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Lecturer’s Guide
Corporate Financial Management
Fourth edition

Glen Arnold
For further lecturer material please visit: www.pearsoned.co.uk/arnold

ISBN 978-0-273-71064-6

© Pearson Education Limited 2008 Lecturers adopting the main text are permitted to download and copy this guide as required.

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Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies around the world Visit us on the World Wide Web at: www.pearsoned.co.uk ––––––––––––––––––––––––––––––––––– First published under the Financial Times Pitman Publishing imprint in 1998 Second edition published 2002 Third edition published 2005 Fourth edition published 2008 © Financial Times Professional Limited 1998 © Pearson Education Limited 2002, 2005, 2008 The right of Glen Arnold to be identified as author of this Work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988. ISBN-978-0-273-71064-6 All rights reserved. Permission is hereby given for the material in this publication to be reproduced for OHP transparencies and student handouts, without express permission of the Publishers, for educational purposes only. In all other cases, no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without either the prior written permission of the Publishers or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd., Saffron House, 6-10 Kirby Street, London EC1N 8TS. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published, without the prior consent of the Publishers.

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CONTENTS

Preface Location of answers to questions and problems SUPPLEMENTARY MATERIAL FOR CHAPTERS Chapter 1 The financial world Chapter 2 Project appraisal: Net present value and internal rate of return Chapter 3 Project appraisal: Cash flow and applications Chapter 4 The decision-making process for investment appraisal Chapter 5 Project appraisal: Capital rationing, taxation and inflation Chapter 6 Risk and project appraisal Chapter 7 Portfolio theory Chapter 8 The capital asset pricing model and multi-factor models Chapter 9 Stock markets Chapter 10 Raising equity capital Chapter 11 Long-term debt finance Chapter 12 Short-term and medium-term finance Chapter 13 Treasury and working capital management Chapter 14 Stock market efficiency Chapter 15 Value management Chapter 16 Strategy and value Chapter 17 Value-creation metrics Chapter 18 Entire firm value measurement Chapter 19 The cost of capital Chapter 20 Valuing shares Chapter 21 Capital structure Chapter 22 Dividend policy Chapter 23 Mergers Chapter 24 Derivatives Chapter 25 Managing exchange-rate risk

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7 10 14 20 24 29 33 38 40 43 47 51 54 58 59 64 66 72 74 77 81 84 86 91 96

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pearsoned.uk/arnold . downloadable Instructor’s Manual including answers for all question material in the book ● A brand new set of over 800 PowerPoint slides that can be downloaded and used as OHTs Also: The regularly maintained Companion Website provides the following features: ● Search tool to help locate specific items of content ● E-mail results and profile tools to send results of quizzes to instructors ● Online help and support to assist with website usage and troubleshooting For more information please contact your local Pearson Education sales representative or visit www.CFML_A01v3. additional to those found in the book.uk/arnold to find valuable online resources Companion Website for students ● Learning objectives for each chapter ● Multiple-choice questions with instant feedback to help test your learning ● Weblinks to relevant. specific Internet resources to facilitate in-depth independent research ● A wide selection of FT articles. to provide real-world examples of financial decision making in practice ● Interactive online flashcards that allow the reader to check definitions against the key terms during revision ● Searchable online glossary For instructors ● Complete.QXD 8/5/08 4:16 PM Page 4 Supporting resources Visit www.co.pearsoned.co.

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PREFACE

This Guide is designed to assist lecturers and tutors using Corporate Financial Management fourth edition.
Supplementary material for chapters

For each chapter: • The learning outcomes are outlined. • Key points and concepts are listed. • Solutions to selected numerical problems (those marked with an asterisk in the main book) are provided. Note that there is often more than one possible correct solution to a problem. Different answers, which nevertheless follow the logic of the argument presented in the text, may be acceptable.

Overhead projector transparency masters

Also available on the website in PowerPoint® for downloading are over 800 selected figures, tables and key points reproduced in a form suitable for creating overhead projector transparency masters. These are arranged in the order in which they appear in Corporate Financial Management. The learning objectives and summary points from the chapters are also included. Glen Arnold

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LOCATION OF ANSWERS TO QUESTIONS AND PROBLEMS
(No answers given to those in final column)
Chapter No Answered in Appendix VII 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
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Answered in Lecturer’s Guide

Essay answer required (see text) All (see note in Appendix VII)

1, 2, 4, 5, 6 1, 2, 3, 6, 9, 11, 13, 15 1, 2, 4, 5 1, 2, 3, 5, 6, 9, 10 1, 4, 5, 6, 7, 8, 9, 10, 11 1, 2, 3, 7, 8, 9, 10, 11, 12, 13, 15 1, 3, 4, 5, 7, 8, 9, 10

3, 7 4, 5, 7, 8, 10, 12, 14 3 4, 7, 8 2, 3, 12 4, 5, 6, 14a, b, c 14d 2, 6, 11 1–11 6, 7, 8, 9

12

8

1–7, 9–11, 13–19 8, 9, 12, 14, 15, 17–20 3, 6, 7, 8, 13, 14, 15 2, 3b, 11, 12, 13–22, 24, 25b, 25c 1, 3–17

1, 2, 3, 4, 5, 6, 10, 11, 13, 16 7 1, 2, 4, 9, 10, 11 1, 4, 5, 7, 9, 10 2 8, 9 7, 10 5, 12 3a, 6, 8, 23, 25a

1–6 1–4

1, 5, 6, 7 1, 2 2, 3 3, 4, 5, 6, 7, 9 2, 3, 6a, 9 4, 5, 8 6 1, 2, 3, 4, 5, 7, 10 1, 2, 7, 8a, 10, 11

2, 3, 4, 4a

8

1 8, 10 1 1, 2 4, 5, 6b, 7, 8 1, 2, 3, 4, 7 1, 3, 4, 5 6, 8, 9 4, 9 2, 7, 8, 9 11, 12, 13 3, 4b, 5, 6, 8b

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SUPPLEMENTARY MATERIAL FOR CHAPTERS
Chapter 1

THE FINANCIAL WORLD
LEARNING OUTCOMES
It is no good learning mathematical techniques and theory if you lack an overview of what finance is about. At the end of this chapter the reader will have a balanced perspective on the purpose and value of the finance function, at both the corporate and national level. More specifically, the reader should be able to:

describe alternative views on the purpose of the business and show the importance to any organisation of clarity on this point; describe the impact of the divorce of corporate ownership from day-to-day managerial control; explain the role of the financial manager; detail the value of financial intermediaries; show an appreciation of the function of the major financial institutions and markets.

■ ■ ■ ■

KEY POINTS AND CONCEPTS
■ ■ ■

Firms should clearly define the objective of the enterprise to provide a focus for decision making. Sound financial management is necessary for the achievement of all stakeholder goals. Some stakeholders will have their returns satisfied – given just enough to make their contribution. One (or more) group(s) will have their returns maximised – given any surplus after all others have been satisfied. The assumed objective of the firm for finance is to maximise shareholder wealth. Reasons: – practical, a single objective leads to clearer decisions; – the contractual theory; – survival in a competitive world; – it is better for society; – counters the tendency of managers to pursue goals for their own benefit; – they own the firm. Maximising shareholder wealth is maximising purchasing power or maximising the flow of discounted cash flow to shareholders over a long time horizon. Profit maximisation is not the same as shareholder wealth maximisation. Some factors a profit comparison does not allow for are: – future prospects; – risk; – accounting problems;

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investment appraisal methods. Types of asset transformation: – risk transformation.QXD 29/7/08 17:25 Page 8 Glen Arnold. globalisation and the rapid development of new financial products have characterised this sector. Corporate Financial Management Lecturer’s Guide. – selling shares and the takeover threat. Deregulation. The secondary markets in financial securities encourage investment by enabling investor liquidity (being able to sell quickly and cheaply to another investor) while providing the firm with long-term funds. Financial institutions encourage the flow of saving into investment by acting as brokers and asset transformers. Their knowledge of financial markets. ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ 8 © Pearson Education Limited 2008 . The financial sector has shown remarkable dynamism. – improve information flow. new technology. The efficiency of production and the well-being of consumers can be improved with the introduction of money to a barter economy. Asset transformation is the creation of an intermediate security with characteristics appealing to the primary investor to attract funds. – maturity transformation.CFML_CH01v3. – International banks – mostly Eurocurrency transactions. – international comparative advantage. – transaction costs. – Wholesale banks – low-volume and high-value business. – corporate governance regulation. Some solutions: – link managerial rewards to shareholder wealth improvement. – Building societies – still primarily small deposits aggregated for mortgage lending. – additional capital. – risk spreading. thus alleviating the conflict of preferences between the primary investors (households) and the ultimate borrowers (firms). Reasons: – high income elasticity. – sackings. – Finance houses – hire purchase. Financial institutions and markets encourage growth and progress by mobilising savings and encouraging investment. Mostly fee based. This may lead to managerialism where the agent (the managers) take decisions primarily with their interests in mind rather than those of the principals (the shareholders). treasury and risk management techniques are vital for company growth and stability. Intermediaries are able to transform assets and encourage the flow of funds because of their economies of scale vis-à-vis the individual investor: – efficiencies in gathering information. – volume transformation. Banking sector: – Retail banks – high-volume and low-value business. leasing. ■ Corporate governance. innovation and adaptability over the last three decades. The financial services sector has grown to be of great economic significance in the UK. This is a principal-agent problem. Financial managers contribute to firms’ success primarily through investment and finance decisions. 4th edition – communication. which are then made available to the ultimate borrower in a form appropriate to them. factoring. Large corporations usually have a separation of ownership and control.

