance measures.J. Learning outcomes By the end of this chapter. cash flow statement and balance sheet are only of limited value when read in isolation and without analysis and evaluation. you should be able to: • compute appropriate financial ratios to enable a set of accounts to be interpreted satisfactorily • interpret part or all of a set of financial reports • describe and evaluate the means and the limitations of ratio analysis • describe and discuss the requirements for strategic financial planning • construct a simple financial plan or model.A.Chapter 8: Financial analysis. 2007) Chapters 17 and 18. . 2005) Chapter 3. Further reading Brealey. (McGrawHill. Remember. and financial planning Chapter 8: Financial analysis. Myers and A. The analysis of financial information can perhaps be best 81 . Atrill. Potential and existing investors. customers and creditors all are interested in a company’s position and performance. and financial planning Aims of the chapter This chapter has two parts. Therefore it is important to give meaning to the results portrayed by the accounts via analysis and interpretation. methods and uses. R. and having completed the Essential reading and activities. Allen Principles of Corporate Finance. Course 25 Principles of accounting will have given you a solid grounding in each part. Myers and F. P Financial Management for Decision makers.C. Marcus Fundamentals of Corporate Finance.C. but particularly so in the financial analysis. A company’s management is also interested because the ratios computed can be used for benchmarks. Statement analysis A company’s set of accounts. Essential reading Brealey. as one learns the basic analytical techniques and ratios. First learn the computational technique then learn how to interpret the messages they are giving or the possible questions they are posing that will require further investigation. 2008) Chapter 29. methods and uses. the first half dealing with the technique and application of financial analysis and the second half concerned with financial planning. its profit and loss account. S. potential lenders.. In each case the alternative titles are more restrictive in what they encompass. that they can be used in many different contexts. (McGraw-Hill Inc. (FT Prentice Hall Europe. R.A.. S. targets.

These are the process and the context elements and each influences the other. or changes from past trends. Each of these areas can be broken down further. Turn your attention to large and important items first. Because there is less scope for influencing cash based results it is argued that cash flow based ratios will become more important in both the analysis and projection of financial results. the proportions of sales taken by the different types of costs. activity and efficiency and financial structure. the margin on sales. The process of analysis will be heavily influenced by the mode and needs for its use. As to what constitutes investment depends on the reviewers’ perspective. Look for trends over time. but the calculation of a few well-chosen ratios is generally much more effective than calculating as many as you can think of. You will find the approach you need to take in numerous specialist books. The structure. A very detailed review will start by strategically analysing the company and then using the ratios to address strategic elements within each area of enquiry. depth and detail of work undertaken will be influenced similarly. What is important depends on the circumstances. profit and loss account and cash flow statement. Profitability also includes the return on the investment made. compare the results with targets set. Is it the return on the long term funds invested – capital employed. analyse them. competitors’ results or industry means.59 Financial management broken down into two elements each with their own parts. benchmarks given. Small changes in large items are usually much more critical than large changes in small items. Remember the process is generally to prepare a set of ratios. for example with profitability it can cover trading profitability. Cash based ratios Cash return on net assets (or cash = Net operating cash flow return on capital employed) Total assets less current liabilities Cash interest cover Cash dividend cover = Net operating cash flow Interest payment = Net operating cash flow less tax and interest payments Dividend payment = Net free cash flow Investment Internally generated investment 82 . To those should be added some cash based ratios which are now available internationally thanks to the new requirement that companies must provide an annual set of accounts including balance sheet. The subject guide for 25 Principles of accounting (2006) in Chapter 7 has the main ratios that you should know. An understanding of accounting principles learnt in 25 Principles of accounting will enable you to appreciate the effects of any changes a company has made in its reporting practices. or is it the return on the total assets used to generate the profit or the return to the ordinary shareholders for their investment in the company? Each of the areas has its own family of ratios each providing information for answers to the appropriate strategic questions. and use them for a review of the past performance with the view of helping in the projections for the future. Look for answers or interpretations from the questions posed by the results and then you have the basis for your report. Most books delineate four areas: profitability. liquidity and solvency. The context of what ratios to compute will depend on the purpose of the analysis.

credit ratings.700 1. This causes the analyst to look at the profit margin change. and financial planning The Du-Pont system which is based on a pyramid of ratios.200 6.768 Net profit before tax Taxation Net profit after tax Dividend paid (during years) Profit retained 2. and valuing shares. Consider the reasons why these attempts have not been very successful and this will ensure you understand the weaknesses underlying ratio analysis.660 1. is helpful in providing pointers for investigation derived from the inter-relationships.320 300 108 9. say in a price war between competitors. each level interlocking with the next.290 270 – 10.320 1.760 960 1.800 900 900 83 . For example return on net assets is the product of operating profit margin (return on sales) and net asset turnover. None has been wholly successful though the credit rating and corporate failure models have had the best success story.080 1.232 642 1. Not all have been successful. possible bankrupts. and see if it has helped improve the net asset turnover enough to result in an overall improvement in return to the net assets employed. Review question The accounts for Chemistrand plc for the two financial years ended 31 December 2008 are given below.020 1.200 1.000 5. Practical applications There are various areas where ratios have been used in practical applications for commercial ends. There have been attempts to use models incorporating ratios to identify potential takeover targets. methods and uses.590 900 690 2007 £’000 13. CHEMISTRAND PLC Profit and loss account for years ended 31 December 2008 and 2007 2008 £’000 Turnover Variable cost of sales Fixed production costs Administration costs Selling and distribution costs Research and development costs Interest 12. This will also help you to understand why the interpretations and predictions are still very subjectively biased.440 2.Chapter 8: Financial analysis. forecasting profits.

020 1.460 1.900 1.980 2007 £’000 Note 3 No sales of assets took place during the year (NBV – Net Book Value) Note 4 All dividends were paid during the financial year at the rate of £0.080 720 (180) 1.220 6.200 450 6.190 1.620 6.880 Note 1 Leasehold property (cost) Accumulated depreciation Balance Note 2 Plant and Equipment (NBV) Additions Depreciation for year Closing balance (NBV) 7.000 2.140 60 (120) 1.200 300 6.750 1.15 per share.080 600 630 720 510 8.880 8.140 1.190 8. 84 .140 60 2.620 8.59 Financial management Balance Sheets as at 31 December 2008 and 2007 2008 £’000 Fixed assets Leasehold property (note 1) Plant and equipment (note 2) 6.080 7.320 – 2.190 7.880 540 1. 370 Current assets Stock Debtors Bank Less Creditors due within one year Tax creditors Taxation Bank Net current assets Net assets Ordinary share capital (£1 shares) – called up Profit and loss account 6.900 1.750 1.470 — 210 8.000 2.

2 50 49 15 13. Using a subset of the ratios calculated in (a) above.0 1.4 2. Write a short commentary on what additional information has been obtained from the results of the computations in (a) which were not used in (b) above.0 1.0 1.5 M 20. 85 .7 2.1 1.Chapter 8: Financial analysis.1 0.0 1. b.0 0.5 1.1 65 65 40 14.2 45 50 15 13.430 2007 £’000 2.0 1.7 LQ – Lower Quartile (25% of group had ratios same as or lower than figure given) M – Median (50% of group had ratios same as or lower than figure given) UQ – Upper Quartile (75% of group had ratios same as or lower than figure given) Required: a.7 LQ 15.0 1. Compute a full set of basic financial ratios which will help give a rounded assessment of Chemistrand’s performance in 2008.3 UQ 25.7 35 25 5 11. methods and uses. c.5 2.0 1.0 2007 M 20. comment on the performance of Chemistrand plc in comparison with the statistics provided by the agency.3 UQ 25.460 The following information from a credit rating agency for the industry is also available for the two years 2008 and 2007.0 70 67 35 14.9 1.000 (1.8 30 20 5 11.8 2. and financial planning Cash flow statement for the year ended 31 December 2008 2008 £’000 Cash flow from the operating activities Returns on investments and servicing of finance Interest paid Taxation Capital expenditure Equity dividends paid Management of liquid resources Financing Share issue Increase/(Decrease) in cash in the period – (780) 3.7 3. 2008 LQ Return on net assets (%) Net assets turnover (times) Current ratio (times) Acid test (times) Collection period (days) Total owing to total assets (%) Long term debt to capital employed (%) Return on sales 15.0 1.740) (108) (1482) (720) 120 (900) (780) – (240) (6060) (3840) (900) (4740) 2.

15 0% 19.880 1.590 6. Divisional and regional breakdowns of profit.0% n/a 23.000 12.000 900 6.020 0 × 100 8.020 600 × 365 7.000 = 25.460) (2.10× 0.880 1950 × 100 (8.5% Other ratios such as the various costs can be computed as percentages of turnover.77× = £0.26× = 0.232 + 108) 108 1.7% = 22.370 + 2.140 × 365 7.232 ×100 8.1 days = 0% = 18% = 21.7% 20. or annual growth rates of turnover.950 1.880 (12.460 1.590 × 100 8.000 8.93× 0% 30.2 days 31.61× 22.8% .430 × 100 8.950 1.265 = £0.30 £0.5× = 0.0× £0. profit etc.6× 21.320 × 365 12.15 = 24.35× =17.7× = 1.020) × 100 12.430 108 840 900 = 1.000 – 7. Profitability 2008 Return on net assets Return on sales Net asset turnover Return on equity Gross profit margin 2.880 2.7% n/a 2.000 2.000 1.232 ×100 12.68× 1.2% = 18.9% 1.880 2.60× = 40.59 Financial management Solution to review question a.0% 40.6% = 1.5% 2007 33.590 900 1. Solvency and liquidity Current ratio Acid test (quick ratio) Activity ratios Debtors collection period Stock holding period Creditor payment period Financing ratios Long term gearing Total owing to Total Assets Interest cover Dividend cover Earnings per share (EPS) Dividend per share Cash based ratios Cash return on net assets Cash interest cover Cash dividend cover Internally funded investment 86 2.320 1.3 days = 31.4 days 25.2 days = 59. turnover and net assets can be evaluated similarly if itis useful to the task.9% = 41.5 days 47.

try to give the actual. (i. the Sales ledger) are doing a better than average job of getting in the money. If so. The above ratios incorporate many more ratios and computations than what you would be expected to compute in an exam answer. It could also be due to increasing current liabilities at a rate which could cause future problems. had got less effective?). or a possible. one can probably still recommend that the company takes out a long term loan. Do remember when you are asked to interpret. Notice how the introduction of the cash based ratios has provided much more meaningful information on interested dividend cover. state the assumptions. but the administration and selling etc. This would improve the gearing. then the company’s liquidity and solvency is perhaps to be put under the spotlight. in the light of the company’s overall profitability. since return on sales had declined (i. do not just describe a change or an event. as return on equity and earnings per share declined. c. probably cost less than short term borrowing and reduce the risk of financial distress.B.e. So even though the cash dividend cover hinted at insufficient funds to maintain the dividend level it was probably felt necessary in order to steady the share price. not something you wish to see when a company has just doubled its called up share capital. The shareholders will not be pleased. An appropriate number could be the eight to be analysed in b) below. or what the present lending situation is like. The increase in collection and inventory periods reinforces this point though the financial effects of this are lessened by the effects of increasing the creditor period.e.e. Note that gross profit had actually improved so perhaps the company has some internal strengths and some weaknesses. Since the collection period is below average(i. The decline in the return on capital employed appears to have been caused by falling operating profit margins and the declining level of sales which is also reflected in the falling asset turnover. and financial planning N. and the overdraft has suddenly emerged and grown.B. 87 . the two ratios. be more than willing to make a medium or long term loan to the company. Even so Chemistrand is still in the upper quartile for its profitability both in its operations and on its capital base. N. reason for it. Additional operating profitability ratios indicating how different types of costs have changed in proportion to turnover would have been useful. b. Given the asset cover and the fact that the assets are recent acquisitions bankers would. The cash interest cover highlights the security lenders can feel over sufficient cash for the payment of interest. The company is distinctly under geared compared with its competitors. Chemistrand’s solvency ratios are below average which could be due to efficient management of current assets. namely that there is no long term debt. Note how over the past two years the cash flow statement shows significant outflows of cash.Chapter 8: Financial analysis. Not knowing what the future holds. To complete the analysis and interpretation this section was added to give the reader further insight into interpreting the accounts. Note when answering these sorts of questions you may have to make some reasonable assumptions in order to make your interpretations. its marketing activities perhaps need reviewing). methods and uses. could it be that production had become more efficient. However compared to the rest of the industry it is below average in turning its assets over. Turning to the financial structure. total owing to total assets and the long term debt to capital employed reinforce what is obvious from the balance sheet.

Learn how to consider the financing and the investment aspects of the future which are to be combined together in the plan and link those financing or investment requirements in with the short term aspects. Financial planning helps ensure a more measured response to events and provide motivation for managers through the establishment of agreed goals. using an agreed return on sales to arrive at a projected profit given a predicted sales outcome). Financial planning helps avoid the nasty surprises.g. Therefore it is important to learn why it is necessary to plan and how to do it. provide an end result where the sum is greater than the parts. with serious consequences for those connected with the business. the analysis. causes managers to think ahead and not just act on a day to day basis or even on a simple reaction basis only (e. Bear in mind. Here the emphasis is on long term which means probably looking up to 10 years ahead. helps to prepare managers and the businesses to deal with those awkward occurrences that can. Businesses which do not undertake financial planning and control more often than not end up in liquidation. the strategic and operating implications of the plans are very important. These decisions should not be undertaken independently and. that in a practical scenario. forecasting. Learn how to build simple models using equations comprising these ratios. or absolute values for profits or sales. namely the investigation of the deviations from plan. and do. Planning for the short term will be dealt with in the next chapter. 88 . occur so that the outcome is more favourable for the business. Technical aspects of financial planning The setting of the objectives of a business will include financial objectives such as growth rates in earning per share. with the amount of detail diminishing over time. contingency plans made to cover the possibility of the government introducing a new sales tax.59 Financial management Financial planning – introductory comments This is a topic which tends to get a ponderous and generalised treatment in the textbooks.g. or a competitor introducing a new product). Ratios will and should be used additionally to help prepare the financial plan by acting as the structural links between items in the plan (e. if done correctly. evaluation and selection of possible strategies and finally the comparison of subsequent performance with the original plan. There should be added to this list the elements that complete the planning and control cycle. because for corporate managers it is very important. the level of debtors and stock can be predicted by using debtor days or inventory period with the predicted level of sales and purchases. Do not be deceived. or rates of return on investment etc. Financial planning is necessary because of the interaction between corporate investment and financing decisions. sales. Financial planning process You should learn the six key elements of financial planning which are the setting of financial goals. It is important to know the detailed requirements and possible approaches for each phase of the planning and control processes. the review of the reasons for the deviations which are then used as bases for appropriate amendments to a revised plan. Learn the types of ratios that can be used as either long or short term objectives. when learning and applying these points.

expansion investments etc.Chapter 8: Financial analysis. a. The different costs of funds and their characteristics will also be of relevance here in the selection. with the long term ones being updated at least annually. or one attempts to use an optimisation model based on some form of linear or integer programming. b. loans. Comment on the interrelationship of these three types and how they will be affected by the choice of the long term financial objective(s) of the business. Planning outputs Learn the three major groups of outputs: the forecast statements of profit flows. Financing decisions The amount and type of funds required will be dependent not only upon the selection of investments made. A similar approach should have been used in preparing the financing plan. if so how much. but also the financial market place conditions and availability. and financial planning Learn the ways in which the planning process can be supported by the use of a financial model. Review question Plantree plc prepares long term financial plans. etc. similarly what effects will the withdrawal or sell off of a major investment produce. the strategic investment and financing plans. The former can be bought in sometimes from a consultancy. retained earning. In order to achieve its long-term financial objectives the planning team will be faced with decisions on investment policy. The levels of required return from the investments and their risk levels must be considered. cash flows and balance sheets. The further into the future the more likely the project is to be as yet unsanctioned and just a sum of money earmarked for a particular subgroup of investments. They also provide the market place with information on one of its major decision criteria. 89 . financing policy and dividend policy. the latter developed in house. 3. Describe briefly some of the main examples of forecast information needed for each type of decision. expansion. Investment policy decisions This type of decision requires an understanding of the corporate strategy as to how the funds should be apportioned between the strategic groupings – replacement needs. leasing and sales of assets. c. Solution to review question 1. In the strategic investment plan the investments to be undertaken will be broken down by category – replacement. Possible types of finance will include new equity. Dividend decisions Whether or not to pay. Comment on the nature of these three types of decisions. whether one uses a simple approach to review a series of options (much easier these days thanks to the advent of spread sheets). methods and uses. 2. the owners of the business. Required: 1. The potentially different cash flow patterns of returns from existing and new investments may need assessment. combined with the present situation of the business. Naturally the detailed short term plans (budgets) will dovetail into the long term ones. new product investments. new products. when and how are all very important and relevant decisions here since they reflect the returns to the shareholders. Whichever form the model takes it will require exogenous and endogenous inputs.

whether it be one or all of those listed. profit growth and thus dividend payment may be targeted at the expense of cash flow in order to influence equity market perceptions if the finance plan requires a share issue as the next major source of long term capital. For example. profit growth. In reality. the size of the earnings per share and the annual growth rate of these variables along with the size of profit and its return on investment will influence the availability and cost of funds. • the trend of costs of funds – increasing costs of loans or equity • market perceptions of gearing.59 Financial management 2. Main forecast needs of investment decisions will include: • predictions of cash flows. For financing decisions the main forecast needs are: • predictions of funds available and type of source – equity. earnings per share. sales. People making decisions whether to invest require the opportunity cost of funds for final evaluation. they also need to know the availability of funds. Interrelations The three types of decisions are interrelated. reduce availability of funds perhaps restraining or deferring new investment. A reminder of your learning outcomes By the end of this chapter. Thus one can see some of the interrelationships amongst the three decision types. these are not always available precisely when investors want them. 3. their timings and the influence of inflation • the degree of variability in the cashflow estimates • the opportunity cost of capital to be used that is appropriate for the business risk of the project • the impact on the accounting profit profile • the interactions (if any) with existing or new projects. etc. share price. 90 . Whatever a business’s objective(s). market share. it will influence the plan. while practice might add some other objectives like profit. a. theory would suggest businesses should be aiming to maximise share price. Likewise. dividend per share etc. b. present corporate position vis-à-vis target gearing level. debt. in the shorter term. For dividend decisions the business needs predictions on: • the level of profits available for distribution over the planning period • the market’s expectations of the business • the expectations of the payout behaviour of competing businesses • internal sources should provide estimates of the needs for retained profits along with the cashflow predictions of the business. risk classification for loans • cost of raising different forms of capital. you should be able to: • compute appropriate financial ratios to enable a set of accounts to be interpreted satisfactorily • interpret part or all of a set of financial reports • describe and evaluate the means and the limitations of ratio analysis • describe and discuss the requirements for strategic financial planning • construct a simple financial plan or model. Increasing dividend payout may. c. and having completed the Essential reading and activities. The amount of dividend paid per share.

numbers 1. See VLE for solution Problems Answer the following problems in BMM: • Chapter 17. 6. methods and uses. number 1. Answer the following problems in BMA: • pp. 91 . making financial planning of little value’. 5. ‘The speed of change increases over time. 2. numbers 2 and 12. 14 and 18. Describe and discuss what you understand by the term ‘financial planning’. 3. Chapter 18. and financial planning Practise questions 1. Incorporate comments on the quotation into your overall discussion. 12 and 24. Describe some of the practical applications where ratio analysis has been used and comment on the effectiveness of such applications.Chapter 8: Financial analysis.810–14. Describe the general uses of ratio analysis and discuss the limitations of the results obtainable.

59 Financial management Notes 92 .

their characteristics. Further reading Brealey. (FT Prentice Hall Europe.Chapter 9: Short-term finance and asset management Chapter 9: Short-term finance and asset management Aims of the chapter This is quite a lengthy topic area as can be seen by the number of chapters listed below. some of which are long and some short.C. however you are not required to learn the detail in the text on cash and inventory models or the management processes described. You also need to know the basic evaluation techniques for choice between sources. Allen Principles of Corporate Finance. debtors and cash and then some techniques for managing those items. the establishment of optimal levels of inventory. Atrill.A. . Rather you need to know the main outlines and characteristics of the sources and the processes of managing the current assets. A problem is then provided to give an example of how and what to do in the choice between different forms of finance. 2008) Chapters 30 and 31. P Financial Management for Decision makers. (McGrawHill. The second part of the chapter considers the management of working capital.. you should be able to: • explain the rationales supporting the financing mix of short and long term funds for an entity • describe the major short-term sources of funds. S.J. R. R. Marcus Fundamentals of Corporate Finance. costs and the providers’ requirements • evaluate different possible short-term sources to meet the corporate needs • discuss how to manage the major current assets including the knowledge of the basic models used in attempting to optimise their levels • make a strategic assessment of the effects of the uses of changes in current asset levels. 2007) Chapters 19 and 20. 93 .A. 2005) Chapter 10.. Myers and A. and having completed the Essential reading and activities. (McGraw-Hill Inc. Myers and F. Essential reading Brealey.C. This chapter starts by making the links between long and short-term financing and moves on to reviewing the features of various short-term sources. S. Learning outcomes By the end of this chapter.

Debt factoring When reading the relevant sections on debt factoring note the services offered by a factor and the fee structure employed. Generally. Trade credit This is an extremely important source of finance for small businesses in particular.59 Financial management Long. if payment is not made within seven days. other forms of short-term finance may prove to be cheaper. though. however. You should note in particular when reading the relevant sections on trade credit. However. they can be repaid more easily and quickly. BMM go through the rationale behind the matching of maturities of assets and liabilities. to increases in purchases on credit from suppliers). firms will attempt to choose whether they will be conservative and predominantly financed by long-term sources or more aggressive and have a much higher proportion funded with shortterm sources. Trade credit can be a free source of finance to a business providing the goodwill of the trade supplier is maintained and providing discounts for prompt payment are taken. the four factors which determine the length of the credit period given to customers. You must be clear about the distinction between debt factoring and invoice discounting. The level of financial distress will be greater the higher the proportion of short terns funds. increases in sales lead. Suppose trade suppliers offer a 2% discount for invoices paid within seven days and. the payment period for invoices is 28 days (with no discount being allowed). since of necessity they will be interest bearing and not equity. therefore. on the other hand. Debt factoring is often a long-term arrangement because of the administrative arrangements required to deal with the transfer of the sales ledger accounting function. Factoring can prove to be expensive and so it is important to identify the relevant costs and benefits before entering into such an arrangement. Invoice discounting. can lead to a reduced level of service in the future and failure to take advantage of discounts can have a high implicit annual interest cost. 94 . may be a temporary arrangement. No period of notice or penalty would normally be attached to repayment which can be done to best advantage.e.versus short-term finance The mix of finance used to acquire the total assets of a firm is a very company specific and time specific selection. in turn. Failure to maintain supplier goodwill. Since a firm’s asset base grows irregularly over time one would expect the mix also to vary. It can be described as a spontaneous source of finance as it results from normal business operations (i. The implicit annual interest cost of a business paying at the end of 28 days rather than at the end of seven days is: We can see that the cost of foregoing discounts can be very high and. Study the worked example below.

The settlement period for debtors will be reduced to an average of 30 days which is in line with the industry norm.5% of sales turnover for this service. Required: Calculate the net annual cost or savings resulting from a decision to employ the services of the factor.000 × 80%)14%} 625 230 855 Factor savings Bad debt savings (£0.000 per annum and will reduce bad debts by half. Solution to Worked example 9 £ 000 Existing investment in trade debtors {(70/365)£25m} Expected future investment in trade debtors {(30/365)£25m Reduced in investment Factor costs 2.000 × 15%) Reduction in overdraft interest through advance {(2.000 × 80%)15%} Net annual savings 100 120 411 247 878 23 £ 000 4.5% of sales turnover Interest charge on advance {(£2. All sales are on credit and turnover has been stable in recent years. the employment of a factor will lead to net savings for the business.Chapter 9: Short-term finance and asset management Worked example 9 Aztec Electronics Ltd has an annual turnover of £25 million of which £0.055.055 2.055. The use of a factoring service is expected to lead to cost savings in credit administration of £120. a bank will take a number of factors into account.740 We can see that. The business currently has an overdraft of £6.2 million prove to be bad debts. in this case. Credit controls within the business have been weak in recent years and the average settlement period for its trade debtors is currently 70 days.2 million and pays interest at the annual rate of 15%. 95 .795 2. When making a decision concerning a business loan application. The business has been approached by a debt factoring business which has offered to provide an advance equivalent to 80% of its debtors (based on an average settlement period of 30 days) at an annual interest charge of 14%. Bank borrowing You should note the kind of loans that the clearing banks and merchant banks are prepared to make.5) Credit admin savings Reduction in trade debtors (£2. These include: • the quality and integrity of the management of the business • the quality of the case made in support of the loan application • the period of the loan and the security being offered • the nature of the industry in which the business operates • the financial position and performance of the business.740. The factor will take responsibility for the collection of credit sales and will charge a fee of 2.2m × 0.

£m Sales Cost of sales Opening stock Purchases Closing stock Gross profit Administration expenses Selling and distribution expenses Finance charges Net profit before taxation Corporation tax Net profit after taxation Dividend payable Retained profit for the year 96 £m 29.4 6.2 7.5 23.5 0. the directors of the business have agreed to reduce the level of trade creditors by keeping to an average settlement period for creditors of 30 days.2 0. For example there are a number of ways of getting money to support exports. In addition. Leasing When reading these sections you should note carefully the distinction between an operating and a finance lease and the reasons put forward to explain the growth of this form of financing in recent years. The profit and loss account and balance sheet of the business for the year ended 31 July 2008 is as follows: Profit and loss account for the year ended 31 July 2008.3 14. Consider the worked example below: Worked example 10 L C Conday Ltd is a family owned business which operates as a wholesaler of garden products. General knowledge of their existence is all that is required. Sale and lease back arrangements offer an opportunity for a business with valuable property to raise new finance.2 15.4 2.3 4. To finance this policy. or the more general hire purchase.59 Financial management Specialist finance There are numerous short and medium term sources available which are only provided with a specific end in view. In order to deal with this problem. During recent months its trade creditors have been pressing for more prompt payment of amounts owing.9 6.2 0. You should compare the advantages and disadvantages of this form of financing with that of a mortgage.4 0. internal sources of finance as well as external sources of finance should be considered. you should study carefully the techniques of lease evaluation. Evaluation of sources of finance When considering an appropriate form of finance for a particular business.6 0.1 .8 13. the directors intend to ask the bank to increase the business’s overdraft by the necessary amount. The current annual interest charge on the overdraft is 14%. This is considered the opportunity cost for short-term funds.7 16. or finance for specific projects.

All sales and purchases are on credit.6 7. 7.4 7. State what you believe the reaction of the bank would be to an approach to finance the proposed policy. Freehold land and buildings are shown at valuation and the other fixed assets are shown at their net book value.5 15.50 ordinary shares Retained profit 3.6 Notes 1. 97 .6 3. which you consider to be the most suitable. 2.2 £m £m The profit for the year to 31 July 2009 is expected to be similar to that for the year to 31 July 2008.4 12.2 15. No dividends have been announced in the preceding four years.0 4. Required: a. Evaluate four other methods of financing the proposed policy and state.6 1. with reasons and supporting calculations.1 12.2 1. Calculate the amount of finance required to reduce the level of creditors in line with the proposed policy b.8 7. 3.2 3. c.2 8.4 9.9 0.Chapter 9: Short-term finance and asset management Balance sheet as at 31 July 2008 £m Fixed assets Freehold land and buildings Fixtures and fittings Motor vans Current assets Stock Trade debtors Less: creditors – amounts falling due within one year Trade creditors Dividend payable Bank overdraft Creditors – amounts falling due beyond one year 10% debentures (secured on freehold) Capital and reserves £0.9 7.

it is secured. We are informed that this is a family-owned business and this may raise issues concerning the amount of capital available and the prospect of dilution of control.6 ×100) and the dividends seem sporadic. as stated earlier.000 per annum.5% (20. As the purpose of the finance is not to generate profits the effect of a new share issue will simply be to reduce equity returns further. To increase the overdraft further will make the bank even more vulnerable to the risk of default. • Debentures/loans: this form of finance is not a strong possibility. 98 .8) and the effect of increasing the overdraft could be to push the interest cover below 1. like debt factoring. The bank is likely to feel that the equity shareholders should contribute more to the financing of the business. • Invoice discounting: this will enable the business to convert trade debts outstanding into cash. which will give cause for concern. the survival of the business could be at stake and so investors may respond to additional calls for funds. The overdraft is already large in relation to other forms of finance employed by the business (including the equity capital) and it is not clear from the information provided how. The finance will not be employed to generate further income for the business but simply used to repay other creditors.59 Financial management Solution to Worked example 10 a) £m Trade creditors at balance sheet date Trade creditors representing 30 days outstanding (£16. it is a costly form of financing a business and is often viewed by outsiders as an indication of financial weakness – a financial institution may expect the debt to be insured before considering an application. the business is already highly geared and there is already a debenture issue which is secured on the freehold land. however. equity shareholders may see little investment potential in the business as the return to equity for the year is only 5. From the information available there does not appear to be any other attractive form of security for prospective lenders – the interest cover ratio is low. the effect will simply be to depress profits (from an already low base) by the amount of the additional interest charge. it appears that the creditors are bearing a large amount of the risk associated with the business.e. 3.4/7.0/27. however. Unless the ability to pay more promptly results in discounts being received from suppliers.0.4 2.2 times (i. c) Four possible sources are: • Equity shares: lenders are likely to look to equity shareholders for reasons mentioned above – the total owing to total asset ratio is currently 72. The interest cover is already low at 1.4/2.9 1. The effect of increasing the overdraft by the amount required will be to increase interest charges by £350. At present.5m × 30/365) Finance required 3.6 ×100) which is very high. The overdraft will not therefore be self-liquidating – indeed. or even if. it is not clear how the overdraft will be repaid. however.5 b) The bank is unlikely to provide the necessary finance for the proposed policy.3% (0.

The chapters listed above in general give greater detail of the concepts and techniques employed in managing each element.2) – this seems very high indeed – a reduction in stock levels by one third would release the necessary funds to pay the trade creditors. that there are many items which are obsolete or slow moving. They can reveal to financial managers the effect of planned events on the liquidity of the business.3 = 6. The efficient management of cash is. Note the general pattern of a cash cycle.1) which again seems to be very high – a reduction in this level by one third would again be sufficient to finance the payment of trade creditors. So ensure you understand the principles of the basic approaches along with the strengths and weaknesses of the models described. however. the timing of finance. In order to survive a business must retain an uninterrupted capacity to pay its maturing obligations. The management of the treasury function is dealt with in the next chapter and should be linked with the critical appraisal of the cash models such as Miller-Orr etc. These models. plans must be made for either the financing of the deficit or for changes in the timing of receipts or payments so as to avoid the forecast deficit. of critical importance to a business. In the event that a cash surplus is forecast. This is concerned with the establishment of optimum levels of investment in the current asset as well as the decisions concerning their finance. 99 . thanks to the variability in the cash flow patterns. Management of short-term assets Now we turn to the management of the assets matched with the shortterm finance. When preparing a cash flow statement it is important to consider the timing of cash receipts and payments and to avoid the inclusion of items which do not involve either inflows or outflows of cash.4 = 3. have not been overly successful in their applications. the influence of investment funding. Hence the need for other approaches to managing the riskiness of the flows.Chapter 9: Short-term finance and asset management • Reduce stocks/debtors: it may be that an internal source of funds offers the most suitable means of dealing with the financing problem – at the balance sheet date stocks represented more than six months’ cost of sales (7. hence. the requirements of the different stages of the product life cycle.5 × 12/29. When reading the relevant chapters you should note the importance of controlling the cash collection and payments cycle and the cash transmission techniques available. Where a cash deficit is forecast. The management of cash Cash has been described as the ‘lifeblood’ of a business. trade debtors and inventory. the management of a company’s working capital. therefore.9 × 12/15. than the course requires. Cash management models are available which seek to minimise the cost of holding surplus cash balances and to maximise the returns from the re-investment of these funds. all these must be reflected in the cash flow projections. it may not be very easy to make the stock reductions required. financial managers can plan for either its short-term or long-term reinvestment. Where stock management is weak and inefficient it may be. Cash flow forecasts are a valuable tool in the management of cash. At the balance sheet date trade debtors represented more than three months sales (7. cash.