QXD 29/7/08 17:25 Page 9 Glen Arnold. The risk spreaders: – Unit trusts – genuine trusts which are open-ended investment vehicles.liffe) dominates the ‘exchange-traded’ derivatives market in options and futures. local authorities and so on. – Insurance funds – life assurance and endowment policies provide large investment funds. – The share market – primary and secondary trading in companies’ shares takes place on the Official List of the London Stock Exchange. – Hedge funds – wide variety of investment or speculative strategies outside regulators’ control. However there is a flourishing over-the-counter market. © Pearson Education Limited 2008 9 . – The derivatives market – LIFFE (Euronext. – Investment trusts – companies which invest in other companies’ financial securities. particularly shares. The risk takers: – Private equity funds – invest in companies not quoted on a stock exchange. ■ ■ ■ There are no numerical questions in this chapter. The markets: – The money markets are short-term wholesale lending and/or borrowing markets. 4th edition ■ Long-term savings institutions: – Pension funds – major investors in financial assets. – The foreign exchange market – one currency is exchanged for another. governments. techMARK and the Alternative Investment Market. – The bond markets deal in long-term bond debt issued by corporations. and usually have a secondary market. – Open-ended investment companies (OEICs) – a hybrid between unit and investment trusts.CFML_CH01v3. answers may be found from reading the text. Corporate Financial Management Lecturer’s Guide.

show an appreciation of the relationship between net present value and internal rate of return.. demonstrate awareness of the propensity for management to favour a percentage measure of investment performance and be able to use the modified internal rate of return. results in a zero net present value.. or impatience to consume.QXD 29/7/08 17:26 Page 10 Chapter 2 PROJECT APPRAISAL: NET PRESENT VALUE AND INTERNAL RATE OF RETURN LEARNING OUTCOMES By the end of the chapter the student should be able to demonstrate an understanding of the fundamental theoretical justifications for using discounted cash flow techniques in analysing major investment decisions. based on the concepts of the time value of money and the opportunity cost of capital. ■ KEY POINTS AND CONCEPTS ■ Time value of money has three component parts each requiring compensation for a delay in the receipt of cash: – the pure time value. NPV = CF0 + CF1 1+k + CF2 (1 + k)2 + . More specifically the student should be able to: ■ ■ ■ calculate net present value and internal rate of return. CFn (1 + r)n =0 ■ The internal rate of return decision rule is: IRR у opportunity cost of capital – accept IRR Ͻ opportunity cost of capital – reject 10 © Pearson Education Limited 2008 . It is an ‘r’ which results in the following formula being true: CF0 + CF1 1+r + CF2 (1 + r)2 + . describe and explain at least two potential problems that can arise with internal rate of return in specific circumstances. Taking account of the time value of money and opportunity cost of capital in project appraisal leads to discounted cash flow analysis (DCF).. Present values are achieved by discounting at the opportunity cost of capital. – risk..CFML_CH02v3. – inflation. CFn (1 + k)n ■ ■ ■ ■ The net present value decision rules are: NPV у 0 accept NPV Ͻ 0 reject ■ Internal rate of return (IRR) is the discount rate which. Net present value (NPV) is the present value of the future cash flows after netting out the initial cash flow. Opportunity cost of capital is the yield forgone on the best available investment alternative – the risk level of the alternative being the same as for the project under consideration. when applied to the cash flows of a project.

whereas NPV ranks the projects in the opposite order. 2.2. 2. 2.1 Project D No solution using IRR. given the non-conventional cash flow. In the case of project D there is no solution. See Fig. If a percentage measure is required. then the modified internal rate of return (MIRR) is to be preferred to the IRR. IRR is a percentage measure. The IRR decision rule is reversed for financing-type decisions. ■ ■ ■ ■ ANSWERS TO SELECTED QUESTIONS 3 Confused plc a Project C IRRs at 12. no IRR where NPV = 0.1. This biases the IRR calculation. © Pearson Education Limited 2008 11 . NPV measures in absolute amounts of money. 2. IRR assumes that intra-project cash flows can be invested at a rate of return equal to the IRR.QXD 29/7/08 17:26 Page 11 Glen Arnold. + NPV Discount rate – Fig. In the case of project C multiple solutions are possible. There are circumstances when IRR ranks one project higher than another. + NPV 12.1 – Discount rate 286 Fig. This ranking problem becomes an important issue in situations of mutual exclusivity. Multiple solutions can be the result. c NPV Project C: +£646 Project D: –£200 Using NPV the accept/reject decision is straightforward.1% and 286%.CFML_CH02v3. Project C is accepted and Project D is rejected. See Fig. perhaps for communication within an organisation. Corporate Financial Management Lecturer’s Guide.2 b This problem illustrates two disadvantages of the IRR method. 4th edition ■ ■ IRR is poor at handling situations of unconventional cash flows.

6407 = –1.7432 = –1 ∴ IRR is slightly under 16%.45 12.975 + 1.4% 20% 16% 7.6610 = –20.100 + 200 × 0.7% best project c Project A –5.000 × 0.500 × 2.000 + 10. 4th edition 7 Seddet International a Project A At 20%: –5.CFML_CH02v3.5 IRR = 22 + 12.7% Project C At 22%: –2.8621 + 800 × 0.8130 + 2.600 × 0.000 × 0.6719 = +12.975 + 1. b Ranking under IRR: Project Project Project Project C A D B IRR 22.45 At 23%: –2.QXD 29/7/08 17:26 Page 12 Glen Arnold. Corporate Financial Management Lecturer’s Guide.100 + 200 + 0.7938 = –62 IRR = 7 + 163 163 + 62 (8 – 7) = 7.7432 = 228 Project D –1.000 + 10. Therefore if all projects can be accepted these two should be undertaken.1065 = 0.900 × 0.593 Project C –2.000 × 0.8621 + 2. The IRR exceeds the hurdle rate of 16% in the case of A and C.900 × 0.2459 = 349 Project B –8.600 × 0.8163 = +163 At 8%: –8.500 × 2.900 × 0.8621 + 800 × 0.100 + 200 × 0.000 + 10.8197 + 2.5 (23 – 22) = 22.7432 = –1 12 © Pearson Education Limited 2008 .45 + 20.266 + 2.266 + 2.4% Project D At 16%: –1. ∴ IRR = 20% Project B At 7%: –8.

Also the drawbacks of IRR should be discussed: ■ ■ multiple solutions. additivity not possible. NPV measures in absolute amounts of money and because project A is twice the size of project C it creates a greater NPV despite a lower IRR. the reinvestment assumption is flawed.CFML_CH02v3. 4th edition Ranking Project A Project C Project D Project B NPV 349 best project 228 –1 –1.QXD 29/7/08 17:26 Page 13 Glen Arnold. d This report should comment on the meaning of a positive or negative NPV expressed in everyday language. ■ ■ © Pearson Education Limited 2008 13 . Corporate Financial Management Lecturer’s Guide.593 Project A ranks higher than project C using NPV because it generates a larger surplus (value) over the required rate of return. It should mention the time value of money and opportunity cost of capital and explain their meanings. ranking problem – link with the contrast of a percentage-based measure and an absolute moneybased measure.

the make or buy decision. For example. ■ 14 © Pearson Education Limited 2008 . That is. the issue of fluctuating output and the make or buy decision. KEY POINTS AND CONCEPTS ■ ■ ■ Raw data have to be checked for accuracy. that is. cash flow effects throughout the organisation. expense of collection. should be considered along with the obvious direct effects. The lowest common multiple (LCM) method is sometimes employed for short-lived assets. Depreciation is not a cash flow and should be excluded. – interest should not be double counted by both including interest as a cash flow and including it as an element in the discount rate. Other applications include the timing of projects. the calculation of annual equivalent annuities. optimal timing of investment. the difference between the cash flows arising if the project is implemented and the cash flows if the project is not implemented: – opportunity costs associated with. etc. working capital adjustments may be needed to modify the profit figures for NPV analysis. ■ ■ ■ The replacement decision is an example of the application of incremental cash flow analysis.CFML_CH03v3.QXD 29/7/08 17:26 Page 14 Chapter 3 PROJECT APPRAISAL: CASH FLOW AND APPLICATIONS LEARNING OUTCOMES By the end of this chapter the reader will be able to identify and apply relevant and incremental cash flows in net present value calculations. incidental costs and allocated overheads and be able to employ this knowledge to the following: ■ ■ ■ ■ ■ the replacement decision/the replacement cycle. reliability. Annual equivalent annuities (AEA) can be employed to estimate the optimal replacement cycle for an asset under certain restrictive assumptions. Analyse on the basis of incremental cash flows. say. fluctuating output situations. using an asset which has an alternative employment are relevant. Profit is a poor substitute for cash flow. – sunk costs – costs which will not change regardless of the decision to proceed are clearly irrelevant. Incremental cash flow analysis helps us to solve these types of problems. – allocated overhead is a non-incremental cost and is irrelevant. The reader will also be able to recognise and deal with sunk costs. – incidental effects. timeliness. Whether to repair the old machine or sell it and buy a new machine is a very common business dilemma.