000) 15 £120 2 30 £150 3 45 £325 The cost of capital to Pinewood Supplies is 12% per annum. if a business decided to insist on more prompt payment from debtors. this might produce improved cash flows and a reduction in bad debts. However. State the square root rule. The accountant of Pinewood Supplies Ltd has provided the following information concerning the product: £ Selling price Variable costs Fixed cost apportioned Net profit 42 6 48 22 £ 70 The annual turnover of the business is currently £1. All sales are on credit and the average collection period for the business is 40 days.1 List the key concepts of the classical static model for cash and inventory. 100 . The business is considering an increase in the average collection period by 15 days. A review problem is shown at the end of this book to which you can apply a critique and so use that as a base for criticisms of such models. Learn the simple approach to a practical derivation of an optimal credit policy. When reading the relevant chapters you should note carefully the ways in which each element can be managed. Worked example 11 Pinewood Supplies Ltd produces a pine bookcase which is sold to retailers throughout Scotland. See VLE for solution The management of trade debtors The credit policy of a business has three major elements. The decision rule to be applied when considering proposed changes is that they should be introduced only where it is expected that the marginal benefits will exceed the marginal costs. 30 days or 45 days. it might lead to additional credit collection costs and lost sales from customers.4m and it is believed that this can be increased in the forthcoming year by increasing the time given for trade debtors to pay. These are: • credit terms offered to customers – this includes the credit period and discounts allowed to credit customers • analysis of creditworthiness – credit customers should be investigated to assess the risk of non-payment • collection policy – efficient procedures must be in place for the prompt collection of amounts owing.59 Financial management Activity 9. It is important to appreciate that changes in credit policy are likely to result in both benefits and costs for a business. Thus. The effect on sales from adopting each option is as follows: Option 1 Increase in average collection period (days) Expected increase in sales (£. For cash and inventory separately consider the elements in an uncertain world that will affect the static model and its usefulness.

000 £42. hence. therefore. Producing reliable sales forecasts will provide a basis for ordering and drawing up production schedules aid will help in identifying the optimum level of stocks to be held.000 £38.425 £75.206 (9.740 130.260 401. which has been dealt with in your previous studies. The management of stock-in-trade A number of techniques and procedures may be used when seeking to manage the stock-in-trade of a business. with supporting calculations. unlikely to be very sensitive to any inaccuracies in the underlying assumptions and estimates.725m × 85/365 Less: Current debtors 1.52 55 2 1. 101 . can provide an insight into the speed with which stocks are moving through the business.425 £143.52m × 55/365 1. which credit policy option should be offered to customers.55 70 3 1. Contribution per unit £ Selling price Less Variable cost Contribution per bookcase Rate of contribution 28/70 = 40% Option 1 Projected sales (£m) Projected debtor period (days) (40 + 15) Projected debtors 1. it is important to try and establish what the future requirements are likely to be.926 60.794) 153.712 1.725 85 70 42 28 The calculations shown above indicate that extending the credit limit by 45 days provides the most profitable option.55m × 70/365 1.041 297.000 £100. The choice of options based on these figures is.206 is considerably higher than the other two options.425 £248. The expected profit of £100. Solution to Worked example 11 The profitability of each option can be determined by weighing the costs of the additional investment in debtors against the benefits from the expected sales.260) (29.Chapter 9: Short-term finance and asset management Required: Explain.616 153.287 229. This ratio can be applied to each line of stock for control purposes. • Financial ratios – the stock turnover ratio. These include: • Producing sales forecasts – stocks are held in order to meet future requirements.4m × 40/365 Increase projected Cost of additional investment in debtors (12% × increase) Increase in contribution (40% × sales increase) Increase in profits 48.074) (17.835 153.

failure to control costs or a failure to attract finance at the appropriate times. and the optimum order quantity – the major models are dealt with in the texts of BMM and PA – the ABC classification system. The consequences of overtrading are liquidity problems and difficulties in supplying customers (through an inability to purchase the unnecessary stock). the loss of bulk discounts. 102 . a business may be forced to cease trading because it lacks the cash to meet maturing obligations. Overtrading is a reflection of weak financial management. Revision question Danton Ltd began trading recently on 1 April 2008 with a balance at the bank of £300. • Clear authorisation procedures – authority for the purchase of stocks should be confined to a few key personnel within the businesses and the ordering process should be clearly set out – failure to do so may result in duplication of orders. Working capital and the problem of overtrading Overtrading will arise where the level of working capital and fixed assets employed by a business is insufficient for its level of operations. can help management ensure the costs of exercising control are commensurate with the expected benefits. It may arise through such factors as poor forecasting of profits and cash flows. high asset/sales ratios and a poor average creditors payment period. also mentioned.000. The business has agreed with its bank an overdraft facility of £20. etc. The business is both a wholesaler and retailer of carpets and floor coverings.000 for motor vehicles. During the first month of trading the business will make payments for fixtures and fittings of £15. Note also the just-in-time (JIT) approach to stock management.59 Financial management • Stock re-order level – the point at which stock is re-ordered will depend on the rate of demand during the period between ordering and receiving the stocks and the lead time. the business will acquire an initial stock on credit costing £24. which has attracted considerable interest in recent years. Overtrading often occurs when a new business expands its trading operations quickly but is unable to find the necessary finance to invest in fixed assets and working capital. • Stock management models – various decision models may be used to help determine the re-order points. The financial statements of a business which is overtrading may reveal low liquidity ratios. • Stock checks – the business should undertake physical stock checks to ensure the stock levels are consistent with the recorded levels – the existence of slow-moving and obsolete stocks may be detected where stock checks are made on a regular basis. In addition. The relevant readings in BMM and PA on this topic provide a good coverage of the stock management models available and should be studied carefully.000 and £8. At the extreme. Financial ratios may help detect the symptoms of overtrading.000 to cover the first year of trading. Careful monitoring and control of fixed asset utilisation and working capital is essential.000. A safety (buffer) stock may be held in order to deal with the risk of stock-outs. To deal with the problem of overtrading it is necessary to bring the level of operational activity into line with the level of finance available (even if this does lead to the rejection of profitable opportunities in the short-term).

0 8.0 0.5) (19. All stock purchases.7 0.3) (26.2 9.5 0.8 17.0 8. Administration expenses and selling and distribution expenses are payable in the month incurred.6) 5. State what problems the business is likely to face in the forthcoming six months and how might these be dealt with? Solution to revision question a) Cash flow forecast for the six months to 30 September 2008 Apr £000 Receipts Share issue Credit sales Cash sales Payments Fixtures Motor vehicles Initial stock Purchases Admin expenses Selling expenses Cash surplus /(deficit) Opening balance Closing balance 0.5 0.7 (29.4 24.8 0.8 0. iii) The business is concerned that supplies will be difficult to obtain later in the year and so.000 per month. including the initial stock.5 0.7 0.6 (26.2) 30.8 May £000 June £000 July £000 Aug £000 Sep £000 103 . Required: a.4 21.4 30.2 10. The second instalment of £0.000 ordinary shares payable in instalments.6 20.3) 12. b.8 0.0 9.0 9.50 per share is payable in September 2008.4 16.2 13.Chapter 9: Short-term finance and asset management Danton Ltd has provided the following estimates: i) The gross profit percentage on all goods sold will be 25%. Prepare a cash flow forecast for the six months ended 30 September 2008 showing the cash balance at the end of each month.5 0.2 (20.6 6.8 0.000 by purchasing an additional £2.000 and to increase at the rate of £4. ii) Sales during April are expected to be £10.000 per month until the end of July.8 9. vii) The initial bank balance arose from the issue of 60.0 5.4 34.4 19.5 (27.0 4. vi) The business intends to buy more fixtures and fittings in June for £8.8 (19.8) 15. Included in the administration expenses is a charge of £200 per month for depreciation and included in selling and distribution expenses is a charge for £300 per month depreciation.3) (27.6 52.1) 9.000 worth of stock each month in addition to the monthly purchases required to satisfy monthly sales.0 24.7 (8. Credit sales will be paid two months after the sale has been made.4 8.000 per month and selling and distribution expenses will be £700 per month. during the first six months of the year.2 8.0 13.0 4.3) 18. will be on one month’s credit. From August onwards.8 0. iv) 60% of sales are expected to be on credit with the remainder being for cash.8 0.6) 20.4 21. v) Administration expenses are likely to be £1. it intends to increase the initial stock level of £24. sales are likely to remain at a stable level of £24.0 7.6 5.2 31.8) (27.7 (27.000 cash.8 15.

(It is this purchase which pushes the business over its overdraft limit. See VLE for solution 104 . Though this problem and its solution are relatively straightforward they nevertheless encompass a number of important ideas and concepts. Depreciation is a non-cash item and therefore is excluded from the relevant expense figures. you should be able to: • explain the rationales supporting the financing mix of short and long term funds for an entity • describe the major short-term sources of funds. A reminder of your learning outcomes By the end of this chapter and having completed the essential reading and activities. b) The cash flow forecast above reveals that the agreed overdraft limit of £20. and reducing the level of credit sales. may involve some cost to the business.59 Financial management Notes: 1. costs and the providers’ requirements • evaluate different possible short-term sources to meet the corporate needs • discuss how to manage the major current assets including the knowledge of the basic models used in attempting to optimise their levels • make a strategic assessment of the effects of the uses of changes in current asset levels. the proceeds of the second instalment of the share issue will bring the business into cash surplus by the end of the six month period under review. 3. 2. Consider the advantages and disadvantages of funding all of a company’s current assets from bank advances or other short-term sources. be possible to negotiate an increase in the overdraft limit to deal with this short term problem. Discuss. it may be possible to defer the purchase of the fixtures and fittings in June until a later date. reducing the credit period to customers. For example. Practise questions 1. However. Consider the derivation and implementation of an optimal trade credit policy. Purchases represent 75% of the sales for the relevant month plus an extra £2. These options.) However. which must be understood both from the practical viewpoint and as a basis for the chapters that follow on treasury management and currency management. It may. 2. How might a firm go about determining its target cash balance? Evaluate the model(s) you have recommended. their characteristics. therefore.000 will be exceeded in three consecutive months. if this is not possible.000 for stockbuilding. If this is not possible the business must consider other options. then the business might consider other options such as the deferring of payments to trade suppliers. however.

numbers 6 and 7. 105 .846–47. Chapter 20.Chapter 9: Short-term finance and asset management Problems Attempt the following problems in BMM: • Chapter 19. numbers 3 and 4. p. numbers 12 and 15. numbers 11 and 19. Attempt the following problems in BMA: • pp.875.

59 Financial management Notes 106 .

and having completed the Essential reading and activities. Allen Principles of Corporate Finance. Thus this chapter describes various forms of financial derivatives such as options which companies can use to help manage their foreign exchange exposure. (McGrawHill. S.C. There is a section on the interrelationships between the variables that affect currency exchange rates in the marketplace.. Further reading Brealey. 2008) Chapters 27 and 28. 2007) Chapters 22.A. transaction and economic are explained. 23 and 24.Chapter 10: Treasury management and international aspects of financial management Chapter 10: Treasury management and international aspects of financial management Aims of the chapter There is an ongoing expansion of overseas trade by companies which means that they need to keep abreast of the changing international foreign exchange markets. The chapter starts with describing types of options and their valuations and then moves on to their use in hedging against foreign currency risk.. translation. Myers and A. you should be able to: • discuss what derivatives are and how they work • describe the types of options and also the factors which affect them • explain the theory underpinning basic option valuation • explain the application of option pricing theory to corporate finance • explain why financial managers are concerned with international financial management • describe the basic definitions associated with foreign exchange transfers • explain the various theories that underpin the activities in the foreign currency markets • explain how financial managers can manage the three major types of currency exposure.A.C. Myers and F. R. Learning outcomes By the end of this chapter. Essential reading Brealey.J. (McGraw-Hill Inc. The three types of currency exposure. 107 . S. Marcus Fundamentals of Corporate Finance. Other methods of hedging such as futures and forward contracts are described and then incorporated into examples showing how the currency risk is minimised. R.

59 Financial management

Introduction
In this chapter we provide an introduction to both the basic instruments of treasury management and how companies manage foreign exchange risk. At first glance, this chapter may seem very long and daunting, but you are asked, first to attempt the section on options and basic treasury management techniques and, secondly, to proceed to aspects of international financial management. The aim of this chapter is to provide you with a basic appreciation of option valuation; and not to turn you into Wall Street option specialists overnight. Keep in mind that Chapter 23 in BMM only provides an introduction to options whereas Chapter 24 in BMM broadly covers risk management techniques in particular, hedging.

Why should financial managers of firms be concerned with options and other financial instruments?
The opportunity to buy or sell an asset in the future can be expressed using options whereby the opportunity to buy an asset known as a call option and to sell a put option. The price at which the purchase of the option is made is known as the exercise price and as to the date of exercise this can be a specific date such as 25th March, 20X7, as in the case of European options or they may be exercised any time up to and including the exercise date, an American option. First, most capital budgeting projects will have options embedded in them; as these options will allow the company to profit if things go well but also provide downside protection should profits go down. Downside risk is associated with the probability of failure for a business. Second, many of the securities that firms issue will include an option. For example, many companies issue convertible bonds whereby the buyer has the option to exchange the bond for ordinary shares at a certain date in the future. Third, financial managers will invariably use currency, commodity and interest-rate options to protect the firm against a variety of risks and therefore provide the firm with a degree of flexibility (such as unpredictable changes in raw material costs, tax rates, technology, etc.) The purpose of this chapter is to provide an introduction into how companies provide flexibility in managing risk by using options and how they use other financial instruments to offset risk –a process commonly referred to as hedging.

Calls and puts
Call option gives you the right to purchase an asset at a fixed exercise price on or before the exercise date. For instance, you would need to pay £5 for an option to buy British Airways shares (call option) in January 2008 at £40 (exercise price) any time until the exercise date which is December 2008. In all instances the movements in the price of the option (between January and December) will reflect movements in the share price of the company. Therefore, if the share price for British Airways shares was greater than £40 in December, then you would want to exercise your right to purchase the share at the £40; as the market price exceeds the price that you must pay to buy the share. On the other hand, if the share price is below £40 then you would not exercise the right to purchase the option and you would only lose £5 (the value you paid for the option in January).
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Share price as option expires: i. exceeds exercise price ii. less than exercise price

Value of call option on expiration: share price minus exercise price zero as option is NOT exercised

Put option gives you the right to sell an asset (which you may not necessarily own) at a fixed exercise price on or before the exercise date. For instance, you would need to pay £3 for an option to sell British Airways shares at £40 (exercise price) any time until the exercise date which is December 2008. Therefore, if the share price for British Airways shares exceeded £40 in December, then you would not want to exercise your put option as you would need to purchase the share at a price greater then £40 and then have to sell at £40, incurring an overall loss; in passing you would only lose £3 for the original price of the option. However, should the price of British Airways shares be below the exercise price of £40 then you would want to purchase the shares at a price below £40, and then get a guaranteed price of £40 thus making a gain between the current share price and the exercise price. Share price as option expires: i. exceeds exercise price ii. less than exercise price Value of put option on expiration: zero as option is NOT exercised exercise price minus share price

Selling calls and puts
If you decided to sell the December 2008 call on British Airways shares, the buyer would pay you £5. However, in return you must promise to sell British Airways shares at a price of £40 if the call buyer decides to exercise his option. The option seller’s obligation to sell British Airways is just the opposite to the option holder’s right to buy the shares. If the share price is below the exercise price of £40 when the option expires in December 2008, holders of the call will not exercise their option and you the seller will have no further liability. On the other hand, if the price of British Airways shares is greater than £40, the option will be exercised and you will have to give up the shares for £40 each. You will therefore lose the difference between the share price and the £40 that you receive from the buyer. The general rule is that the seller’s loss is the buyer’s gain.

The rights and the obligations of buyers and sellers of calls and puts
These are as follows: Buyer Call option Put option right to buy asset right to sell asset Seller obliged to sell asset obliged to buy asset

What the value of a call option depends upon
• To exercise the option the holder must pay the exercise price. Therefore, with other factors remaining constant, the less you are obliged to pay the more you are likely to gain. Therefore, the value of the option will be lower when the exercise price is high relative to the share price. • Investors who purchase shares by the way of a call option are purchasing on instalment credit. They pay the purchase price of the option today but delay payment of the exercise price until the option is exercised. The higher the rate of interest and longer the period to the expiration date, the higher this ‘free credit’ will be worth.

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• The owner of a call option cannot lose more than the price of the call irrespective of how far the share price falls. On the other hand, if the share price rose above the exercise price, the holder of a call would benefit when the option is exercised. • Thus, the option holder in reality should not lose the total amount as a result of increased variability (share price volatility) if things were to go wrong; on the other hand the option holder would gain if things were to go right. Obviously, the value of the option increases with (a) the variability of share returns and (b) the longer the period to the final exercise date, as this will provide a greater opportunity for the share price to be volatile. In summary, what the price of a call option depends upon: If the following indicators increase The value of the…call option will… Exercise price Share price Time to expiration Share private volatility Interest rate Activity 10.1 Why should financial managers be concerned with using options? What does the value of a call option depend upon? See VLE for solution Drop Rise Rise Rise Rise

Option valuation model
The Basic approach to option valuation relies on finding a balance between a combination of borrowing and investment in a particular share that mimics the option. Worked example 12 Suppose it is January and you are contemplating the purchase of a call option on British Steel shares. The call has a December exercise date and exercise price of £40. The current market value of a British Steel share is £30; thus the option will be valueless unless the share price rises by £10 over the 12-month period. The outlook for British Steel’s share price is uncertain and all you know is that at the end of the year, the price will be either £10 or £70. Finally, the rate of interest on a bank loan is 10 per cent a year. You are required to calculate the value of a British Steel call. Here are the cash flow projections for the alternatives which are currently available: Here are the cash flow projections for the alternatives which are currently available: British Steel shares Jan Outcome 1 Investment Outcome 2 £30 £70 Dec £10 ? £30 Call option Jan Dec £0 £100 £110 Bank loan Jan Dec £110

Note: when the call expires in December, the option will be valueless if the share price falls to £10 and it will be worth 70 − 40 = £30, if the price rises to £70.

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in this section we extend our current understanding of allowing for flexibility with the aid of options. The formula for the number of shares per call option is: Spread of possible share prices Spread of possible options prices = 70 – 10 = 60 = 2 30 – 0 30 Therefore 2 shares need to be bought to replicate one call option. This level is not required here. the put options exercise price would be the value of the project’s assets if shifted to an alternative use. • In other words.09 –20. Chapters 22 and 23 in BMA illustrate advanced calculations of option values using put-call parity. For example. for instance. buy 1 British Steel share and then borrow the present value of £10 is Cash flow in Jan Strategy I Buy 2 calls Strategy II 1 British steel share Borrow PV (£10) −30 +9. The two strategies require a computation of the number of shares per call option to ensure equality between the strategies.09)/2 = £10. Therefore. 111 .91 +10 −10 0 +70 −10 +60 ? Payoff in Dec if share price is equal to £10 +0 £70 +60 You will notice that. binomial and Black Scholes option valuation models. the payoffs from Strategy I and Strategy II are identical. In contrast. These projects are in fact. If the two investments give the same payoffs in all circumstances. 2 call options = 30−9.46. providing the firm with a call option (for the future) on getting additional capacity. Using options to allow the expansion or abandonment of real assets You have seen the need to allow for flexibility in investment projects in Chapter 4 of this guide. to calculate the value of the call you can replicate a call by combining a bank loan and an investment in the same share. Therefore.91 • thus the price of 1 call = (30−9. many capital investment projects on real assets provide flexibility to expand capacity should it be found that demand turns out to be more buoyant than expected.09 = £20. Black and Scholes (1973) came up with a similar formula which showed that you could price calls by replicating the investment in the call by performing a series of investments in shares and partly funded by borrowing. irrespective of whether the share price falls to £10 or rises to £70. then their value must be the same today. if the firm suddenly realised that demand was not as high as they had anticipated.09 buy 2 call options (adopt a strategy to profit from volatility). This would in theory be the complete opposite to the option to expand which utilised a call option and therefore would make use of a put option (to abandon in the future). firms may also consider the position concerning the alternative uses for their assets.Chapter 10: Treasury management and international aspects of financial management Now consider the two investment strategies that are available: • Strategy I • Strategy II £9.

hedging certain likely events such as foreign exchange movements by companies which import or export goods reduces the currency exposure risks these companies are open to. They are essentially agreements to buy or sell an asset in the future at an agreed price 112 . forward contracts and swaps which have been regarded as some of the great success stories in finance. They can adopt the use of a number of specialised financial instruments known as derivative instruments (derivatives) which allow them the opportunity to manage these risks. they often include an option in the package. but the final payment for the asset does not occur until the delivery date. exchange rates and share prices • commodity futures to allow companies to fix the future price that they pay for a wide variety of agricultural commodities. Futures contracts tend to come in a standardised format and tend to be traded on formal exchanges. Dramatic changes in interest rates. Finally. for instance. Why do companies hedge? Most companies hedge (using treasury management techniques) to reduce risk rather than make money. metals and oil. As already discussed. Futures contracts These are agreements made today to purchase or sell an asset in the future. options are often used by firms to limit their downside risk. The price is usually fixed today. should interest rates decline and the value of the bond rise).59 Financial management Options on financial assets When companies issue securities. Other derivatives include futures contracts. if a firm’s profits grew by 30% the directors can decide how much the increase is due to a shift in the exchange rate and how much it is due to good managerial decision-making. • Callable bonds are bonds that may be repurchased by the firm before the maturity date at a specified call price (gives an option to the firm to buy the bond back at a specified price. exchange rates and commodity prices can make planning difficult for financial managers. By reducing the risk of a project the financial planning of it becomes easier and therefore the likelihood of an embarrassing short-fall is also reduced (in extreme cases the short-fall could even trigger off bankruptcy). Here are a few examples of the options that are associated with new financing: • Warrants allow the right to buy shares in a company at a stipulated price on a set date(s) (long-term call option). Hedging is also a technique which may be able to help the directors of a firm assess the performance of their top management. • Convertible bonds are bonds that the holder may exchange for a specified number of shares (give the investor the option to buy the firm’s shares in exchange for the underlying bond). Forward contracts These are usually bespoke (specially made) futures contracts. In essence there are two broad types of futures: • financial futures to help firms to defend themselves from unseen movements in interest rates.

selling you) £1.77 or Euros 1. The difference between the bid and the ask is called the spread.Chapter 10: Treasury management and international aspects of financial management Activity 10. the extent of which is influenced by the level of risk. Unfortunately. compared with the environment faced by them solely operating in the domestic market place. The foreign exchange market enables the transfer of purchasing power denominated in one currency into another currency by providing a market place and acting as an intermediary. whilst it would ask $12. It is to these new dimensions that you need to address yourself.80 or Euros 1.e.02 0. exchange risk exposure and management of foreign exchange exposure. which balances demand and supply for a currency today is called the spot rate. However.28 12. and for a future date is called the forward rate. so if the value of £1 is expected to fall over the month then the HK$ will be trading at a small forward premium to the spot rates since it takes less HK$ to acquire £1. The forward rate incorporates the market’s expectation of the future movement in the currency.77 Ask 8. See VLE for solution International financial management Introduction When a business goes international it adds many new dimensions to the analysis and actions undertaken by its financial managers.30 before giving you (i. 113 .2 Describe in what circumstances are companies likely to hedge: illustrate your answer with an explanation of two derivative instruments. Foreign exchange market It is always worthwhile to learn not only the terminology associated with this topic but also the mechanics of the foreign exchange markets before learning the theories and some of the primary management techniques of dealing with currency risk.80 Spread 0. the volume of deals and the type of the market. The market clearing price. Each of the quotes (examples of which are found in the respective chapters of BMM and BMA) are in pairs – bid and ask. you will be required to know the basic definitions associated with foreign exchange transfers.30 12. Trading at a discount means the points would be added to the spot to get the forward rates because the £1 is expected to appreciate.03 Thus HK$12. there is only a brief outline in the BMM textbook on this subject but more can be found in Chapters 27 and 28 in BMA. In the example HK$ is trading forward at a premium as sterling is expected to weaken.28 is the amount the bank will give you for £1. Rates per £1 (Sterling) Bid F Francs HK $ 8.

if the market is operating effectively.59 Financial management Forward and spot rates per £1 for Hong Kong $ Bid Spot rate ($) Points Forward rate (30 days) ($) 12. If this happens the relationships. shown below. will move closer and closer to the equilibrium positions presented here.1 attempts to show the theoretical links between differences in interest rates in different countries (A&B). and the market forward rate and the expected spot rate which should be identical.1 Interrelationships between variables affecting exchange rates Figure 10. 114 .60 Spread 0. Bear in mind the objective of maintaining as efficient a market as possible.80 (0. Interrelationships between variable affecting exchange rates Learn the five basic interrelationships that affect the exchange rate between two currencies. If they are different then the traders should buy or sell appropriately until equilibrium is achieved.54 Ask 12. then the traders will be looking to test the relationships in order to generate trading profits. But.23) 12. on the one hand and the desire for traders to profit through arbitrage which.03) 0.06 Remember that the concepts of market efficiency and arbitrage are also applicable here in the international foreign exchange market as they were in the capital market.77 (0. will enhance efficiency. if there are some inefficiencies. by the same token.03 (0. Figure 10.20) 12. differences in inflation rates and the resultant expected parity with differences between the present spot rates.

Borrow $10 million at 10. (The difference in annual interest rates of 1.Chapter 10: Treasury management and international aspects of financial management Worked example 13 The following exchange.35% 10.0587 2.0552 × 4891822 = $10. convert and invest $10 million loan in UK.0645 2.15% 10.0551 Interest rates (annualised) USA Lend 30 days 90 days Required: a. Repay it with interest after 30 days. $ Capital and interest due for repayment in 30 days Borrow Lend 11. Bid Spot ($ per £1) 30 day forward 90 day forward 2.0645 and invest the proceeds in the UK at 11. evaluate the above situation in terms of pure interest arbitrage. Try this for yourself using easy amounts like $10 million or £10 million.35% p. – would you comment differently if the transaction costs were 0.577 If the mechanism was operating perfectly there would be zero loss or gain. lending and borrowing rates were quoted on 30 March for the US$. This approach can be repeated for the three other alternatives. take as your example borrowing for 30 days in USA and investing in UK and b.60% Take. If the market is in complete equilibrium the dollar proceeds exactly pay off borrowings plus interest.0552 2.822: 2. b.55 p. Buy a forward contract to convert the sterling investment proceeds back to dollars. £ sterling in the USA and UK.9% p.250 = $ 32. With dollars in hand pay back loan and outstanding interest. Having borrowed $10 million.0511 Ask 2.086.053. discuss whether the interest rate parity equilibrium is holding.891. or just $1 or 115 . Sterling value at end of 30 days: Buy $ forward contract to convert to £ to $ for the expected proceeds of £4.40% 10.10% 11.25%? Solution to Worked example 13 a.60% UK Borrow 12. a.a.40% 10.673 Loss on deal = 10.0615 2.053.673 − 10. Let us assume we can borrow $10 million for the benefit of our answer (but we could have used $1 just as easily).a.90% 11. convert it into £ sterling at the spot rate of $2. suggests it might be a worthwhile operation). borrow in USA and invest in UK for 90 days and borrow in UK and invest in USA for either 30 or 90 days.

59 Financial management

£1. The losses or gains you will derive will tell you in theory whether it is a worthwhile trade. The larger the loss or gain the less the market is in equilibrium and the more likely the arbitrageurs will move in and, by their actions, influence currency and interest rates to make it less rewarding for those that follow. In practice, traders may have to pay some transactions costs which if they amounted to 0.25% would increase the loss shown in (i) above and obviously affect the figures you have calculated for the other possible deals. Any transactions costs influence operating efficiency and the movements towards equilibrium.

Exchange risk exposure
A business is exposed to exchange risk when a movement in a currency would change for better or worse the parent business’s home currency value of any of the business’s assets, liabilities, cashflow or expected profit streams. You will be expected to describe the three main categories of exposure: translation, transaction and economic exposure. Some texts may call economic exposure by another name, operating exposure, as well as treating transaction exposure as a subset of economic exposure. You are only required to learn the basics of translation exposure as an advanced financial accounting course would cover the topic in greater depth. Translation exposure arises from the need to consolidate overseas subsidiary balance sheets and profit and loss accounts into the one set of accounts for the group in one currency. This consolidation requires the translation of foreign currency valued assets etc. into the home-currencyvalued assets etc. on a particular date. The choice of exchange rate can have a material effect on the consolidation figures. For this paper we concentrate on the problems faced by management of actual or potential cashflows. When a debt is payable or receivable, in a foreign currency, this gives rise to transactions exposure, while economic exposure relates to the exposure of potential cashflows For example, if a steel manufacturer tenders a contract to make and supply large steel pipes to an oil drilling company, then the steel business will have a potential (economic) exposure during the tendering process and period which becomes an actual (transaction) exposure once the contract has been accepted with delivery and payment dates agreed.

Management of foreign exchange exposure
You will be expected to discuss the internal techniques a holding company can use to manage and minimise foreign currency exposure such as netting, matching, leading and lagging and asset and liability management. In addition, you will also be required to explain the mechanics of hedging, the use of options and swaps. (you will not be required to do worked examples of these.) Worked example 14 – hedging question Lee Ltd import goods to the UK from Singapore. At the end of December the business has just signed a contract requiring a payment of $ (Singapore) 586,000. The business is considering the cost of three possible ways of hedging the foreign exchange risk arising from the contract: forward contract, money market hedge or the acquisition of foreign currency options. The various rates and prices at the time of signing are given below:

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Chapter 10: Treasury management and international aspects of financial management

Exchange rates (London Market) Singapore $/£ Spot 3 months forward 6 months forward Interest rates (annual) Six months $ Sterling Singapore $ Borrowing 12.5% 9.0% Lending 9.5% 6.0% 3.4212 – 3.4280 1.64 – 1.54 cents premium 2.78 – 2.68 cents premium

Foreign currency option prices (LIFFE Market) (Prices are cent per £ contract size £12,500) Put option Exercise price ($) 3.40 3.60 June 13.80 18.64

(Note: If the forward contract is undertaken then cash will be paid in six months’ time, as it will if the option is taken up.) Required: 1. Calculate the cost of the three possible ways of hedging the foreign exchange exposure open to Lee Ltd; identify the extent of the exposure. 2. Evaluate the three possibilities and make a recommendation to the business. Solution to Worked example 14 1. a. Forward exchange market–forward contract • Use forward rates for six months. • Use the bid rate because you are buying S$ • Remember it is the cost to Lee in £ Sterling that matters (i.e. required as the answer). Forward rates = Spot − premium = (3.4212 − 0.0278) − (3.4280 − 0.0268) = $3.3934 − 3.4012 Cost of forward contract to buy S$586,000 = 586,000 3.3934 = £172,688 b. Money market hedge • S$586,000 to be paid in six months • Borrow £ now, convert immediately to S$ and invest it so it becomes $586,000 in 6 months. • Singapore lending rate 6.0%, sterling borrowing at 12.5% Amount needed for investment: = 586,000 1+[0.06 × (16/12)] = S$568,932

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59 Financial management

Amount if £ required at spot to provide S$568,932 = 586,000 3.4212 = £166,296 Amount required in six months to repay sterling loan and accumulated interest: = 166,296 × [1 + 0.125 × (16/12)] = £176,690 Cost of money market hedge: £176,690 c. Currency option • • • • Choose option rate, note price per £. Calculate required number of option contracts of £12,500. If option to be exercised calculate net S$ flow, convert to £. Sum sterling flows.