193m Proposal 2 Central overhead (£70.000 –4.400 1 2 –200 +600 –100 –100 –50 +150 0 150 (1.4% © Pearson Education Limited 2008 15 .CFML_CH03v3.QXD 29/7/08 17:26 Page 15 Glen Arnold.000) – sunk cost Time (years) £000s Design & build Revenue Operating costs Equipment Executive Opportunity cost Sale of club Cash flow Discounted cash flow 0 –9. Corporate Financial Management Lecturer’s Guide.1)3 1 2 3 –100 –100 NPV = –£137.000 –9.100 –100 –100 1.000 –400 –100 5. 4th edition ANSWERS TO SELECTED QUESTIONS 4 Mercia plc a Proposal 1 Consultant’s fee – sunk cost Central overhead – irrelevant Depreciation – irrelevant Time (years) £000s Earthmoving Construction Ticket sales Operational costs Council Senior management Opportunity cost Cash flows Discounted Cash flows 0 –150 –1.650 + NPV = + £2.100 –9.500 11.566 Recommendation: accept proposal 1 IRR Proposal 1: 20.000) – irrelevant Consultants fees (£50.1 + +500 500 (1.000 –400 –100 +11.000 5.650 –1.500 (1.1 (1.1)2 –100 –1.2% Proposal 2: 9.1)2 3→∞ +600 –100 –50 +450 450/0.1)2 + +11.000 –4.

CFML_CH03v3. Allocated overhead treatment.2 –0.4%.575 + 6.0 2.12)4 (1.575 6.0 1.25 1.25 –0.5 5.75 0 +1.QXD 29/7/08 17:26 Page 16 Glen Arnold.125 –0.25 2. c Points to be covered: ■ ■ ■ ■ ■ ■ ■ Time value of money.125 0.85 –6.125 0.15 0.75 +0.75 0.25 0 2. – ranking problem.05 + 6.229 + 4.75 –6.582 + 1.9 + 8.50 1. Sunk cost. Comparison of NPV with other project appraisal methods: Advantages over IRR: – measures in absolute amounts of money.12)3 (1.30 0 0 2 3.10 0 –0. Corporate Financial Management Lecturer’s Guide.025 0.85 1. Treatment of depreciation.2 0.10 0 –0.12)5 (1.75 0.625m The maximum which MI should bid in the auction is £6.2 –1.125 = –5.12)2 (1.2 +1.0 –2.625m. This additional cash outflow at time zero would result in a return of 12% being obtained.25 as time 6.15 0. (Some students may time the final debtor and creditor payments at time 5.7 2.9 8.7 2.12)5. 4th edition 5 Mines International plc a Survey – sunk cost Time (years) £m Profit (loss) Add depreciation Capital equipment Survey Debtor adjustment: Opening debtors Closing debtors Creditor adjustment Opening creditors Closing creditors Overheads Hire cost Cash reserves Government refund Cash flow Discounted cash flow 0 0 0 –4.25 2.75 – 5.025 0.0 +0.10 0.2 0.035 = £6.0 2.) b IRR = 29.15 +0.125 0.20 4.125 0 2.9 2. Cash injections. Hire cost – opportunity cost.075 + 1.2 –5.10 0.05 6.0 5 2.385 + 4.0 4 4.75 1 –2.9 2.1 0 –4. 16 © Pearson Education Limited 2008 .75 –5.0 3 4.680 + 4.05 +0.12 (1. Opportunity cost of money for a given risk class.0 0. – multiple solution problem.20 + 4.075 1.536 + 3.10 0 0.1 0.

4th edition ■ Advantages over payback: – time value of money allowed for. – all cash flows considered.604 0.039 2. ■ 7 Reds plc One-year cycle: Time (years) 0 –10.CFML_CH03v3.000 – 12.500 –6.9009 – 6.039 AEA = –39.9009 – 13.000 1 –12.9009 = –£15.7312 = –39.000 2 –13.000 8.000 3.9009 = –13.233 Three-year cycle: Time (years) 0 –10.500 × 0.500 × 0. – cash flows within pay back period considered properly.000 2 –13.000 3 –14.604 AEA = –13. – defined decision criteria.086 1.8116 – 10.000 – 4.000 1 –12. Corporate Financial Management Lecturer’s Guide.000 × 0.000 – 12.QXD 29/7/08 17:26 Page 17 Glen Arnold.7125 = –£15.086 AEA = –26.500 NPV = –10.000 6.975 Reds should replace the machinery on a one-year cycle. Advantages over ARR: – firm theoretical base.000 NPV = –10.000 × 0. time value of money.4437 = –£15.000 – 4. © Pearson Education Limited 2008 17 .000 × 0.000 1 –12.500 NPV = –10.000 × 0.8116 = –26.100 Two-year cycle: Time (years) 0 –10.500 –10.

5523 0.000 +4.000 –24.000 3 121. Corporate Financial Management Lecturer’s Guide.000 68.706 26.000 0.000 37.570 8.000 47.410 –1.966 Replacement after two years: Time 0 –2.100/0.100/0.500 × 0.013 32.QXD 29/7/08 17:26 Page 18 Glen Arnold.000 2 +1.11 (1.100 – 15.000 –28.500 3→∞ –15.000 28.11)2 = –£113.100 5 146.000 47.000 × 1 3.6407 0.000 2 110.100 –86.139 20.9009 + 1.410 = = = = = = –70.8116 × × × × × 0.960 1 100.000 28.000 37.7432 0. 4th edition 8 Immediate replacement: Time (years) 0 +4.100 0.000 –70.000 1 –1.11 = –£122.000 –2.000 10.CFML_CH03v3.000 –28.000 –70.100 –15.000 –2.9009 2→∞ –15.000 1→∞ –15.000 4 133.8621 0.810 23.11 1.4761 The positive incremental NPV indicates that acceptance of the proposal to manufacture in-house would add to shareholder wealth.000 –82. 18 © Pearson Education Limited 2008 .000 + 3.100 68.000 –84. 10 Curt plc Incremental cash flows Time (years) 0 Current cash flows New plan 0 –70.410 –88.11 = –£133.273 Replacement after one year: Time 0 –2.097 Recommendation: Commence replacement cycle after two years.000 –80.000 × 0.100 –15.000 –48.

629/1.3333 × 2 1.000 + 6.13 = £34. e.231 0.3 333.000/(1. 14 Opti plc Costs One-year replacement: PV = 20.75 × 2 1.000 + 6.13 The lowest cost option is to replace both machines.5 × 2 = 667 500 333 1.3 166.CFML_CH03v3.000 Two-year replacement: PV = 20. © Pearson Education Limited 2008 19 3.000 × 0.1 + 8. factory space usage? 12 Netq plc Output per year: 1.1 + 8.000 × 0.1)3 = 35.000 PV = 6.7 0 500 New 333.1)2 + 10.3 1.3 333.000/(1.629 AEA = 24. Corporate Financial Management Lecturer’s Guide.500 × £1. Are there some other incidental effects Curt has not considered.9091 = 16. Perhaps a search for another supplier would be wise.80 = £2.000/1.000 × 1.191 Three-year replacement: PV = 20.000 + 2.7355 = 14.410/3.1 = 14.500 Cost of annual output 1.000/0.500 × £4 = £6.700 0.072/2.800 PV = 7.072 AEA = 35.QXD 29/7/08 17:26 Page 19 Glen Arnold.000/1.4869 = 14.800 .000 Annual costs 500 × 4 + 1.154 Both machines replaced: Annual costs 1.1)2 = 24.1699 = 14.1 – 1.700 PV = 14.g.000 – 6.3333 × 0.000 × 0.000/(1.410 AEA = 46.3333 × 0.545/0.000/(1.1)2 + 4.000/(1.103 Four-year replacement: PV = 20. 4th edition Other factors: some possibilities The relative bargaining strength of Curt and its supplier.545 AEA = 14.8 = £3.000/1.1)4 = 46.1)3 + 10.000/1.000 + = £36.641 The optimal replacement cycle is 3 years.13 = £46.000/(1. Perhaps it would be possible to negotiate a multi-year price agreement.769 One machine is replaced: Old Output: first third of year second third of year last third of year 333.000 + 6.

the capital-allocation planning process. and easy to use.QXD 29/7/08 17:27 Page 20 Chapter 4 THE DECISION-MAKING PROCESS FOR INVESTMENT APPRAISAL LEARNING OUTCOMES The main outcome expected from this chapter is that the reader is aware of both traditional and discounted cash flow investment appraisal techniques and the extent of their use. the calculation of payback. – profit is a poor substitute for cash flow. Thought to be useful when capital is in short supply. – some perverse decisions can be made.CFML_CH04v3. – arbitrary cut-off rate. Payback has a few drawbacks: – no allowance for the time value of money. – cash flows after the cut-off are ignored. ■ ■ ■ ■ ■ ■ ■ 20 © Pearson Education Limited 2008 . expressed as a percentage. – simple. The student is expected to gain knowledge of: ■ ■ ■ ■ ■ the empirical evidence on techniques used. – projects returning cash sooner are ranked higher. discounted payback and accounting rate of return (ARR). The reader should also be aware that these techniques are a small part of the overall capital-allocation planning process. Most large firms use more than one appraisal method. KEY POINTS AND CONCEPTS ■ Payback and ARR are widely used methods of project appraisal. Discounted payback takes account of the time value of money. Payback is the length of time for cumulated future cash inflows to equal an initial outflow. the balance to be struck between mathematical precision and imprecise reality. – no allowance for the time value of money. – good for communication with non-specialists. – arbitrary selection of cut-off date. but discounted cash flow methods are the most popular. the drawbacks and attractions of payback and ARR. Projects are accepted if this time is below an agreed cut-off point. – often gives the same decision as the more sophisticated techniques. – makes allowance for increased risk of more distant cash flows. Payback’s attractions: – it complements more sophisticated methods. Accounting rate of return is the ratio of accounting profit to investment. Accounting rate of return has a few drawbacks: – it can be calculated in a wide variety of ways.