Assume buy put option at S$3.60. It gives Lee the right to sell £1 at S$3.60 in June. Price per £=18.64 cents. £ value of debt owed at option rate: = 586,000 360 = £162,778 Number of option contracts (to next whole number): = 162,778 12,500 = 13.02 = 14 contracts Cost of 14 option contracts: = 14 × 12,500 × 0.1864 = S$32,620 Amount required in six months to repay sterling loan and accumulated interest. If exercised, 14 contracts provide: S$(14 × 12,500 × 3.60) = S$630,000 Net S$ cashflow in June: = 630,000 − 32,620 − 586,000 = S$11,380 inflow Net inflow must be converted at forward rate to £ sterling (As an inflow use ask rate, for outflow use bid rate). Total £ sterling outflow in June = (14 × 12,500) − 11,380 3.4012 = £171,654 (Note: If Lee Ltd had chosen to buy options at S$3.40 rate it would have required 14 option contracts, produce a net S$ outflow on conversion, which when translated at the forward bid price plus £ sterling outlay for the contracts of £175,000 would show a total cost of £179,465. You can give yourself some practice by reworking the option section using the information for S$3.40 options, the guidance in this paragraph and then checking your answer.) d. The extent of the exposure is the amount due S$586,000. 2. The cheapest possibility is to buy 14 put options at S$3.60 per £. This method costs £171,654, £1034 cheaper than the simpler, easier method of buying a forward contract at S$3.3934 per £. However, if the spot bid price in June rose above S$3.6039 then Lee Ltd could dispense with using the options and buy S$ in the market to cover the combined cost of the outstanding debt and option purchase cost (586,000 + 32,620) [N.B. The cut off spot price of S$3.6039 comes from dividing the £ sterling cost (£171,654) into the combined S$ cost of S$618,620], the more the future spot price exceeds S$3.6039. The more the future spot price exceeds S$618,620, the cheaper the cost of paying off Lee’s debt becomes. The exposure risks are covered in all three methods but in the money market hedge there is an
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To take out a forward exchange contract.150 premium iii. Via the bank use a money market hedge. A reminder of your learning outcomes By the end of this chapter. It is required to make a 20 million rupee payment in six months’ time for a shipment of tea just received. Sugarloaf Tea Importers Ltd. the premium cost would be £0. At present. Separately set out the financial implications of each of the four options for each of the two exchange rate expectations. Using the figures calculated in (a) review your 119 .5% on the sterling value as administration expenses. and having completed the Essential reading and activities. the two person department is split equally. annual interest rates are UK 5% India 10%. Outline the strengths and weaknesses of the hedging methods used in the four options above. Practise question 1. They are: i. of 75 and 65 rupees. is a British tea-importer importing teas from various foreign countries. To take out an over-the-counter currency option via the bank at an exercise price of £1 = 69 rupees. The department is considering four options. of the treasury department members. In addition the bank would charge 0. you should be able to: • discuss what derivatives are and how they work • describe the types of options and also the factors which affect them • explain the theory underpinning basic option valuation • explain the application of option pricing theory to corporate finance • explain why financial managers are concerned with international financial management • describe the basic definitions associated with foreign exchange transfers • explain the various theories that underpin the activities in the foreign currency markets • explain how financial managers can manage the three major types of currency exposure.2657 6 months forward (rupees) 0. ii. Currently the exchange rates are: £/rupees spot 70. iv.05 per 100 rupees. (10 marks) b.100 rupees – 70.Chapter 10: Treasury management and international aspects of financial management added practical risk that interest rates might change during the six months thus not completely wiping out the exposure risk using this method. while the other member believes it will strengthen to 75 rupees. REQUIRED: a. In this situation. in that one member believes that shortly the £1 will weaken to 65 rupees per £1.60 – 0. The treasury department of the company is reviewing its general strategies for hedging foreign currency payments as well as trying to decide how to hedge against the foreign exchange risk associated with this payment. Do nothing and pay the bill when it falls due in 6months time.

numbers 19 and 20. numbers 1.750. 10 and 18. numbers 9. and if so.781. 120 . 5 and 12. 3. no. Briefly discuss whether the treasury department should maintain a general rule as to which hedging method to use. which one. Chapter 23. or should they treat each transaction on its merits. 7. p. number 16. Chapter 24. Attempt the following problems in BMA: • p.59 Financial management results and make a recommendation as to the hedging option to be used for making the payment. (3 marks) See VLE for solution Problems Attempt the following problems in BMM: • Chapter 22. giving your reasons. (12 marks) c. 4.

Myers and F.A. S. corporate restructuring and off-balance sheet funding Aims of the chapter Most companies are involved in either a merger or a takeover sometime during their corporate existence so understanding the motives and tactics behind them is very important.. R. (FT Prentice Hall Europe. Atrill. S.Chapter 11: Mergers. Further reading Brealey. you should be able to: • explain the reasons why companies may decide to merge with another firm • describe the factors that may give rise to merger waves • explain the motives underlying individual mergers (including economic theories) • explain the role that takeovers play in removing inefficient management • describe the rules governing takeovers in the UK • describe takeover defences and any advantages and disadvantages they may have • describe the theory and evaluate the methods of company restructuring and refinancing • explain both the types and reasons underlying leasing.J. corporate restructuring and off-balance sheet funding Chapter 11: Mergers. A section then looks at corporate restructuring and divesting. There are waves of merger activity and an explanation is put forward for this before describing the motives and theories behind mergers and takeovers. (McGrawHill. 2007) Chapter 21. Finally off balance sheet financing and leasing is introduced and explained. .A. P Financial Management for Decision makers. Essential reading Brealey.C. R. 2005) Chapter 12. 121 . Myers and A. Learning outcomes By the end of this chapter and having completed the essential reading and activities. (McGraw-Hill Inc. These are explained. as does a knowledge of defence tactics should a company not wish to be taken over. Allen Principles of Corporate Finance.C. Marcus Fundamentals of Corporate Finance. To achieve success in taking over a company requires a knowledge of appropriate tactics. 2008) Chapters 32 and 33..

legal and accounting regulations that need to be followed. this situation is also referred to as the economic disturbance theory of mergers. value of shares exchanged and pre-acquisition profits. When one firm buys another. financial managers spend a great deal of time searching for firms to acquire or they spend time worrying about firms which are likely to take their firm over. the accounting rules emphasise the continuity of ownership and in takeovers the emphasis is rather on a purchase and discontinuity of ownership. In a merger. One of the most popular reasons advanced for waves of merger activity suggests they are associated with booms and slumps in the economy and stock market prices. it is exactly the same as undertaking any ordinary investment. buying a machine. and the directors of the smaller company do not recommend shareholders to sell their shares to the purchaser and neither the pre-bid shareholders nor the directors of the company have any interest in the combined firm. there was a takeover boom between 1984 and 1989. It was also a period when company profits and liquidity in general were relatively high and large funds were available to perform takeovers. During periods of intense merger activity. 122 . Strictly. Many academics believe that the reasons for merger waves may not be economic but behavioural. then this is an acquisition or takeover. gives a UK perspective on merger activity. Several reasons have been advanced for these so called merger waves: • during the 1960s boom conglomerate mergers became fashionable and • during the 1980s boom the UK was preparing itself for the single European market in 1992. due to the tax. a merger is when two companies of equal size come together and continue to have an interest in the combined business. France and the US also experienced a similar trend in merger activity. The only problem with the notion of the economic disturbance theory of mergers is that we do not understand the economic forces that underlie the pattern of merger activity. when a large company makes a bid for a smaller company.59 Financial management Introduction This chapter focuses on trying to explain the motives and tactics involved in merger and acquisition activity. say. Merger waves In the UK. This supports the idea of the combination while. from our earlier studies of financial management we will know that the investment should only proceed if there is going to be a net contribution to shareholder wealth. Chapter 21 in BMM gives a predominantly US perspective on the topic whereas Chapter 12 in PA though very detailed. the main differences between the accounting rules are concerned with the treatment of goodwill. Therefore. This was not only the case in the UK – Germany. in general. The terms mergers and takeovers are used interchangeably. but this boom had been driven largely by a small number of very large acquisitions. The only problem is that mergers are very difficult to evaluate because the benefits and costs may not be easy to measure and also they are more complicated than. there was increased expenditure on acquisitions which coincided with a general increase in capital expenditures by industrial firms. This is because in many instances it is not clear whether one or the other is occurring.

and 20. as the shareholders of company B would then receive two-thirds of the gain (30.000 + Gain Here the relative gain would be 30.000. this is commonly referred to as a synergistic effect (the simplest explanation is that the combined firm’s resources increase the potential for future growth and make it possible to utilise each firm’s relative advantage).000 − 20. in which situation the shareholders of company B would gain. or • if they can buy company B at a price below the present value of its future cash flow. Economic theories of mergers • Economies of scale • Internationalisation of transactions • Market power • Entry into new markets/industries • Elimination of misguided management • Free cash flow (trapped equity) • Undervalued shares 123 . If we assume: PVab = 100. If company A decides to take over company B then their reasons for the attempt would be either: • if they believed the value of the two firms together exceeds the value had they remained separate entities.000 Gain. it could end up paying a price above the PVab. For example: PVab = PVa+ PVb + Gain If company A decided to bid for company B (the target).000 = 10.000/30. The management of the firm should be acting in the interests of their shareholders (we discuss managerial motives for takeovers in a later part of this chapter).000 was paid for company B.000 then PVab = PVa + PVb + Gain 100.Chapter 11: Mergers. when a firm decides to merge with another. it is important to point out that.000. it is the management of the firm who make the decision. PVa = 50.000 = 50.000 = 2/3 gain to shareholders of company B).000 + 20. Note: if PVab is the value placed on the consideration by company A’s management then (PVab − PVa) equals the maximum value they will pay for company B. Motives for individual mergers Before the motives are discussed. corporate restructuring and off-balance sheet funding What causes merger waves: • high merger activity when share prices are low (firms are bought at a bargain) • high merger activity when share prices are high (the stock market allows a firm’s management to finance takeovers through equity issues) • high merger activity in certain economic situations (especially prevalent in technology driven industries).000. but the gain would be much smaller if 40. PVb= 20.

but if markets are efficient then over the longer period. suppliers may be less inclined to compete with one another leading to higher prices paid by the merged entity. it may only be that the interests of managers differ from those of the shareholders. but to revise the concept we provide a brief explanation of economies of scale in finance – which arise where administrative costs per unit raised are less with large issues of finance than with small issues. Elimination of misguided management There is a substantial separation between the ownership and management of large firms. they will be identified and the market mechanism should ensure that they are replaced. Internalisation of transactions This usually occurs when firms vertically integrate (vertical integration backwards occurs by the acquisition of firms that supply raw materials and vertical integration forwards occurs when firms are acquired nearer the selling of the product). Shareholders do not appoint or supervise the firm’s management. and the merger leads to a greater share of a particular market).59 Financial management • Tax advantages • High prices/earnings rations (bootstrapping) • Risk diversification Economies of scale The topic economies of large scale production should have been adequately covered in your earlier economic studies. this is commonly termed the agency problem. What then happens if managers are inefficient? Inefficient managers can exist for a limited time period. it can provide almost instantly the necessary size for a firm to be an effective and formidable competitor. Entry into new markets/industries Entry into areas where an expanding firm lacks the know-how. In some instances. It is an important form of merger as it eliminates transaction costs when firms have to deal with each other. they only elect directors who are agents responsible for the choosing and monitoring of top management of the firm. For example. it was estimated that 3% of assets in the UK changed hands as a result of vertical integration while 57% were a result of horizontal integration (horizontal integration occurs where firms acquired are at the same stage of the production process. One drawback is that by merging two large firms. this general process is referred to in the academic literature as the market for corporate control. 124 . Market power During the boom of 1979–85. This is an attractive feature for firms as it has been shown that a concentration in an industry leads to a greater level of profit. As the growth through a takeover is quick. extra costs may result.

1 Undervalued shares An acquisition can also occur when the stock market is underestimating the real value of a firm. In the UK. then this may make it an ideal takeover target. 323–29. For instance. the law is more restrictive with regard to these considerations than in the US. Free cash flow (trapped equity) Michael Jensen (1986) suggested that managers with cash flows in excess of those required to finance all positive NPV projects within a firm would use the excess resources to finance takeovers. First. then the stock market value of the shareholders’ investments would increase more than if the money was distributed to shareholders. 1 Jensen. so as to reduce the overall groups taxation liability. ‘Agency Costs of Free Cash Flow. Two benefits to shareholders were identified by Jensen concerning the free cash flow theory. corporate restructuring and off-balance sheet funding How then do takeovers perform the disciplining function on inefficient management? For example. then the former company is able to purchase the latter firm on advantageous terms. The victims could actually be firms using assets to their best advantage but their share price may not fully reflect the true value of the firm and its assets. as banks and financial institutions are more likely to support a takeover bid from a company with a better stock market rating. if company A has inefficient management or they are neglecting the interests of shareholders then the managers of another firm. The point here is that the victims of takeovers are not necessarily the firms failing to make the most efficient use of their resources. High price/earnings ratios (bootstrapping) This was particularly important during the conglomerate merger booms of the 1960s. which would ultimately raise shareholders wealth in the future. Corporate Finance and Takeovers’. there would be tax benefits and second. company B will make a takeover bid for company A.C. they would use the funds to acquire other firms.Chapter 11: Mergers. M. If company A possesses a high stock market rating relative to another company B. Tax advantages The crucial point is whether or not the losses of one company can be used to offset the profits of another in the group. if a firm is not too familiar with its stock market valuation and its share price is low in relation to its actual potential. promising the shareholders of company A that they will be able to manage the assets of the firm better than the present managers. The same would apply if profitable growth opportunities were limited. and rather than distribute the excess cash to the shareholders. 125 . if the excess cash was used to finance a takeover in preference to a dividend. American Economic Review 26 (May 1986) pp.

It is in reality the management who initiate the bidding for the target on behalf 126 .000 shares at £1) and 500 shares of company A (500 shares at £2) will need to be offered. which would not be in their interest. From this point of view takeovers reduce risk for companies. Risk diversification During the conglomerate merger boom of 1979–85.000 shares outstanding Company A Total earnings EPS Share price P/E ratio 100 0. Companies A and B each have 1.000 shares would need to be exchanged for the takeover.000 shares priced at £l. the rationale for the mergers was said to be diversification. showing a gain for shareholders of company A of £0. the share price will be £2. If company A’s share price fell to £0.59 Financial management Worked example 15 If an acquisition is valued at £1. This is because they hold shares in company A which now has higher growth prospects. valuing the company at £1. as a firm can raise its EPS by merely acquiring other firms and not by normal trading.67 each giving a total value of £1. the lower the share price of the acquirer. See VLE for solution Management motives In the traditional theory of takeovers it is assumed that one company (bidder/purchaser) seeks to acquire another company (target). therefore. The shareholders of company B will also have benefited as prior to the merger they held 1. Activity 11. The key to this type of problem lies in the earnings per share (EPS). The position of company A after the purchase is as follows. which would eventuate in the stability of future cash flows. If the same P/E ratio is maintained for company A.67.000 and the present market price of company A (purchaser) shares is £1.13 The EPS has increased due to purchasing company B. As firms in different industries experience booms and slumps in their profits and cash flows at different times. then 1. Briefly describe the benefits and limitations of four different economic theories of mergers.67.1 Discuss how merger waves may occur.5 then 2000 shares would be needed. then the market value of company B is £1.333. it was felt safer for firms to conglomerate to reduce this volatility.00 20:1 Company B 100 0.000 but after the takeover they hold 500 shares at £2. If company A purchases company B. Total earnings Number of shares EPS £200 1.000 (1.00 10:1 Company A has a higher P/E ratio because it is assumed to have a higher prospect of future growth.10 2.500 0. the greater the number of shares (proportion of the acquirer) need to be exchanged.10 1.

who are regarded as the activists in the takeover. managers are unable to diversify their risk. corporate restructuring and off-balance sheet funding of the shareholders of the bidding firm. Takeover tactics • Rules governing takeovers in the UK • Bidding tactics • Market raids • Concert parties • The offer Rules governing takeovers in the UK Rules are self-regulatory and statutory: • the self-regulatory rules are known as the City Code on Takeovers and Mergers • the City Code is designed to protect shareholders • the City Code does not have the force of the law but all stock exchange listed firms must follow it • the major problem with the Code is that it cannot reverse events (impose sanctions after the event) • the statutory rules are governed by the Companies Acts. It will obviously be the target company’s shareholders who will ultimately decide whether to sell their shares to an acquirer.S Ruback ‘ The Market for Corporate Control. Another motive for management might concern their own survival. M. The Scientific Evidence’ Journal of Financial Economics 11 (April 1983) pp. The bidding company’s managers cannot diverge too much from shareholder wealth maximisation but they can and do take their own interests into account (i. The bidding management will make an offer to the target company’s shareholders. Activity 11.Chapter 11: Mergers. As already mentioned. in which alternative managerial teams compete for the rights to manage corporate resources. 2 Jensen and Ruback (1983) referred to the takeover market as creating the ‘market for corporate control’. the reduced risk of losing their job. Thus by pursuing an active takeover strategy they are less likely to offer themselves as targets for takeover predators. as they are tied to one firm usually.e. 127 .C. with or without agreement from the target company’s management. Unlike shareholders. 5-50. See VLE for solution 2 Jensen. The rules will vary between countries. higher status and remuneration). and R. Can you think of real examples that you have read about in the newspaper. This theory moves the emphasis from shareholders to the management of the company.2 Explain the role that takeovers play in disciplining inefficient management. Fair Trading Act and the Monopolies and Mergers Act • the objective of the Monopolies and Mergers Commission is to promote competition and prevent takeovers that reduce competition and are against the interest of the public • an EU takeover code and a statutory harmonisation code still needs to be developed.

The raider achieves their acquisition objectives before they have to notify the target company of the acquisition. 128 . only informed brokers acting on behalf of large institutional shareholders are quick enough to benefit from any market raids. The disadvantage with raids is that the initial high price offered at the outset of the raid is not usually offered to all the shareholders and. If the purchaser fails to acquire all the shares from the target firm’s shareholders then the remaining shareholders will become minority interests who will be entitled to receive dividends on their shares until they are sold. Concert parties Concert parties occur where several persons act together to buy shares in a particular company. the levels of cash flow for the target and c. the value of the target’s assets. The bidding company may have to obtain approval from its shareholders before the bid for the target can be made. the offer is posted disclosing the terms to the shareholders of the target. thus they do not need to notify the company of their holding. Market raids Market raids occur when a person or a company acts with speed of action in buying shares of a target company. this is the difference between the value of cash and securities being offered and the pre-bid market price of the target company.59 Financial management Bidding tactics Having decided to purchase a company. The factors which have been most commonly found to influence the size of the premium are: a. In the meantime. Within a few days. The idea is to make the offer as attractive as possible to the target company’s shareholders. the consent of the targets board and the takeover panel may be required. debentures. the bidding firm has to offer a premium to the target’s shareholders. whether there are any other firms keen to bid for the target b. both the stock exchange and the city code require concert parties to disclose any holding greater than 5% in total within 36 hours of an action. The offer only becomes unconditional (win/accepted) when the bidder has acquired over 50% of the voting equity. However. recently in the UK the city code has been revised to strengthen the restrictions prior to the announcement of an offer in an effort to achieve equity between shareholders. In the UK. The offer can be financed by the purchasing company’s equity. usually. The offer The acquiring company first announces its intention to make an offer disclosing its terms to the board of the target firm. the board of the target must circulate its own view of the offer and suggest whether shareholders should accept the offer. cash or other security. so that no one individual owns or has an interest exceeding 5%. the problems that arise are: • what is the value of the company and • how to finance the purchase. Almost always. When only between 30–50% of the shares can be acquired. Dawn raids are ones which take place at the early minutes/hour after the stock exchange has opened.

Chapter 11: Mergers. The city code on takeovers and mergers requires certain principles that must be met. corporate restructuring and off-balance sheet funding Activity 11. The city code makes it clear that shareholder approval is usually required before any approach to an outside party can be made. they need to convince their shareholders of the benefits associated with the defence. the board of the target company may also offer future incentives to their shareholders such as higher future dividends/profits or even changing the management team. In addition to these suggestions. If directors find a bid financially unattractive to their shareholders then in defence they may try to convince their shareholders that: • at the current market price. shareholders are given the right to convert loan stock/preference shares into ordinary equity on the announcement of a takeover bid. If directors decide to fight the bid. Usually. Takeover defences The directors of a company that is the subject of a takeover bid should act in the best interests of the shareholders. Glamorous defence tactics • White knights • Poison pills • Crown jewels. Crown jewels This defence involves a tactic of selling off certain highly-valued assets of the company subject to a bid: the intention being to put off any acquirer. Poison pills Another defence occurs where a company takes steps before a takeover bid has been made to make it less attractive to a potential bidder. In most takeover cases. It is a very successful strategy but should only be used as a last resort. 129 . Before they decide to defend a bid. the purchaser’s shares are overvalued or • the current market price offered by the purchasers is undervalued. in this case the friendly acquirer is termed the white knight. White knights One defence the directors of the target company may employ is to offer the ownership of their firm to a more friendly outside interest (defensive merger). professional advisors are recruited in the preparation of any documents relating to bids and defences. there are many defences open to them. as the value of the firm will be substantially reduced with the ‘crown jewels’ sold off.3 Under what circumstances are the rules and regulations which govern takeovers in the UK likely to prevent a takeover from occurring? Explain the following terms: • market raids • the offer.

Therefore. mergers seem to generate economic gains. or divestiture. Divestments During the 1980s and 1990s a new trend in corporate restructuring was evidenced. However. These include: demergers (spin-offs). Divestitures. refinancing and reverse takeovers. In concluding. Practically. several aspects of mergers have been discussed. division or product line by one business to another. You should be aware that this section only briefly outlines corporate divestments. namely divestments. The term divestment. buy-outs/buy-ins. This came about partly due to the increased tendency of company management to concentrate on the strategic processes of the firm. 130 . and you should read about and understand the motives and methods behind the other forms of change in Chapter 33 of BMA. although this term is usually reserved for describing the practice of selling unwanted or unprofitable parts of a business following an acquisition. means the sale of either a subsidiary. A situation soon developed in the UK whereby conglomerates were seen as being risky and highly inefficient both from a managerial and an investor’s point of view.59 Financial management Other tactics which you may be asked to discuss can be found in BMA chapter 32 are: • golden parachutes • pac-man • greenmail • producing a revised profit forecast • ESOP’s • shark repellents. especially to focus on the core-business activities. going private. In this section. during the 1970s many conglomerates (such as Hanson plc and ICI in the UK) sold off assets that they thought were unprofitable to them. probably the form which attracts the greatest media attention. occur whether or not a company has been involved in takeover activity. in additional to the financial issues. Company restructuring In the previous section of this chapter. namely a move towards company management adopting strategies of demerger or divestment. premium buybacks. on the other hand. Selling the parts of a business can be seen as similar to ‘asset stripping’. we briefly outline other forms of corporate restructuring in addition to mergers and acquisitions. there are many problems involved in attempting to evaluate the results of divestment as the mechanics of divestment involve a number of important behavioural issues. This increased competitive pressure encouraged firms to reorganise their group structure into more specialised and smaller manageable units and sell off aspects of the business which were not likely to be profitable in the future. but competition between bidders and active defence strategies by the target firm’s management may push most of the benefits to the selling shareholders. mergers are only one form of company restructuring. Typical mergers seem to realise positive net benefits for the shareholders of the acquiring firm.

In contrast. The lessor is usually a finance company. Leasing The topic of leasing is not covered in BMM but BMA (Chapter 26) provides too much material on the topic as you are only required to possess a general understanding of what leasing entails. to make the balance sheet look different. yet it obviously contains information content. a firm may be able to achieve a better value position for itself when it is more tax efficient to lease rather than own an asset. Leasing has increasingly become a popular form of medium. For instance. But at other times the effect is merely cosmetic. The major advantage of adopting a lease in preference to buying an asset is that it allows one party (the lessee) the use of an asset for a specified period of time. The lessee is usually the company making use of the equipment and in return paying a rental to the lessor. The distinction between the is concerned with the risks and rewards associated with the ownership of the asset. finance leases and operating leases.Chapter 11: Mergers. which purchases the asset and then leases it out for a period of time. The difference between hire purchase and leasing is that the former agreement the ownership of the asset at the end of the hire purchase period transfers to the party which had made the hire purchase payments. corporate restructuring and off-balance sheet funding Off-balance sheet funding This subject guide is. But.or shortterm finance. There is a brief introduction in PA (pages 226–8). In reality. • There can be considerable tax advantage. it can choose alternative ways of structuring its assets and liabilities to achieve the same business outcome. about how to make investment and financing choices which add value. Reasons for leasing The main reasons for leasing are as follows: • A company may not have the funds available to purchase the asset. in large part. given that a firm has a mix of business activities. at the end of the period of the lease the ownership of the assets remains with the lessor. There are two broad types of lease: namely. whilst. Therefore in this section we analyse the ways in which off-balance sheet financing may add value to a firm. 131 . The most common example of off-balance sheet financing involves the decision to lease assets rather than purchase them outright. In the case of an operating lease (which is usually for a shorter period than a finance lease) it is the lessor who is usually responsible for the maintenance of the asset and it is the lessor who loses should the asset become obsolete before the end of its useful economic life. off-balance sheet financing is undertaken so that its effects will not influence the market’s view since it is not information that is publicly available and visible to investors and potential investors. while the supplier of the asset (the lessor) still retains legal ownership. a finance lease essentially passes the risks (maintenance) and rewards of ownership to the lessee over the useful economic life of the asset and who in turn agrees to pay fixed annual amounts.

Prepare a report describing the takeover defence policies you are likely to suggest. you should be able to: • explain the reasons why companies may decide to merge with another firm • describe the factors that may give rise to merger waves • explain the motives underlying individual mergers (including economic theories) • explain the role that takeovers play in removing inefficient management • describe the rules governing takeovers in the UK • describe takeover defences and any advantages and disadvantages they may have • describe the theory and evaluate the methods of company restructuring and refinancing • explain both the types and reasons underlying leasing. Practise questions 1. Suppose you are the financial manager in a large firm and have been asked by the board of directors who have been threatened by a takeover bid to describe some policies that the firm may adopt in defending the takeover bid. A reminder of your learning outcomes By the end of this chapter. 2. and having completed the Essential reading and activities. The abbreviated st financial accounts for the year ended 31 December 2008 for both companies are as follows: Balance Sheets as at 31 December 2008 Jono plc. £ million Fixed assets net Current assets Less Current liabilities Less Long-term liabilities Ordinary share capital Share Premium Profit and Loss Account (50p shares) 800 (300) 500 860 (200) 660 50 250 360 660 (£1 shares) 360 200 (300) (100) 40 – 40 100 – (60) 40 Wilco plc £ million 140 132 . Jono plc is considering making an offer for Wilco plc.59 Financial management • A company may not wish to own a certain type of asset (such as a computer which may become out of date relatively quickly) • It is often suggested that leasing does not interfere with other borrowing or credit facilities.

REQUIRED a. its ordinary share capital is 40% owned by a group of business angels and the majority. 7.a. The merchant bank report that the average net dividend yield for the market as a whole is 4% p. 60%. and that if the two companies were to merge. with the second expected to be successful if the first is not. (9 marks) Problems Attempt the following problems in BMM: • Chapter 21. Attempt the following problems in BMA: • pp. numbers 1.000 100 50 50 Wilco plc £ million 500 1 1 0 Jono plc is a quoted public company with a price earnings (PE) ratio of 16x. even with no change in the annual turnover of Wilco or Jono. net asset value ii.910–12. 133 . The after-tax profits of Wilco would increase to 10% of its turnover with no change in the after-tax profits of Jono. by the original owner and members of her family. whilst the average net dividend yield for the industry is 3% p. Jono and Wilco are in the same industry.. nos 6. corporate restructuring and off-balance sheet funding Profit and Loss Accounts for year ended 31 December 2008 Rhy plc £ million Turnover Net Profit after tax Dividends proposed Profit Retained 2. earnings yield approach iii dividend approach. (6 marks) c.Chapter 11: Mergers. Using the underlying rationale of the valuation methods to support your argument. Wilco plc. 3 and 12. Provide valuations per share of both companies using three separate approaches: i. there would be considerable savings in administration and other fixed overheads. is not a quoted company. The merchant bank advising Jono have indicated that if Wilco were a quoted company. provide a reasoned strategy for Jono to follow in bidding for the share capital of Wilco assuming they will only make a maximum of two offers. the PE ratio for the company would be 5x. that Jono could pay for a share in Wilco without loss of value to Jono shareholders.a. (10 marks) b. the combined company would have a PE ratio of 14x. in their view. Give your reasons. Calculate the maximum. Jono and its advisors have just completed their due diligence investigation of Wilco and believe that if the two companies were combined then. in your view. 8 and 11.

59 Financial management Notes 134 .

within reason. c. at an interest rate of 10% per annum. It will help you review and critique the subjects covered in this guide. and the remainder from equity. which has a yield of 10% per annum.Appendix 1: Review questions Appendix 1: Review questions Read Chapter 26 in BMM. again assuming that Modigliani and Miller were correct in their assessment of the effect of capital gearing on the value of a business. Both the chairman and chief executive have recently expressed concern at the rising level of inflation within the economy and its implications for the financial management of the business. What will be the value of a share in MIM. It is the business’s policy to pay all of its annual profit as a dividend to the shareholders.000 on shares in AIP. or • make an investment in MIM which will provide her with an identical income. Jane is an individual who has £1. Required: a. what other assumptions have you made and how valid are they in real life? 135 . but that there is Corporation tax at 25%. AIP has 5 million shares in issue.000 to invest and wishes to make an investment either in MIM or AIR She is able to borrow as much money as she wishes. with identical risk. Associated Industrial Producers plc (AIP) is another Stock Exchange listed company which is identical to MIM in every respect except that it is financed 50% (based on market values of debt and equity) from a debenture loan. assuming that Modigliani and Miller were correct in their assessment of the effect of capital gearing on the value of a business and that there are no taxes. MIM is all equity financed and generates a steady profit of £5 million a year. MIM has 10 million shares in issue. This level of profit is expected to continue indefinitely. what is the theoretical price per share of the shares of MIM? b. The current market price is £4 per share. Jane is contemplating two investment strategies: • spend all of her £1. above. Question 2 Modern Industrial Manufacturers plc (MIM) is a Stock Exchange listed company. A board meeting has been arranged to discuss the issue. Required: Prepare a report for the board of directors which sets out the ways in which inflation may effect the financial management of the business. Question 1 Simat plc produces electrical and electronic components for the defence industry. Apart from the assumption of no taxes in part (a). Assess the position of Jane in respect of each of the two investment strategies. On the basis of your assessment of Jane’s position.

5 17. Average annual returns from short term UK government stocks over the past 10 years have been 10%. Required: a. The chosen figure will then be used in the assessment of Aspiration plc’s investment proposal. Capital asset pricing model Published sources reveal the following: James plc equity beta is 0.90 Average annual returns from Stock Exchange listed companies over the past 10 years have been 18%. The two approaches and the relevant data for use are as follows: 1. The management is contemplating making an investment which will expand its existing business. Because of the size of the outlay the business’s management is keen to assess the investment as carefully as possible. b.5 28. will come from debentures. Dividends per share for James plc over the past six years have been as follows: Year 1988 1989 1990 1991 1992 1993 Dividend per share (£) 15. Estimates have been made of the cash flows which will arise from the investment and the management is fairly confident of these estimates. The cash for the investment. One of the staff of the business has recently complete an Economics degree. To what extent would the management of Aspiration plc be justified in using the figures calculated for James plc’s cost of capital (part (a)) to apply to the estimated cash flows of Aspirations plc’s investment proposal? Explain any reservations which you may have about using these figures. Use the information provided to deduce James plc’s cost of capital on both of the suggested approaches. should it go ahead.5 22. Dividend valuation model The Gordon growth model will be used. 136 .59 Financial management Question 3 Aspirations plc is an unquoted. He has decided to select a business of similar size and activity to those of Aspiration plc and apply two approaches to deducing that business’s cost of capital. The business selected is James plc. which will be issued at par with a coupon investment rate of 12% per annum.5 19. He has been asked to look into the problem of finding an appropriate cost of capital figure. nor has there been a recent sale of shares in the company. 2.0 24. which included a course in Financial Management.47. medium sized business. particularly since the business’s shares are not traded on a Stock Exchange.0 James plc cum-div share price is £3. A problem has arisen in selecting an appropriate cost of capital to apply to the cash flow estimates.

there is no change in credit policy. Describe and critically evaluate at least three methods of evaluating risk that might be used when a business is appraising a group of investments. discuss how and why it may have to be adapted if it is to be used by the business in evaluating a major investment.000 per month. and ii. All expenses are paid one month in arrears. c. is currently reviewing its policy concerning trade credit. Having obtained the (β value for a business’s equity from a research source. Required: a. Question 5 a.Appendix 1: Review questions Question 4 Cameron plc. The introduction of a cash discount scheme is likely to attract new customers and so a 10% increase in sales is predicted. to encourage customers to pay earlier. Separately prepare a forecast profit and loss account for the business for the forthcoming year assuming: i. Separately calculate the investment in working capital at the end of the forthcoming year assuming: i. Address critically the assumptions underlying your proposed method and. cash discounts are introduced. 137 .000 at the year end. The rate of corporation tax is 30%. The level of sales for the next 12 month is expected to be £4m if there is no change in credit policy. State. the business will maintain a gross profit margin of 25% on all goods sold and will hold two months stock throughout the year. No cash discounts are currently offered to customers for prompt payment. with reasons. b. whether or not the business should implement the proposed policy. interpret the possible empirical results you could have obtained. Whatever trade credit policy is adopted. Trade creditors will represent two months’ cost of sales and the dividend payout ratio of the business is 60% of after tax profits. The business also intends to achieve a cash balance of £50. the business is considering offering a 2% discount for those paying amounts outstanding in one month or less. c. Briefly describe how the equity (β of a publicly quoted company could be estimated. cash discounts are introduced. and ii. At present. there is no change in credit policy. 25% of trade debtors pay one month after the invoice date and the remainder pay two months after the invoice date. This pattern is expected to continue in the forthcoming year if the current trade credit policy continues. in the light of those comments. The variable costs of the business (excluding cash discounts) are expected to represent 15% of sales and fixed costs are £20. b. However. which sells all of its goods on credit. It is expected that this incentive will lead to 50% of customers paying one month after the invoice date and the remainder paying two months after the invoice date.