– post-completion auditing. Mathematical technique is only one element needed for successful project appraisal. – entrepreneurial spirit.943 Discounted payback: 5 years. ■ ■ ■ ANSWERS TO SELECTED QUESTIONS 3 Oakland plc (1) a Payback £000s Year 1 2 3 4 5 Cumulative inflows 50 170 520 600 1. – intangible benefits.223 958.583 462. – social context.400 Payback in year 5 and therefore not accepted under the board’s decision criteria. – expense. It has many stages: – generation of ideas.QXD 29/7/08 17:27 Page 21 Glen Arnold. 4th edition ■ Accounting rate of return attractions: – familiarity.CFML_CH04v3.7513 80 × 0.168 262.96 54. – thought (wrongly) to give a better ranking.455 144. – managers’ performances are often judged using ARR and therefore they wish to select projects on the same basis. Internal rate of return is used more than NPV: – psychological preference for a percentage. – can be calculated without cost of capital. – implementation.6209 45.6830 800 × 0. Corporate Financial Management Lecturer’s Guide.9091 120 × 0.455 99. The investment process is more than appraisal. Other factors to be taken into account are: – strategy.623 407.64 496. – appraisal.72 Cumulative 45. – screening. © Pearson Education Limited 2008 21 .8264 350 × 0. ease of understanding and communication. b Year 1 2 3 4 5 50 × 0. – report and authorisation. – development and classification.

4th edition c Accounting rate of return (one possibility): £000s Year 1 2 120 180 –60 3 350 180 170 4 80 180 –100 5 800 180 620 Profit before depreciation 50 Depreciation 180 Profit/loss –130 1 Assets at start of each year: Profit Assets 900 –130 900 –14. 5 and 6 for payback.8% is greater than the required rate of 10%. Discounted payback 1 Receipts beyond the payback are ignored. 4 May be used to filter out obviously poor projects quickly. 2 Receipts beyond the payback period are ignored. 3 Initial outlay is not always unambiguously identifiable. 2 Relatively simple to use and understand.3% +31. 22 © Pearson Education Limited 2008 .8% 2 720 –60 720 3 540 170 540 4 360 –100 360 5 180 620 180 –8. 5 In an uncertain world a quick return leaves less exposure to unquantifiable risks. 2 Easy to understand. Demerits Payback 1 No allowance for the time value of money.4% The project is acceptable under the IRR method as the IRR of 11. 3. the sooner other profitable investments can be undertaken (for an imperfect world scenario).4% Average = 65% d Internal rate of return: 11.5% –27. therefore this project is acceptable under the NPV method. 2 Arbitrary cut-off.CFML_CH04v3.QXD 29/7/08 17:27 Page 22 Glen Arnold. (2) Merits Payback 1 Simple to use. 3 Easier for communications with non-specialists. the sooner the money is returned.8% 344.943 NPV is positive. 4 ‘Initial’ outlay is not always unambiguously identifiable. 4 and 5 are the same as 4. Discounted payback 1 Time value of money within payback allowed for. 3 Arbitrary cut-off. e NPV: +£58. 6 If funds are limited. Corporate Financial Management Lecturer’s Guide.

3 Consistency of method. 3 Management performance is often evaluated by an ARR method. Demerits Accounting rate of return 1 Not based on cash flow – profit and asset figures are often derived from subjective and arbitrary decisions. Thus. Net present value 1 Less commonly understood than the other methods. 6 All cash flows considered. e. 2 More effort is needed to carry out the calculations. 4th edition Merits Accounting rate of return 1 Easy to understand. e. 2 Easy to calculate – accounting information is usually available. 4 Relates directly to shareholder wealth enhancement. Internal rate of return 1 Multiple/no solution.CFML_CH04v3. 3 Measures in percentage terms rather than absolute amounts of money.g. 2 No allowance for time value of money. ROCE. 3 Consistency of method. 5 All cash flows considered. 3 Relies on inputs being correct. 4 Easier to communicate to the non-specialist than NPV. 2 Time value of money considered. rather than many alternative methods. 4 Arbitrary cut-off point for accept/reject decisions. as with ARR. 5 Measures in absolute terms not percentages. ARR may be preferred by the management team for project appraisal. as with ARR. Internal rate of return 1 Cash flow based. 5 As a percentage measure it does not measure in absolute terms. © Pearson Education Limited 2008 23 . 2 Time value of money considered.g. an appropriate discount rate is available. rather than many alternative methods. Corporate Financial Management Lecturer’s Guide. Net present value 1 Cash flow based. 2 Ranking problem.QXD 29/7/08 17:27 Page 23 Glen Arnold. 3 Many variants of ARR – no consistency.

Two rules for allowing for taxation in project appraisal: – include incremental tax effects of a project as a cash outflow. taxation and inflation.CFML_CH05v3. © Pearson Education Limited 2008 ■ ■ ■ ■ ■ ■ 24 . – real cash flows – future cash flows are expressed in constant purchasing power. he/she should be able to: ■ explain why capital rationing exists and be able to use the profitability ratio in one-period rationing situations. Taxable profits are not the same as accounting profits. show awareness of the influence of taxation on cash flows. discount money cash flows with a money discount rate. TAXATION AND INFLATION LEARNING OUTCOMES By the end of this chapter the reader should be able to cope with investment appraisal in an environment of capital rationing. ■ ■ KEY POINTS AND CONCEPTS ■ Soft capital rationing – internal management-imposed limits on investment expenditure despite the availability of positive NPV projects. focus on the returns per £ of outlay: Profitability index = Benefit-cost ratio = Gross present value Initial outlay Net present value Initial outlay ■ ■ ■ ■ For indivisible one-period capital rationing problems. and real cash flows with a real discount rate. For divisible one-period capital rationing problems. More specifically. examine all the feasible alternative combinations. Fisher’s equation (1 + money rate of return) = (1 + real rate of return) × (1 + anticipated rate of inflation) (1 + m) = (1 + h) × (1 + i) Inflation affects future cash flows: – money cash flows – all future cash flows are expressed in the prices expected to rule when the cash flow occurs. depreciation is not allowed for in the taxable profit calculation. Specific inflation – price changes of an individual good or service over a period of time.QXD 29/7/08 17:27 Page 24 Chapter 5 PROJECT APPRAISAL: CAPITAL RATIONING. but writing-down allowances are permitted. – get the timing right. For example. General inflation – the reduced purchasing power of money. General inflation affects the rate of return required on projects: – real rate of return – the return required in the absence of inflation. Hard capital rationing – externally imposed limits on investment expenditure in the presence of positive NPV projects. – money rate of return – includes a return to compensate for inflation.

05)3 × (1.05 1.100 –800 –300 –100 × × × × 1.07)2 2.CFML_CH05v3.009 × 0.6244 NPV = –£359K Project Y Time 0 Time 1 Sales Materials Labour Overheads 1.000 © Pearson Education Limited 2008 25 .QXD 29/7/08 17:27 Page 25 Glen Arnold.04)3 × (1.7305 + 1.009 –2.1)2 × (1.04 1.07 1.995 –208 –770 –54 963 £000s –2. ANSWERS TO SELECTED QUESTIONS 4 Wishbone plc a Project X Time 0 Time 1 Sales Materials Labour Overheads 2.07)3 2.05)2 × (1.10 1.100 –800 –300 –100 × (1.900 –200 –700 –50 × × × × 1.205 –832 –330 –107 936 £000s –2. – Approach 2 – Estimate the cash flows in real terms and use a real discount rate.431 –900 –399 –123 1.500 + 936 × 0.500 Time 2 Sales Materials Labour Overheads 2.10 1.07 2.315 –865 –363 –114 973 Time 3 Sales Materials Labour Overheads 2.100 –800 –300 –100 × (1. 4th edition ■ Adjusting for inflation in project appraisal: – Approach 1 – Estimate the cash flows in money terms and use a money discount rate.04)2 × (1.05 1.04 1. Corporate Financial Management Lecturer’s Guide.1)3 × (1.8547 + 973 × 0.

0833)2 779/(1.0833)3 Discounted real cash flows –2.04)2 (1.500 9.CFML_CH05v3.08) Project X Year 0 1 2 3 £000s 936 × 0.000 37.0833 or 8.0833 834/(1. b h= – 1 = 0.7938 Real cash flows –2.07)3 2.500 800 711 630 NPV = –359 Project Y Year 0 1 2 3 £000s 963 × 0.9259 973 × 0.500 28.900 –200 –700 –50 × × × × (1.07)2 2.33% (1.6244 = +£148k The superior project is Y as this generates more than the required return of 17%.7305 + 981 × 0.000 823 712 613 NPV = 148 7 Bedford Onions plc Year 0 1 2 3 4 26 Annual WDA £ 0 12.900 –200 –700 –50 × (1.199 –225 –932 –61 981 NPV = –2.7938 Real cash flows –2.821 © Pearson Education Limited 2008 . 4th edition Time 2 Sales Materials Labour Overheads 1.500 866 834 801 866/1.05)2 (1.000 892 836 779 892/1.8547 + 975 × 0.QXD 29/7/08 17:27 Page 26 Glen Arnold.009 × 0.375 7.031 5.8573 981 × 0.125 21.8573 1. Corporate Financial Management Lecturer’s Guide.04)3 × (1.05)3 × (1.095 –216 –847 –57 975 Time 3 Sales Materials Labour Overheads 1.0833)3 Discounted real cash flows –2.10)2 (1.9259 975 × 0.000 + 963 × 0.1)3 × (1.0833)2 801/(1.094 15.273 Written-down value £ 50.0833 836/(1.17 1.

000 2 25.000 3 25.672 –65 NPV = –65 + 38.408 B Revenue Fixed cost Variable cost 30 –10 –12 8 – 30 + 8 × 3.000 25.812 100 –50 –12.094 38.4869 = +£7.250 25.CFML_CH05v3.500 11.25 38.000 4 25.75 100 –50 –12.633 8 Clipper plc NPVs: A Revenue Fixed cost Variable cost 20 –5 –8 7 –10 + 7 × 2.8 –15 + 4.375 40.7695 + 37.8772 + 37.625 12. 4th edition Tax payments 1 Profit plus depreciation and overhead less WDA Incremental cash flow Tax @ 30% £000s Time (year) Machine Working capital Sales Costs Tax 0 –50 –15 100 –50 –11.031 42.7908 = +£326 C Revenue Fixed cost Variable cost 18 –6 –7.1699 = +£216 © Pearson Education Limited 2008 27 .675 + 63.891 25.328 25.000 –7.109 × 0.000 –12.75 × 0.188 25.000 –9.188 37.000 –-11.969 12.QXD 29/7/08 17:27 Page 27 Glen Arnold.672 63.8 × 3.109 1 2 3 4 10 15 100 –50 –11.500 37.5921 = 60. Corporate Financial Management Lecturer’s Guide.2 4.328 × 0.891 37.812 × 0.906 11.

8 – 18 + 2.1446 = +£1.877.6061 = +£3.518 3.000 30.000 18.2 – 12 + 2.408 3.518 E Revenue Fixed cost Variable cost 8 –2 –3. 4th edition D Revenue Fixed cost Variable cost 17 –8 –6.8 10.8 Benefit-cost ratio 0.1832 Rank 1 4 3 N/A 2 œ _ qw † of C 28 © Pearson Education Limited 2008 .297 Project A B C D E Project A E Investment 10.297 NPV £ 7.7408 0.1265 0. Corporate Financial Management Lecturer’s Guide.408 326 216 1.000 40.000 18.000 12.8 2.0144 0.000 12.000 15.CFML_CH05v3.000 NPV 7.QXD 29/7/08 17:27 Page 28 Glen Arnold.0109 0.2 2.000 Investment 10.8 × 7.2 × 6.297 172.

enables search resources to be more efficiently directed and allows contingency plans to be made. Expected return – the mean or average outcome is calculated by weighting each of the possible outcomes by the probability of occurrence and then summing the result: – = ∑ (x p ) x i i i=1 i=n ■ ■ ■ Standard deviation – a measure of dispersion around the expected value: σx = 2 or σx i=n i=1 –)2 p } ∑ {(xi – x i © Pearson Education Limited 2008 29 . some theoretical support. Probability analysis allows for more precision in judging project viability.QXD 29/7/08 17:28 Page 29 Chapter 6 RISK AND PROJECT APPRAISAL LEARNING OUTCOMES The reader is expected to be able to present a more realistic and rounded view of a project’s prospects by incorporating risk in an appraisal. undertake scenario analysis. ■ KEY POINTS AND CONCEPTS ■ ■ ■ Risk – more than one possible outcome. It permits a broader picture to be presented. Risk can be allowed for by raising or lowering the discount rate: Advantages: easy to adopt and understand. explain the appropriate use and make an accurate interpretation of the results of the four risk techniques described in this chapter. ■ ■ ■ Scenario analysis permits a number of factors to be changed simultaneously. discuss the limitations. make use of probability analysis to describe the extent of risk facing a project and thus make more enlightened choices. Objective probability – likelihood of outcomes established mathematically or from historic data. present a sensitivity graph and discuss break-even NPV. changed one at a time.CFML_CH06v3. Drawbacks: susceptible to subjectivity in risk premium and risk class allocation. Specifically the reader should be able to: ■ ■ ■ ■ adjust for risk by varying the discount rate.and worstcase scenarios. Drawbacks of sensitivity analysis: – does not assign probabilities and these may need to be added for a fuller picture. – each variable is changed in isolation. Sensitivity analysis views a project’s NPV under alternative assumed values of variables. This enables more informed decision making. Subjective probability – personal judgement of the likely range of outcomes along with the likelihood of their occurrence. Allows best.

for example insolvency. and the variance is less than that of Y. but not the obligation.423 +59.009 124.371 Some data for sensitivity graph: NPV Sales price Sales price Labour Labour Materials Materials Discount rate Discount rate 30 ↑ ↓ ↑ ↓ ↑ ↓ ↑ ↓ 10% 10% 10% 10% 10% 10% 10% 10% : : : : : : : : +99. to take action in the future.974 49. bell-shaped distribution of possible outcomes can be assumed. Corporate Financial Management Lecturer’s Guide. Z = X–µ σ ■ Careful interpretation is needed when using a risk-free discount rather than a risk-adjusted discount rate for probability analysis.319 +46.CFML_CH06v3.240 +39.7513 © Pearson Education Limited 2008 .QXD 29/7/08 17:28 Page 30 Glen Arnold. the probabilities of various events. ■ ■ If a normal.000 × 0. 2 The expected return of X exceeds that of Y and the variance is equal to or less than that of Y.109 –367 +24.026 –74. Mean-variance rule: Project X will be preferred to Project Y if at least one of the following conditions apply: 1 The expected return of X is at least equal to the expected return of Y.502 +74. can be calculated using the Z statistic. – projects may be viewed in isolation rather than as part of the firm’s mixture of projects. Problems with probability analysis: – undue faith can be placed in quantified results. preferring less risk to more risk. Sensitivity analysis and scenario analysis are the most popular methods of allowing for project risk.000 × 2.4869 –90. 4th edition ■ It is assumed that most people are risk averters who demonstrate diminishing marginal utility.345 20.000 15. The real options perspective takes account of future managerial flexibility whereas the traditional NPV framework tends to assume away such flexibility.809 +52. Real options give the right. – can be too complicated for general understanding and communication. ■ ■ ■ ANSWERS TO SELECTED QUESTIONS 2 Cashion International a Most likely NPV: £ Annual cash inflows: Other cash flows Investment Recovery of WC: 50.

000 £1.QXD 29/7/08 17:28 Page 31 Glen Arnold. 6.000 × £1. 49.80 £119. 4th edition 100 Sales price 50 Discount rate Materials NPV (£ 000) Labour 0 –50 –100 –15 –10 –5 0 5 10 Percentage deviation of variable from expected level 15 Fig.90 110.852 £59.000 × 2.6%.862 –76.000 44. © Pearson Education Limited 2008 31 .000 × 0.000 Annual cash inflows 4. 19.000) 4.000 13.3612 Other cash flows: Investment Recovery of WC: 20.000 (167. Corporate Financial Management Lecturer’s Guide.1 Sensitivity graph for Cashion International b Break-even NPV Sales price: Labour costs: Materials costs: Discount rate: 3 Worst-case scenario £ Annual sales Annual costs Labour Material Other costs 90.85%.6931 Net present value –90. 270%.138 –66.693 9.000 13.CFML_CH06v3.852 37% 10%.445 171.