000 tonnes of the new fibre each year for a three-year period at a price of £44 per tonne. The wage costs for the additional workforce is expected to be £200.000 per annum One third of this figure is arrived at by the reallocation of existing overheads to the contract. to be paid at the outset. borrow in Singapore and invest proceeds in UK. 138 .5 4. All other combinations are possible. nor the reciprocal. Assume you can buy and sell the currencies at the same mid rate for the time period (i.1378 2. ii. You are not allowed to borrow in the UK and invest the proceeds in Singapore.000 will be required immediately in order to commence production. are expected to be £15. The bank which is sponsoring the competition will lend up to 100. At the end of the three-year period the equipment will be sold for an estimated £6. there are no transactions costs).0 Borrowing 11. Question 7 Atlane Ltd has recently received an offer to produce a new type of synthetic fibre for a large international company.0 7. Indicate with evidence whether the £ sterling and US$ are in equilibrium together. Recruitment and selection costs. Indicate with evidence whether the S$ and US$ are in equilibrium together. iii. • Eleven new workers will be required to help produce the fibre.000 in the first year and will rise at a compound rate of 10% per annum.000 At the end of the three year contract the workers will no longer be required and redundancy payments of £2. Discuss briefly four techniques available to a company to use in hedging against foreign exchange risk arising from overseas trading.e.59 Financial management Question 6 a. b. The equipment required is highly specialised and can only be used by the company for production of the new fibre.5105 Fixed money market rates Lending Euro sterling (£) Euro dollar (US$) Singapore (S$) 6.4875 . Take up the competition’s challenge and indicate your predicted maximum gain through your money market operations. The directors of Atlane Ltd are currently considering the offer and have collected the following information: • New equipment costing £85.000 per worker will be paid.0 i. You have been given a challenge as part of a competition to see who can make the most money through trading on the foreign exchange market.0039 US$/£ 1.000 units of the local currency at the going market rate. • Overheads relating to the contract are estimated at £60. The offer is to produce 14.0 7.0 11.000. Foreign exchange rates Singapore $/US$ Spot 3 months forward 2.

This chemical is widely used in other production processes of the company. Points rating classes Cumulative percentage of market sales 11 40 82 95 100 Cumulative percentages of sales which turn out good 2 15 54 66 71 of sales that turn out bad debts 9 25 28 29 29 0 – 19 0 – 39 0 – 59 0 – 79 0 – 100 139 . The report gives the points rating for customers and the cumulative percentage of sales in the market that fall in that category or worse. Required: a.71 Question 8 Dewstone Ltd has received the following credit rating report on the customers in its industry.00 0. d.000 tonnes of this chemical already in stock. however if the contract is not undertaken the chemical could not be used in any other of the company’s production processes or resold in the market. if the new fibre is not produced. The directors of Atlane believe that successful execution of the contract may result in further contracts being offered by the same company. The directors have agreed that. The company has 4. b. The company already has 3. The original cost of this stock is £22 per tonne and the replacement cost is £25 per tonne. The total market is estimated at sales of one million units of which Dewstone has 25%. c.000 tonnes of chemical XT3 each year in order to produce the required amount of fibre. The original cost of this stock was £16 per tonne.80 0. • The production process also requires the use of 8. Outline the basic principles to be applied when identifying relevant costs and benefits relating to the offer. Present value of £1 receivable in ‘n’ years at 12%: n 0 1 2 3 12% 1.Appendix 1: Review questions • The production process requires the use of 6. Ignore taxation. Prepare a statement showing those incremental cash flows which are relevant to a decision concerning whether or not to accept the offer. Atlane has an estimated annual cost of capital of 12%. the existing stock of XT3 will be disposed of immediately at a cost to the company of £2 per tonne. The replacement cost of the chemical is £20 per tonne. State whether or not you believe the offer should be accepted.000 tonnes of chemical ZF6 each year to produce the required amount of fibre.89 0.000 tonnes of this chemical in stock. Calculate the net present value of the offer.

000 £180. At present they estimate they will still only achieve success with 25% of the total market sales to customers with those ratings. b.000) × .000 225. = = 900. check whether the predicted profit from the sales under the suggested credit policy are correct.000. Selling price/unit £20.000 175. Sales (25% × 1. 15% of the total markets sales turn out good and the balancing 25% turn out to be bad debts. The following profit estimate is based on that assumption. Any customer with a 0–59 rating is rejected.000) × 18% × 20 Variable costs 45.costs are £175.000 405. Dewstone is considering restricting its sales personnel to making sales to customers with a credit rating of 60 or better.000 × 11 Contribtion Fixed – administration.000 495. etc Bad debt cost (25% × 1.59 Financial management In other words 40% of the market’s sales are taken by customers with a rating of between 0 and 39.01 × 20 Net profit Required: a.000.000 for the year. Assuming selling price and variable cost per unit are £20 and £11 respectively and fixed administration etc. Of the year’s sales of 1 million units 29% turn out to be bad debts.000 140 .000 50. Using the credit rating agency estimates and the above company costs show what is the optimal credit policy for the company to follow (show your workings).

Financial reports based on the historic cost convention produce distorted results during a period of inflation. inflation can complicate matters. • Financial reports. The effect will be to overstate the return on capital employed. If the dividends paid exceed the profit as measured in real terms the capital of the business will be eroded. there may well be some customer resistance to attempts to pass on price increases and so any policy on this matter should be considered carefully. • Working capital. • Investment projects. the overstatement of profit may lead to higher tax payments. Escalation clauses may have to be built into long-term contracts in order to pass on the risk of price rises to the customer. 141 . In addition. there will be a transfer of wealth from lenders to equity shareholders. The effect of overstating profit may be to encourage the payment of higher dividends. overestimation may result in producing uncompetitive prices for goods and services which will again result in lower than expected profits. Similarly. although this is likely to be offset by an increase in trade creditors to some extent. • Taxation and dividends. Some adjustment for inflation is required in order to ascertain the profitability of an investment proposal. In addition interest rates are likely to increase making it difficult to estimate the correct discount rate. which will reduce the amount available for retention or dividends and which may also result in the depletion of the capital base. • Pricing policy. The value of stocks and debtors held will increase during a period of inflation. However. Conversely. This means that increased investment in working capital may well be required. Where prices have to be established some time in advance. Profits are understated and assets understated because of the time lag between acquiring and utilising resources. Underestimating the rate of inflation may result in a lower than expected profit or even a loss.Appendix 2: Suggested solutions to review questions Appendix 2: Suggested solutions to review questions Solution to Question 1 The major ways in which inflation can have an effect on the financial management of a business are as follows: • Loan capital. A fixed loan will mean that inflation will erode the value of the amount owing in real terms. lenders will normally expect to receive compensation for this in the form of a higher rate of interest. These may be important in the assessment of performance. Rising prices may make it more difficult to forecast future receipts and payments during the period of an investment project. Gains and losses in holding the monetary elements of working capital must be taken into account when considering the appropriate level of investment. gains and losses from holding monetary items during a period of inflation are not recorded. However. In effect.

because the business pays a dividend of £0. Thus: Total £ million Profit per annum of AIP Less: debenture interest (10% x £20m) Profit and dividend 5.000 3. 0. In order to generate a dividend of £250 Jane would need to buy 500 shares in MIM. 142 .000 Jane’s portion £ 250 100 150 In order to have the same income with the same level of risk.000.00 37.50 112.50 187. Jane’s portion of the profit of AIP would be as follows: £ Profit per annum of AIP Less: Debenture interest Corporation tax @ 25% Profit and dividend 250.00 87. b) Assuming a 25% rate of corporation tax.000 to invest in AIP at a market price of £4 per share she can buy 250 shares.00 62. as had she bought shares in AIR.50 per share. both risk and return.11 (i. This amount of interest (at 10%) would imply a loan of £1. Were this not the case it would be possible to earn higher returns for the same risk by buying one share rather than the other. Market forces should ensure that this cannot happen. This means. the value of a share is independent of the level of capital gearing. she would be exactly as well off in terms of income. If MIM shares cost less than £4. £4 × 87. This would mean a total maximum expenditure on MIM shares of £2. investors could get better returns by an investment in AIR Market forces would drive the price of both shares to the same value.000.50 Were Jane to buy shares in MIM Jane’s portion of the profit would be as follows: £ Profit per annum of AIP Corporation tax @ 25% Profit and dividend Less: interest on personal loan 250. on the basis of the assumptions stated below. a share in MIM must be worth £3. Thus must be the theoretical price of MIM shares.00 100.59 Financial management Solution to Question 2 a) If Jane has £1.000 2.50 If a share in AIP is worth £4.50 100. Thus if Jane paid £4 per share. Jane (and others) could achieve a better return on her investment than by an investment in AIR If the price were above £4.50/112.00 150.50).e.0005 of the business. Jane could buy sufficient shares in MIM to gain an annual dividend of £250 and pay interest out of this of £100.

Appendix 2: Suggested solutions to review questions The difference between the theoretical values of the two shares stems entirely from the greater tax efficiency of a business borrowing. then: DKNY = Dl(1+g)n–1 According to the Gordon dividend growth model 143 . as in Gordon’s model. Unless this is valid the market forces necessary to drive share prices together. Generally. • Interest rates are equal between individuals and businesses. thus the shareholders will not lose wealth as a result of the business being forced into liquidation because of the financial distress arising from capital gearing. This does not hold in real life. corporate and ‘home-made’ gearing are not perfect substitutes for one another. where the interest is allowable for tax. where the interest is not allowable for tax. as compared with personal borrowing. • Shares can be bought and sold without dealing costs. If individuals have to pay more to borrow than does the business. where there are identical returns. c) The main assumptions on which the above analysis is based are as follows: • There are no ‘bankruptcy’ (liquidation) costs. This seems unlikely to be true in real life. • Borrowing and lending rates are the same. Gordon Dividend growth model basis The annual rate of dividend growth (for the current year) is calculated as: (Dividend of current year – dividend of previous year)/dividend of previous year. it is probably the case that businesses can borrow more cheaply than can the average individual. Solution to Question 3 a. may not fully operate. Using the assumption of a compound annual growth rate.

for example the level of capital gearing.28 × (1 + 0. The business is seeking a future cost of capital and should use estimates of the future in the analysis. set out below. The fact that the figures obtained using these two bases are different should be a cause for concern.2244 or 22. rf. but they could.1256) − £0. • The rates used in CAPM look to be incompatible as regards the treatment of taxation.9(0.10) = 0. nevertheless be profoundly different in other significant ways.e.44% Capital asset pricing model basis Eri = rf + βi (Erm – rf) where Eri. Both approaches are theoretically valid and should.3152/3.1256 = 0.19) + 0. the current ex-dividend price per share) i = (0. • Is the quoted company (James plc) really comparable with Aspirations plc? They may operate in the same industry and be of similar size.2% b. therefore. which raises doubts about using them as a guide for the future. 144 . produce the same result.e.3152 (i. but it is illogical to presume that the past will be precisely replicated in the future.10 + 0. Inflation is incorporated into the analysis. the risk free rate looks as if it is a gross figure. which makes the assumption that it will continue at the same rate as it has done historically. • The annual figures for past dividend growth are a little erratic.172 or 17. the beta of a particular security i and the expected return from the market portfolio Eri = 0.19 (i.18 – 0.47 – 028 = £3. which have been used for both models.59 Financial management D1 = £0. The past may provide a useful guide as to that which is likely to happen in the future. are based on historic data. This and other reasons. βi(Erm – rf) are respectively the expected return from a particular security i. the risk free rate. should cause management to view the results with some scepticism. next year’s dividend) P0=£3. whereas the expected return from the market is almost certainly an after-tax figure. Other relevant points include the following: • The inputs.

400 3.000 3.150 500 550 £000 Cash discounts £000 £000 600 240 840 160 48 112 67 45 660 240 44 944 156 47 109 65 44 £000 4.4m × 2/12) Cash Trade creditors (£3m × 2/12) (£3.100 The calculations reveal that the proposed policy to introduce cash discounts will lead to a marginal decline in profitability in the forthcoming year.Appendix 2: Suggested solutions to review questions Solution to Question 4 a.300 1.3m × 2/12) Trade debtors [25% × £4m × 1/12) + (75% × £4 × 2/12) [(50% × 4.000 Cash discounts £000 £000 4.4m)] Net profit before taxation Corporation tax (30%) Net profit after taxation Dividend (60%) Retained profit b.3m × 2/12) Accrued expenses fixed variable (600 × 1/12) (660 × 1/12) Taxation due Dividends due Working capital 48 67 685 448 50 55 47 65 737 413 20 20 500 550 50 1. The benefits of increased sales to the business are more than offset by the cost of the cash discounts. Forecast profit and loss accounts Current policy £000 Sales Cost of sales (75% sales) Gross profit (25% sales) Less Variable costs (15% sales) Fixed costs Discounts allowed [2%(50% × £4.4m × 1/12) + (50% × 4.000 1. Investment in working capital Current policy £000 Stock (£3m × 2/12) (£3. The proposed policy leads to a slight reduction in working capital.133 583 550 50 1. This is largely because the increase in stocks are more than offset by the decrease 145 .

However. If the company is investing in a new commercial area then it will have to go to the market and find a company with the appropriate beta and return for that risk class. Is the company a geared company? No. The rate needed is that one appropriate for the risk class of the investment under investigation. Solution to Question 5 a. the quality of their estimates may be poor. To obtain the asset beta necessary for the calculation of the required rate of return to be used in the evaluation of a major physical investment requires a number of steps. Where: rd id the desired rate of return. it does not seem sensible to adopt the cash discount scheme. So if the company is a single industry company then the WACC will be the asset beta. (i. The equity beta and debt beta can be calculated separately using regression analysis on time series data of the price relatives of the company’s equity and debt with the market index movements. There are weaknesses in the model used to derive the ßs and thus the cost of capital. Starting with the equity beta of a company. Yes. If the company is a ‘single industry’ company then its asset beta is the same as weighted average beta. (See text) 3. and thus the company will need to calculate its equity and debt betas and then weight them as above. If the company has a portfolio of investments in a different risk class then use the following formula to solve to find the required rate. 5. this change does not compensate for the decline in profitability.e. Thus knowing its own equity values will be of no use. low r2) and the estimates 146 . then equity beta is average asset beta for the company. On the basis of the calculations above. but in general the rates obtained are accurate enough for practical use. ri is the return of the risk class i of which the company has no divisions MVi is the market value of the ith division MVd is the market value of the division d which wants to make the investment TMV is the Firms total market value. In practice they are available from brokers. To do that requires estimates of equity and debt betas.59 Financial management in debtors and the increase in trade creditors. thus WACC is the required rate of return. Remember that the ßs are actually single period estimates. the equity and debt betas and the market values for the equity and debt the company’s WACC can now be calculated. Using the values for the market rate of return and the riskless rate. 2. Derive weighted average beta for the company using market values of debt and equity as weights for the debt and equity. b. 1. 4.