1 0.1 0.05m) × 6.500 × 2.380 493.QXD 29/7/08 17:28 Page 32 Glen Arnold.1 (0.30 Expected NPV Standard deviation = £1.7 0.16 –545.085.033.05m) × 6.455 0.7m – 0.2 – 0.3 (1m – 0.000.21 3.3 0.700 1.000 236.516 Annual cash inflows 93.272 1.2m = 727.026 Net present value 12 Willow plc a and b: Time 0 Time 1 –74.058 1.15 £ 95.630.055341 2.1446 = 279.200 (NPV – NPV)2 pi £m 1.000 39.1 0.1 (0.000) 93.976. Corporate Financial Management Lecturer’s Guide.974 157.77 1.05m) × 6.000 Recovery of WC: 20.7513 15.0m – 0.9077 × 1012 × 1010 × 1012 × 1011 × 1011 × 1012 5.71017 6.4 –1m 0.542 Time 2–11 0.545 1.000 × £2.4756 1.900 1.000 9.300 1.9057 3.671 –130.05m) × 6.4868 Other cash flows Investment –90.2 = 0 NPV Probability NPV x pi 453.836 5.4 0.000 0.1446 = 5.1446 = 3.445 0.977 Probability of avoiding bankruptcy = 77.572 0.7m – 0.1446 =0 1.05m – 0.6 0. 4th edition Best-case scenario £ Annual sales Annual costs Labour Material Other costs 110.306.500 232.1 (0.972 0.94% 32 © Pearson Education Limited 2008 .09 6.000 517.CFML_CH06v3.000 × 0.500 (143.3 1.2m = 454.909 –300.24 –1.785 c –1 – 0.1m – 0.5172 = 0.

both the expected returns and the standard deviations of portfolios are weighted averages of the expected returns and standard deviations. RD) a2σC2 + (1 – a)2σD2 + 2a(1 – a) RCDσCσD n ■ ■ ■ ■ ■ ■ ■ Covariance means the extent to which the returns on two investments move together: – – cov (RA. respectively. With perfect positive correlations between the returns on investments. identify efficient portfolios and then apply utility theory to obtain optimum portfolios. estimating measures of the extent of interaction – covariance and correlation coefficients. Perfect positive correlation has a correlation coefficient of +1. ■ With perfect negative correlation the risk on a portfolio can fall to zero if an appropriate allocation of funds is made. The degree of risk reduction for a portfolio depends on: a the extent of statistical interdependency between the returns on different investments. but it will not be eliminated. and b the number of securities in the portfolio. being able to describe dominance. Perfect negative correlation has a correlation coefficient of –1. risk can be reduced through diversification. of the constituent investments. RB) = ∑ {(RA – RA)(RB – RB)pi} i=1 © Pearson Education Limited 2008 33 . describe and explain in a formal way the interactions between investments and the risk-reducing properties of portfolios.CFML_CH07v3.QXD 8/4/08 15:07 Page 33 Chapter 7 PORTFOLIO THEORY LEARNING OUTCOMES This chapter should enable the student to understand. ■ KEY POINTS AND CONCEPTS ■ The one-year holding period return: R= D1 + P1 – P0 P0 Use IRR-type calculations for multi-period returns. Portfolio expected returns are a weighted average of the expected returns on the constituent investments: RP = aRA + (1 – a)RB Portfolio standard deviation is less than the weighted average of the standard deviation of the constituent investments (except for perfectly positively correlated investments): σP = σP = a2σC2 + (1 – a)2σD2 + 2a(1 – a) cov (RC. The correlation coefficient ranges from –1 to +1. This includes: ■ ■ ■ calculating two-asset portfolio expected returns and standard deviations. In cases of zero correlation between investments. recognise the properties of the multi-asset portfolio set and demonstrate the theory behind the capital market line.

0 9. Covariance can take on any positive or negative value. 4th edition ■ Covariance and the correlation coefficient are related. RD) σC2 + σD2 – 2 cov (RC.4 15.2 0. Optimal portfolios are available where the highest attainable indifference curve is tangential to the efficient frontier. – do not intersect. Most securities have correlation coefficients in the range of 0 to +1. Corporate Financial Management Lecturer’s Guide. – indifference curve generation is difficult. – have a slope which depends on the risk aversion of the individual concerned. – few investment managers use computer programs because of the nonsense results they frequently produce. Most of this benefit is achieved with a portfolio of 10 securities. RB) = RABσAσB ■ Efficient portfolios are on the efficient frontier. The feasible set for multi-asset portfolios is an area that resembles an umbrella. – involves complicated calculations. These are combinations of investments which maximise the expected returns for a given standard deviation. – are part of an infinite set of curves. Problems with portfolio theory: – relies on past data to predict future risk and return. International diversification can reduce risk even further than domestic diversification. – are preferred if they are closer to the ‘north-west’. To find the proportion of the fund. RD) ■ ■ Indifference curves for risk and return: – are upward sloping. Such portfolios dominate all other possible portfolios in an opportunity set or feasible set.6 0.4% 34 © Pearson Education Limited 2008 .0 0.QXD 8/4/08 15:07 Page 34 Glen Arnold. The correlation coefficient is confined to the range –1 to +1: RAB = cov (RA. to invest in investment C in a two-asset portfolio to achieve minimum variance or standard deviation: a= σD2 – cov (RC.CFML_CH07v3. a.2 Expected return Ri pi 6. Diversification within a home stock market can reduce risk to less than one-third of the risk on a typical single share. ■ ■ ■ ■ ■ ■ ANSWERS TO SELECTED QUESTIONS 4 a Ri % 30 15 2 pi 0. RB) σA σB or cov (RA.

QXD 8/4/08 15:07 Page 35 Glen Arnold.7% Standard deviation: 0.64 8.4 + 0.6 0.2 0.6 0.8 × 0.0 4.2 0.2 – – (Ri – Ri ) (Rs – Rs ) pi –26.4 Rs % 5 15 20 – Rs % 14 14 14 pi 0.4 + 0.0 14.2 24.2 Expected return – Rs % 14 14 14 b Rs % 5 15 20 pi 0.2 σ2 Standard deviation 6 a Covariance Ri % 30 15 2 – Ri % 15.5 × –42.2 σ2 Standard deviation 5 a Rs % ps Rs pi 1.2 0.2 15 0. Corporate Financial Management Lecturer’s Guide.64 + 0.63 0.0 4.22 × 24 + 2 × 0.52 × 78.08 –42.4 15.6 0.2 × 14 = 15.6 7.52 × 24 + 2 × 0.2 0.1% Portfolio B Expected return: 0.6 = 2.24 –16.0 9.6 = 6.87% b Ri % 30 15 2 pi 0.CFML_CH07v3.4 15. 4th edition – Ri % 15.5 × 14 = 14.4 – (Ri – Ri)2 pi 42.2 × –42.9% 5 0.0% – (Rs – Rs )2 pi 16.82 × 78.8 × 15.10 35.5 × 15.5 × 0.64 + 0.12% Standard deviation: 0.1% © Pearson Education Limited 2008 35 .91 78.60 Portfolio A Expected return: 0.4 15.4 15.6 20 0.28 –0.

6 = 35.576 1.35 14 B A ICMC C S 0. 7.3546 × 0.6) 78.62% 15.5% Standard deviation: 0.6454 × –42.25 × 0.5% 187.64542 × 24 + 2 × 0.35% Standard deviation: 0.9 6.8 13.75 × –42.1 4.4 0.64 + 0.46% of the fund devoted to ICMC and 64.87 Fig.35462 × 78. Corporate Financial Management Lecturer’s Guide.3546 × 15. 4th edition Portfolio C Expected return: 0.1 Standard deviation % 8.36% Standard deviation Acehar 100% Strong Normal Slow Expected return 0.25 × 15.60 = 1.4 Expected return % 15.12 14.CFML_CH07v3.360 2.62 1.50 375.46% Lowest standard deviation is achievable with 35.252 × 78.64 + 24 – 2 × –42.56 2.452 6.8 13.3 3 6 4.56% b a= 24 – (–42.3 50 25 0 15 10 0 25 25 25 25 Standard deviation 36 © Pearson Education Limited 2008 .8 4.4 + 0. Expected return: 0.5 14.64 + 0.00 19.6 = 0.1 14 a Horace Investments Event (growth) Ecaroh 100% Strong Normal Slow Expected return pi R % 10 15 16 R × pi – R % 13.8 13.54% devoted to Splash.00 187.4 + 0.75 × 14 = 14.6454 × 14 = 14.3 0.332 0.752 × 24 + 2 × 0.4 0.QXD 8/4/08 15:07 Page 36 Glen Arnold.7 14.8 – (R – R)2 pi 0.3 0.50 0.

9 × 13. 7. © Pearson Education Limited 2008 37 . – Curved.4 0.5 × 25 = 19. A and E (50%) Inefficient portfolios: E.1 × 25 = 14.5 × 0.8 RA 50 25 0 – RA 25 25 25 – – (RE – RE)(RA – RA) pi –28. – Slope to the NE–SW.52 × 375 + 2 × 0.CFML_CH07v3.92 × 6.8 + 0.9% b 30 25 Expected return 20 15 10 5 E E and A 90% 10% J E and A (50%) Indifference curve A 2 Fig. c Indifference curves – Shallow slope.8 13.9 × 0. – Optimal point at tangent to risk-return line.12 × 375 + 2 × 0.2 4 6 8 10 12 14 16 Standard deviation 18 20 22 24 Efficient portfolios: A.52 × 6.92% Standard deviation: 0.10%) depending on the position of the risk-return line.5% Ecaroh 90%.8 + 0.3 RE 10 15 16 – RE 13. possibly E and A (90%.0 Expected return: 0. Acehar 50% Covariance: Event Strong Normal Slow pi 0.QXD 8/4/08 15:07 Page 37 Glen Arnold. 4th edition Ecaroh 50%.5 × –45 = 8.36 + 0. – Do not cross.5 –45.1 × –45 = 0.5 × 13.3 0.4% Standard deviation: 0. Corporate Financial Management Lecturer’s Guide.36 + 0.5 0 –16.8 13. Acehar 10% Expected return: 0.