If assessing the investments individually then one can compute their expected NPVs. • Buying foreign currency options is a fourth way. The profit or loss on sale will correspond approximately to the loss or profit on the currency transaction they were hedging. • The simplest technique is for a company to trade solely in its own currency. most likely and best possible. • The company can use the forward market contracts. standard deviations and coefficient of variations. The optimal combination is the one that provides the highest return R at the company’s risk level. They are usually sold before maturity since their prices move in response to forex price movements. are the most sensitive and thus the ones that need most careful management. Finally one can use sensitivity analysis which will give the company an indicator as to which of the variables. otherwise the company avails itself of its option. sales. since the projects’ results will not necessarily be straightforward to assess. worst possible.Appendix 2: Suggested solutions to review questions could vary from one time period to the next. etc. Moving away from the world of certainty means that there are no hard and fast decision rules which will ensure you select the optimal mix of investments. so transferring the risks to its customers or suppliers. 147 . The conceptually sound method of evaluating a group of investments is to use the portfolio approach where one combines the expected returns and standard deviations of the group of projects with those of the existing portfolio of assets. The range is probably not too wide and is no more error prone than the figures estimated for the investments’ cash flows. What this means is that there is a range of rates that one can choose from. either buying or selling the currency forward at the contracted rate. • The matching technique whereby assets and liabilities in a particular currency are netted off and any difference between the two kept as small as possible. c. with the buyer acquiring the right to sell (put option) or buy (call option) a certain amount of a currency at a fixed rate on some future date. The following are techniques a company can use to protect itself from adverse foreign exchange movements. • The company can use the financial future exchange and buy foreign currency futures. This depends on its competitive situation as to whether it can use that approach. thus locking the company into a given future payment for the future contracted date. This allows for risk but not the benefits arising from diversification. Then there is the decision of selecting the appropriate riskless rate and market index bearing in mind they vary daily and there is more than one market index. costs. Futures are effectively forward contracts in standard sizes with fixed maturity dates. using rule of thumb. They are a form of insurance in that if the rates move favourably then the option can lapse and they can take advantage of the new favourable rate. where the NPV for each project is calculated under three environments. A third way is to use the three point estimate approach. Then one selects. Solution to Question 6 a.

0775 – 1. This is where one currency is borrowed. Borrow $1 in USA and invest in UK then repatriate.0275 = $0.0275 =$0. (Note: More than the requested four answers were given in order to provide an indication of the majority of options. = 1.0032 (Gain) . Borrow $1 in USA and invest proceeds in Singapore then repatriate. then repatriate.0275 = $0.0307−1.0178 = −S$0. 1. 148 =1. i. One is to compute the values in accordance with the basic equations: whether or not The second method. Proceeds of Investment – Cost of Borrowing = 0.) The size of the debt. The reconverted amount should just equal the amount to be repaid if equilibrium holds.0629 (loss) 2. thus influencing the choice of techniques used. convert it.05 (Gain) 3.0032 (Gain) 4. the frequency of the foreign trades. = 1. converted into another which is invested to earn sufficient by the end of the original period to pay off the due debt in that currency. since this is a subject guide. Borrow £1 in UK and invest in USA then repatriate. There are two ways to present the evidence on whether or not the market appears to be in equilibrium.9549 – 1. as well as the level of market efficiency will influence the size and sophistication of the organisation used by a company. rather than to provide an answer that precisely fits the requirements. with the cost of protection being the difference between the cost of borrowing in one and the returns of investing in the other currency. b. invest the conversion then reconvert the accumulated principal and interest. The early conversion is undertaken to provide the protection against adverse exchange rate movements.59 Financial management • A further way is to use the money market hedge. Borrow S$1 in Singapore and invest proceeds in USA. which will be used here since it helps with the answer to the second part of the question is to see if it pays to borrow a unit of currency in one country. the degree of hardness in the currency of the trades.0307 – 1. the variety and range of currencies used.

000 Gain Solution to Question 7 a.05.20 2 26 0.71 (1. The calculations in (b) above reveal that the offer has a positive net present value.80 3 (2) 0.e.000 × $0. When identifying relevant costs and benefits the following principles should be applied: • Differential costs and benefits (i. From answer 2 above. since traders cannot make material gains through arbitrage except through that one combination.a.000.42) 6 (60) (200) 116 (120) (200) 36 (120) (200) (2) (15) (40) (40) (40) (85) (200) (200) 1 £000 616 2 £000 616 3 £000 616 6 (242) c.000 Proof: = $5. ii.89 103. However.1378. investing at 4% p.. therefore Gain 100. the ‘margin of safety’ relating to the offer is relatively low and further analysis to deal with the problems of risk and uncertainty would be prudent before a final decision is made. those costs and benefits which vary as a result of the decision) should be taken into account whereas costs which are independent of the decision should be ignored. the additional overheads (£40.000 then the gain to be made by borrowing $100. 149 .000 gain. for three months and selling forward the proceeds at the forward rate of S$2. a gain of 5%.000) resulting from the decision to accept the contract will be included in the analysis whereas those overheads reallocated (£20.6 1 116 0. Net present value 0 Incremental cash flows Discount factor (12%) Present value Net present value (94) 1. gain for $1 = $0.05 = $5. Acceptance of the offer would. Thus. for example.Appendix 2: Suggested solutions to review questions The computations suggests that the market is close to equilibrium except when one borrows in the USA and invests in Singapore. therefore.80 28. converting it at S$2. If the bank will lend up to $100.00 (94. d.0039 should give a $5. increase the wealth of shareholders in Atlanta Ltd.00) £36. Incremental cash flows 0 £000 Sales Equipment Wages Recruitment & selection costs Overheads Disposal cost savings Cost of chemical XT3 Cost of chemical ZF6 (94) b.000) will be ignored as they will have to be paid whether or not the offer is accepted.

only future costs are relevant. Thus £180. 2.000 is the correct net profit. Thus.e.5 135 165 177. Contribution per unit is £20 – £11.000 will be achieved.5 800 Incremental profit/class (£’000) (202.5 100 205 237. By computing the profit before fixed costs we can assess the optimum credit policy.5 22 62.250) (1.000 1. the fact that successful execution of the contract may result in further benefits accruing to the company may be taken into account only if it is possible to quantify the expected benefits in cash terms.450) Net profit cum. therefore.e. (£’000) (202. • Only costs and benefits which can be expressed in cash terms should be taken into account. etc Bad debts (10K@20) 175.000 3.000 1. 2. Sales Less Less 150K units @ £20 variable costs @ £11 contribution overheads Administration.000 200.450) (1.5) (350) 445 687.650. 60–79.18 × . This means that the cost of stock already acquired by the company is irrelevant whereas the (future) replacement cost of the stock is relevant.000 150 . 18% of the market sales are purchased by customers with ratings of 60 and above) then. the Dewstone sales can only be .400) (1.25 × 1 million(i.59 Financial management • Past costs are irrelevant to the decision to accept the offer.000 units).e.5 112. and sales to customers in each of the three rating classes 40–59.5 Contribution (‘000) 247. 45. Points rating 0–19 0–39 0–59 0–79 0–1000 Cum. No decision can be taken to alter the past and.000. (29 – 28)% × 25% of 1 million) will cost the company £20 per unit of lost revenue (i. since Dewstone can only achieve 25% of that slice of the market.5) (147. All bad sales (i.5 250 Good Sales Bad Sales (‘000) (‘000) 5 37.000 375.5) 795 242.5 Note that sales to customers of rating 39 and below make losses. % sales 11 40 82 95 100 Dewstone Sales (‘000) 27. Since only (100 – 82) (i. Solution to Question 8 1. 80–100 make incremental profits therefore the optimum credit policy is to restrict sales to customers with rating of 40 or better and a net profit of £975.350.500 units). £9.5 70 72.5 900 1845 2137.5 2250 Bad debt Expense (‘000) (450) (1.000 £ 975.5 72.e.

You can find the most recent examination papers on the VLE where all changes to the format of the examination are posted.Appendix 3: Sample examination paper Appendix 3: Sample examination paper Important note: This Sample examination paper reflects the examination and assessment arrangements for this course in the academic year 2010−2011. The format and structure of the examination may have changed since the publication of this subject guide. 151 . it must be detached and fastened securely inside the answer book. If used. All questions carry equal marks. Any necessary assumptions introduced in answering a question are to be stated. Workings should be submitted for all questions requiring calculations. 8-column accounting paper is provided at the end of this question paper. The make and type of machine must be clearly stated on the front cover of the answer book. Extracts from compound interest tables are given at the end of Section A of the paper. A calculator may be used when answering questions on this paper and it must comply in all respects with the specification given in the Regulations. Time allowed: three hours Candidates should answer FOUR of the following NINE questions: TWO from Section A. ONE from Section B and ONE further question from either section.

000 per annum and $60. Calculate the project’s net present value. At present the line has a capacity of 650. The new line has a capacity of 750. The accountant has prepared the following cost estimates based on output of 500.000. The introduction of the new machine will enable stocks to be reduced by $80.000 units per annum. (3 marks) d. (8 marks) b. Discuss which method you consider to be preferable and under what sets of circumstances.000 and a book written-down value of $90. Prepare a statement of the incremental cash flows arising from the project. (5 marks) 2. It is considering automating its line for producing crankshaft casings.59 Financial management SECTION A Answer two questions from this section and not more than one further question. Old line (per unit) c Materials Labour Variable overheads Fixed overheads Selling price Profit per unit 40 22 14 44 120 150 30 New line (per unit) c 36 10 14 20 80 150 70 Fixed overheads include depreciation on the old machine of $20.) 1.000 for the new machine. It is considered that for the company overall. Required: a.000. fixed overheads are unlikely to change. (7 marks) e. 152 . Splott Engineers Limited manufacturers components for the car industry. The company uses 10% as its cost of capital.000. He is near retirement and he would like to sell some of his shares in the company and then also to raise further equity to reduce its gearing. The automated equipment will cost $350. He understands that one way to do this. Explain the terms net present value and internal rate of return. Give a brief critique of the method you have selected. Calculate the project’s approximate internal rate of return. An extract of some recent accounts of the company appear below. It will replace equipment with a scrap value of $25.000 units per annum but typically it has only been run at 80% of capacity because of the lack of demand for its output.000. Its life is expected to be 5 years and its scrap value at that time $50. You should ignore taxation. Your client is the owner of a small group of hotels. (You are reminded that four questions in total are to be attempted with at least one from Section B.000 units per annum. is to seek a quotation on the unlisted securities market. (2 marks) c. Briefly describe one way how the above analysis could be extended to incorporate a treatment of risk.

8 1.5 The company’s cost of capital is 12% net of tax.5 15.0 8.07 £ million 33.08 £ million Sales Profit before interest and tax Interest Profit before tax Taxation Profit after taxation Retained Balance sheet data Fixed assets Less: Depreciation Current assets Stock Debtors Cash Less creditors (Amount due in under 1 year) Trade creditors Taxation Dividends Net current assets Total assets less current liabilities Less: Loans (due in over 1 year) Net assets Capital and reserves Share capital* Reserves * 5p shares Profit before tax for 2009 is forecast at £6.9 4.4 13.7 2015–30 9.5 9.2 1.3 million.1 7.8 0.5 43.5 43.5 12.5 1.3 1.8 0.5 1.3 1.3 3.5 3.8 1.0 10. it would anticipate paying out 2/3rds its income as dividends.9 0.0 5.6 3.12.9 2.9 0.4 13.0 16.3 2.1 million and after tax at £3.8 2013 8.2 16.1 3.4 2014 8.8 8.5 1.1 1.9 4.0 6.2 47.9 1.5 1.0 34.7 31.9 3. If the group went public.3 22. 153 .12.9 2011 7.7 2. An analyst forecasts the free cash flow of the company to be: 2010 £ millions 6.Appendix 3: Sample examination paper Profit and loss data 31.4 2012 7.8 36.5 36.1 0. A surveyor has recently valued the fixed assets of the group at £93 million.5 1.4 54.6 31. Similar hotel groups have price earnings ratios of approximately 17 times and dividend yields of approximately 4%.8 0.3 3.

Of this £60.6 50. (5 marks) c. Prepare a cash forecast for each of the six months to 30 June 2008. commenting on the practical and theoretical merit of each basis used. Comment briefly on the financial prospects of Osmond.0 18.000 is to be invested in new fittings in January. Dividend yield iv.0 102. Osmond Limited is a small company to be formed by Conny and Winnie Bond to sell an exclusive range of furnishings from a boutique in a fashionable suburb of London.2 60. One month’s credit is allowed by suppliers. with your reasons for selection.0 Feb Mar Apr May June Total * These include wages but exclude depreciation.0 18.0 108. Calculate how many shares need to be issued to reduce the company’s gearings so that it has the same amount of long-term debt as equity. payable on 1 January and 1 April. Free cash flow (4 marks) (4 marks) (4 marks) (4 marks) b. Other costs shown above do not include rent and rates of £20. Net assets ii.000. (5 marks) d.000 £1 shares each in the company. The sales and purchases forecast for the company are as follows: Jan £000 Sales Purchases Other costs* 20.000 cash to purchase 50. For your convenience you are advised to work to the nearest £’000.000 per quarter. The sales will all be made by credit card.4 40.2 50. Required: a.0 61. Prospective price earnings ration iii. All other costs will be paid in cash. You should refer both to its profitability and liquidity. A half-year’s depreciation is to be charged in the first six months. Select the share price from the above calculations at which the company’s shares should be issued. (6 marks) c. (7 marks) 154 .0 408. In January 2008 they plan to invest £100. Prepare a forecast profit and loss account for the same period.0 18. Closing stock at the end of June is expected to be £116.0 18.0 81.0 320.0 61. Calculate the value of one 5p share in the company on each of the following bases. (8 marks) b. The credit card company will take one month to pay and will deduct its fee of 2% of gross sales before paying amounts due to Osmond Limited. (3 marks) 3. You should ignore taxation.0 81.59 Financial management Required: a. These fittings are to be depreciated over 3 years on the straight-line basis (their scrap value is assumed to be zero at the end of their lives).0 18.0 18. i.0 60. Prepare a forecast balance sheet at 30 June 2008.6 60.

savings of £60. The accounts department has recently approached a factoring company which has agreed to provide an advance equivalent to 80% of trade debtors (based on an average settlement period of 40 days) at an interest rate of 12%. The credit department are confident that these new policies will not result in any reduction in sales. The credit department believes that all bad debts can be effectively eliminated by adopting the above policies and by employing stricter credit investigation procedures costing an additional £50. which is equivalent to that of its major competitors. All sales made by the company are on credit and.Appendix 3: Sample examination paper 4. Trilley Building Supplies Ltd has an annual turnover of £25 million before taking into account bad debts of £150. The company currently has an overdraft of £5. These are as follows: Proposal A The credit control department has proposed that customers should be given a 2. Calculate for each proposal the net annual cost (savings) to the company of changing its existing credit policies and either i. On average.2 million at an interest rate of 14% per annum.000 per annum. credit terms are negotiable by the customer. Required: a. For those who do not pay within this period. Explain which of the two proposals (if either) you would support and why? (5 marks) 155 . adopting the proposals of the credit control department (10 marks) or ii. Two major proposals have so far been put forward concerning the management of trade credit.000. at present. Proposal B The company is also considering whether it should factor its trade debts. As less time will be spent chasing debtors.5% discount if they pay within 30 days.000.000 in the credit control administration can be made if the new policies are adopted. The bank has written recently to the company stating that it would like to see a reduction in the overdraft of the company. the settlement period for trade debtors is 60 days. factoring the debts of the company. a maximum of 50 days credit should be given. The credit department believes that 60% of customers will take advantage of the discount by paying at the end of the discount period and the remainder will pay at the end of 50 days. The factoring company will undertake collection of the trade debts and will charge a fee of 2% of sales turnover for this service. The company is currently reviewing its credit policies to see whether more efficient and profitable methods could be employed. The settlement period for trade debtors will be reduced to an average of 40 days. The factoring service is also expected to eliminate bad debts and will lead to credit administration savings of £130. (10 marks) b.

Accountants place considerable emphasis on profit when reporting results to shareholders. Describe two methods whereby a company may estimate its costs of equity capital. Discuss why these authorities believe the dividend payout ratio to be irrelevant and give your own views on this matter. (13 marks) 7. a. Explain and evaluate this apparent anomaly.59 Financial management SECTION B Answer one question from this section and not more than one further question. a. the stockmarkets of the world will never achieve th ‘‘strong fom’’ of the efficient market hypothesis. Securities can be issued using the following methods: i. in your view. However press comments suggest otherwise. Offer for sale ii. (12 marks) b. However for assessing the viability of capital projects cash flow forecasts are used. Discuss why. (12 marks) b. Tender issue Describe briefly each method and state where its use might be appropriate. Rights issue iii. (You are reminded that four questions in total are to be attempted with at least two from Section A. Describe and discuss the relevance of the Fisher Effect and the Purchasing Power Parity theories to a foreign currency dealer in a merchant back in London (25 marks) 9.) 5. What are the advantages and limitations of each method? (13 marks) 6. Describe and discuss the problems the company faces in trying to achieve the use of a single period empirically determined and market based hurdle rate. Some authorities maintain that the dividend payout ratio is unimportant. Assume a quoted British company wants to use the CAPM approach in deriving the hurdle rate (cost of capital) it will use in evaluating its major investments. (25 marks) END OF PAPER 156 . (25 marks) 8.

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