show an awareness of the empirical evidence relating to the CAPM. such as shares quoted on the London Stock Exchange. – identifying mispriced shares. – measuring portfolio performance. Total risk consists of two elements: – systematic risk (or market risk. But remember. The Security Market Line (SML) shows the relationship between risk as measured by beta and expected returns. express a reasoned and balanced judgement of the risk-return relationship in financial markets.CFML_CH08v3. explain the key characteristics of multi-factor models. including the Arbitrage Pricing Theory (APT) and the three-factor model. – rate of return on firm’s projects. Risk and return are positively related. At times it may seem that this chapter is marching you up to the top of the hill only to push you down again. By the end of this chapter the reader should be able to: ■ ■ ■ describe the fundamental features of the Capital Asset Pricing Model (CAPM). ■ ■ ■ ■ ■ ■ ■ 38 © Pearson Education Limited 2008 . – unsystematic risk (or specific risk. the annual swings in returns are much greater for shares than for Treasury bills. ■ KEY POINTS AND CONCEPTS ■ Risky securities. Unsystematic risk can be eliminated by diversification. The equation for the capital asset pricing model is: rj = rf + βj (rm – rf) The slope of the characteristic line represents beta: rj = α + βj rm + e Some examples of the CAPM’s application: – portfolio selection. or non-diversifiable risk) – risk factors common to all firms. sometimes what you learn on a journey and what you see from new viewpoints are more important than the ultimate destination. or diversifiable risk). frameworks and theories surrounding the relationship between the returns on a security and its risk are pivotal to most of the issues discussed in this book.QXD 29/7/08 15:10 Page 38 Chapter 8 THE CAPITAL ASSET PRICING MODEL AND MULTI-FACTOR MODELS LEARNING OUTCOMES The ideas. Beta measures the covariance between the returns on a particular share with the returns on the market as a whole. An efficient market will not reward unsystematic risk. have produced a much higher average annual return than relatively risk-free securities. However.

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Technical problems with the CAPM: – measuring beta; – ex ante theory but ex post testing and analysis; – unobtainability of the market portfolio; – one-period model; – unrealistic assumptions. Early research seemed to confirm the validity of beta as the measure of risk influencing returns. Later work cast serious doubt on this. Some researchers say beta has no influence on returns. Beta is not the only determinant of return. Multi-factor models allow for a variety of influences on share returns. Factor models refer to diversifiable risk as non-factor risk and non-diversifiable risk as factor risk. Major problems with multi-factor models include: – the difficulty of finding the influencing factors: – once found, the influencing factors only explain past returns. The Arbitrage Pricing Theory (APT) is one possible multi-factor model: Expected returns = risk-free return + β1 = (r1 – rf ) + β2(r2 – rf ) + β3 (r3 – rf ) + β4 (r4 – rf ) … + βn (rn – rf ) + e Fama and French have developed a three-factor model: Expected return = risk-free rate + β1 (rm – rf ) + β2 (SMB) + β3 (HML)

■ ■ ■ ■

Traditional commonsense-based measures of risk seem to have more explanatory power over returns than beta or standard deviation. Projects of differing risks should be appraised using different discount rates.

Refer to Appendix VII in Corporate Financial Management for answers to all numerical questions in this chapter.

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Chapter 9

STOCK MARKETS
LEARNING OUTCOMES
An appreciation of the rationale and importance of a well-organised stock market in a sophisticated financial system is a necessary precursor to understanding what is going on in the world around us. To this end the reader will, having read this chapter, be able to:

describe the scale of stock market activity around the world and explain the reasons for the widespread adoption of stock exchanges as one of the foci for a market-based economy; explain the functions of stock exchanges and the importance of an efficiently operated stock exchange; give an account of the stock markets available to UK firms and describe alternative share trading systems; demonstrate a grasp of the regulatory framework for the UK financial system; be able to understand many of the financial terms expressed in the broadsheet newspapers (particularly the Financial Times); outline the UK corporate taxation system.

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KEY POINTS AND CONCEPTS

Stock exchanges are markets where government and industry can raise long-term capital and investors can buy and sell securities. Two breakthroughs in the rise of capitalism: – thriving secondary markets for securities; – limited liability. Over 100 countries now have stock markets. They have grown in significance due to: – disillusionment with planned economies combined with admiration for Western and the ‘tiger’ economies; – recognition of the key role of stock markets in a liberal pro-market economic system. The largest domestic stock markets are in the USA, Japan and the UK. The leading international equity market is the London Stock Exchange. The globalisation of equity markets has been driven by: – deregulation; – technology; – institutionalisation. Companies list on more than one exchange for the following reasons: – to broaden the shareholder base and lower the cost of equity capital; – the domestic market is too small or the firm’s growth is otherwise constrained; – to reward employees; – investors in particular markets may understand the firm better; – to raise awareness of the company; – to discipline the firm and learn to improve performance; – to understand better the economic, social and industrial changes occurring in major product markets. A well-run stock exchange: – allows a ‘fair game’ to take place; – is regulated to avoid negligence, fraud and other abuses;

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Glen Arnold, Corporate Financial Management Lecturer’s Guide, 4th edition – allows transactions to take place cheaply; – has enough participants for efficient price setting and liquidity.

Benefits of a well-run stock exchange: – firms can find funds and grow; – society can allocate capital better; – shareholders can sell speedily and cheaply. They can value their financial assets and diversify; – increase in status and publicity for firms; – mergers can be facilitated by having a quotation. The market in managerial control is assisted; – corporate behaviour can be improved. The London Stock Exchange regulates the trading of equities (domestic and international) and debt instruments (e.g. gilts, corporate bonds and Eurobonds, etc.) and other financial instruments (e.g. warrants, depositary receipts and preference shares). The primary market is where firms can raise finance by selling shares (or other securities) to investors. The secondary market is where existing securities are sold by one investor to another. Internal funds are generally the most important source of long-term capital for firms. Bank borrowing varies greatly and new share or bond issues account for a minority of the funds needed for corporate growth. LSE’s Main Market is the most heavily regulated UK exchange. The Alternative Investment Market (AIM) is the lightly regulated exchange designed for small, young companies. techMARK is the sector of the Official List focused on technology-led companies. The rules for listing are different for techMARK companies than for other OL companies. PLUS provides a share trading facility for companies, less costly than the LSE. Stock exchanges undertake most or all of the following tasks to play their role in a modern society: – – – – – – supervise trading; authorise market participants (e.g. brokers, market makers); assist price formation; clear and settle transactions; regulate the admission of companies to and companies on the exchange; disseminate information.

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A quote-driven share trading system is one in which market makers quote a bid and an offer price for shares. An order-driven system is one in which investors’ buy and sell orders are matched without the intermediation of market makers. The ownership of quoted shares has shifted from dominance by individual shareholders in the 1960s to dominance by institutions many of which are from overseas. High-quality regulation generates confidence in the financial markets and encourages the flow of savings into investment. The Financial Services Authority is at the centre of UK financial regulation. Dividend yield: Dividend per share × 100 Share price Price-earnings ratio (PER): Share price Earnings per share

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42 © Pearson Education Limited 2008 . – corporation tax. Corporate Financial Management Lecturer’s Guide. – selecting type of finance.QXD 29/7/08 15:10 Page 42 Glen Arnold. 4th edition ■ Dividend cover: Earnings per share Gross dividend per share Taxation impacts on financial decisions in at least three ways: – capital allowances.CFML_CH09v3. ■ Answers to questions can be found in the text of the chapter.

Advantages to the firm 1 Dividend ‘optional’. 2 Capital does not have to be repaid – ‘shock absorber’. Preference shares offer a fixed rate of return. 2 Loss of control. scrip issues. but are required to have £50. Debt capital holders have no formal control but they do have a right to receive interest and capital. ■ ■ ■ KEY POINTS AND CONCEPTS ■ Ordinary shareholders own the company. etc. They are part of shareholders’ funds but not part of the equity capital. 2 Dividends are not tax deductible. but without a guarantee. 4 Financial gearing considerations. 3 Extraordinary profits go to ordinary shareholders. They have the rights of control. 3 Dividends not tax deductible. ■ © Pearson Education Limited 2008 43 . explain why some firms become disillusioned with quotation. Public limited companies (plcs) can offer their shares to a wider range of investors. Share premium The difference between the sale price and par value of shares. This residual can be very attractive.CFML_CH10v3. Disadvantages to the firm 1 High cost of capital relative to debt. voting. Issued share capital is the amount issued expressed at par value. open offers and warrants. receiving annual reports. give an account of the options open to an unquoted firm wishing to raise external equity finance. describe the nature and practicalities of rights issues. More specifically the reader should be able to: ■ ■ contrast equity finance with debt and preference shares. vendor placings. ■ ■ ■ ■ ■ ■ ■ Authorised share capital is the maximum amount permitted by shareholders to be issued.QXD 29/7/08 15:10 Page 43 Chapter 10 RAISING EQUITY CAPITAL LEARNING OUTCOMES By the end of this chapter the reader will have a firm grasp of the variety of methods of raising finance by selling shares and understand a number of the technical issues involved. 2 Usually no influence over management. Private companies Companies termed ‘Ltd’ are the most common form of limited liability company. Disadvantages 1 High cost: a issue costs. They have no rights to income or capital but receive a residual after other claimants have been satisfied. explain the admission requirements and process for joining the Main Market of the London Stock Exchange and for the AIM. and present balanced arguments describing the pros and cons of quotation. Equity as a way of financing the firm: Advantages 1 No obligation to pay dividends – ‘shock absorber’.000 of share capital. b required rate of return.

© Pearson Education Limited 2008 ■ ■ ■ ■ ■ ■ 44 . Ordinary shares rank higher than deferred ordinary shares for dividends. – competent and broadly based management team.QXD 29/7/08 15:10 Page 44 Glen Arnold. Stages in a flotation: – pre-launch publicity. – accountants’ reports. – 25% of share capital in public hands. – underwriters (usually). – an acceptance of new responsibilities (e. Book-building Investors make bids for shares. – a corporate broker. – lower ongoing costs. – market pricing costs. Following flotation on the main market: – greater disclosure of information. – annual fees to LSE. – intermediaries’ offer. convertible. method. redeemable. – usually three years of accounts.CFML_CH10v3. – decide technicalities. e. – solicitors. – offer for sale by subscription. – close of offer. Corporate Financial Management Lecturer’s Guide. – a sponsor. – launch of public offer – prospectus and price.g. Issuers decide price and allocation in light of bids. – restrictions on director share dealings. price. not sponsors. underwriting. 4th edition ■ ■ ■ ■ Types of preference share Cumulative. – no minimum capitalisation. To float on LSE’s main market of the London Stock Exchange the following are required: – a prospectus. – placing. – announcement of price and first trading. Methods of flotation: – offer for sale. – lower costs. – introduction. – registrar. – reverse takeover. directors’ freedom to buy and sell may be restricted). Golden shares have extraordinary special powers. Costs of new issues: – administrative/transaction costs. – allotment of shares. – pathfinder prospectus. – high standards of behaviour. – offer for sale by tender. – the equity cost of capital. The Alternative Investment Market (AIM) differs from the Main Market in: – nominated advisers. – that the company is suitable. dividend policy may be influenced by exchange investors. trading history or percentage of shares in public hands needed. – appropriate timing for flotation.g. participative.

000 to £250. Placings New shares sold directly to a group of external investors. Also offer knowledge and skills. the issue is termed an open offer. own-share repurchase and sale to an institution are other possibilities. Exit (‘take-out’) is the term used by venture capitalists to mean the availability of a method of selling the holding. The most popular method is a trade sale to another organisation. ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ © Pearson Education Limited 2008 45 . Stock market flotation. – start-up. – Public-to-private (PTP). Incubators provide finance and business services. – management buyouts (MBO): existing team buy business from corporation. which is committed to selling the shares if warrant holders insist. Venture capitalists often strike agreements with entrepreneurs to give the venture capitalists extraordinary powers if specific negative events occur. The theoretical ex-rights price is a weighted average of the price of the existing shares and the new shares. Warrants The holder has the right to subscribe for a specified number of shares at a fixed price at some time in the future. 4th edition ■ ■ ■ ■ Rights issues are an invitation to existing shareholders to purchase additional shares. Corporate Financial Management Lecturer’s Guide. Private equity/venture capital (VC) Finance for high-growth-potential unquoted firms. The shares can be immediately sold by the business vendors to institutional investors. Enterprise Investment Scheme (EIS) Tax benefits are available to investors in small unquoted firms willing to hold the investment for five years. e. Vendor placing Shares are given in exchange for a business. The nil paid rights can be sold instead of buying new shares. Warrants are sold by the company. poor performance. Value of a right on an old share: Theoretical market value of share ex-rights – subscription price Number of old shares required to purchase one new share Value of a right on a new share: Theoretical market value of share ex-rights – subscription price The pre-emption right can be bypassed in the UK under strict conditions. so that existing shareholders can buy the shares at the same price instead. Business angels Wealthy individuals investing £10.CFML_CH10v3. Corporate venturing Large firms can sometimes be a source of equity finance for small firms. young companies with high growth prospects. If there is a clawback provision.QXD 29/7/08 15:10 Page 45 Glen Arnold. Rates of return demanded by VC range from 26% to 80% per annum depending on risk. Scrip issues Each shareholder is given more shares in proportion to current holding. average £5m.g. Some of the investment categories of VC are: – seedcorn.000 in shares and debt of small. Sums: £250. Venture Capital Trusts (VCTs) are special tax-efficient vehicles for investing in small unquoted firms through a pooled investment. – management buy-in (MBI): external managers buy a stake in a business and take over management.000 minimum. No new money is raised. – expansion (development). – other early-stage. Acquisition for shares Shares are created and given in exchange for a business.

QXD 29/7/08 15:10 Page 46 Glen Arnold. ranging from consumption of senior management time to lack of understanding between the City and directors and the stifling of creativity. 4th edition ■ ■ Government agencies can be approached for equity finance. Being quoted has significant disadvantages. 46 © Pearson Education Limited 2008 .250. ANSWERS TO SELECTED QUESTIONS 8 a Three old shares @ £3 One new share @ £2 9 2 11 &_ qq ®& = £2.75 – 2.00 = 25p 3 e See chapter. c Discuss pre-emption rights and ability to sell rights. Corporate Financial Management Lecturer’s Guide. he would receive 75p × 3.000 = £2.75 b 30m. d 2.CFML_CH10v3. If Patrick sold his rights. f See chapter.

A trust deed has affirmative covenants outlining the nature of the bond contract and negative (restrictive) covenants imposing constraints on managerial action to reduce risk for the lenders. – debt holders generally do not have votes. Drawbacks of debt: – Committing to repayments and interest can be risky for a firm. – interest is tax deductible.g. ultimately the debt-holders can force liquidation to retrieve payment. demonstrate an understanding of the value of the international debt markets. describe the main considerations for a firm when borrowing from banks. sale and leaseback. LIBOR). securitisation and project finance. give a considered view of the role of mezzanine and high-yield bond financing as well as convertible bonds. At the end of this chapter the reader will be able to: ■ ■ ■ explain the nature and the main types of bonds. – covenants may further restrict managerial action. explain the term structure of interest rates and the reasons for its existence. – arrangement fees. A bond is a long-term contract in which the bondholders lend money to a company. A straight ‘vanilla’ bond pays regular interest plus the capital on the redemption date. Factors for a firm to consider with bank borrowing: Costs – fixed versus floating. Attractive features of bank borrowing: – administrative and legal costs are low. Debentures are generally more secure than loan stock (in the UK). © Pearson Education Limited 2008 47 ■ ■ ■ ■ ■ ■ ■ . – flexibility in troubled times. – the use of secured assets for borrowing may be an onerous constraint on managerial action. – bargaining on the rate. ■ ■ KEY POINTS AND CONCEPTS ■ Debt finance has a number of advantages for the company: – it has a lower cost than equity finance: a lower transaction costs. their pricing and their valuation. A floating rate note (FRN) is a bond with an interest rate which varies as a benchmark interest rate changes (e.QXD 29/7/08 17:28 Page 47 Chapter 11 LONG-TERM DEBT FINANCE LEARNING OUTCOMES An understanding of the key characteristics of the main categories of debt finance is essential to anyone considering the financing decisions of the firm. – available to small firms.CFML_CH11v3. – quick. b lower rate of return.

– interest is tax deductible. especially leveraged management buyouts (LBOs). and (b) the extent to which the lender is protected in the event of a default. – leveraged recapitalisation. – mortgage style. ■ A syndicated loan occurs where a number of banks (or other financial institutions) each contribute a portion of a loan. Corporate Financial Management Lecturer’s Guide. – self-liquidating. 4th edition Security – asymmetric information. They have the following advantages: – lower interest than on debentures.. Convertible bonds are issued as debt instruments but they also give the holder the right to exchange the bonds at some time in the future into ordinary shares according to some prearranged formula. default). A credit rating depends on (a) the likelihood of payments of interest and/or capital not being paid (i. A foreign bond is a bond denominated in the currency of the country where it is issued when the issuer is a non-resident. The Euromarkets are informal (unregulated) markets in money held outside the jurisdiction of the country of origin of the currency. Mezzanine debt and high-yield bonds are forms of debt offering a high return with a high risk. Repayment arrangements Some possibilities: – grace periods. – personal guarantees. – few negative covenants. – term loan. – fast-growing companies.e.CFML_CH11v3. – cheap way to issue shares. – shares might be temporarily underpriced. A Eurobond is a bond sold outside the jurisdiction of the country of the currency in which the bond is denominated. They have been particularly useful in the following: – management buyouts (MBOs). – covenants. + The interest yield on a bond is: Gross interest (coupon) Market price × 100 ■ ■ The yield to maturity includes both annual coupon returns and capital gains or losses on maturity. A bond is priced according to general market interest rates for risk class and maturity: Irredeemable: PD = i kD i1 1 + kD i2 (1 + kD)2 i3 (1 + kD)3 Rn (1 + kD)n ■ ■ ■ ■ Redeemable: PD = ■ + + + .. – collateral. – an available form of finance when straight debt and equity are not. ■ ■ 48 © Pearson Education Limited 2008 .QXD 29/7/08 17:28 Page 48 Glen Arnold.

9591 + 100/(1.64 20-year bond 6 × 8. the original owner agrees to lease the assets back for a stated period under specified terms.085)2 10-year bond 6 × 6. – the liquidity-preference hypothesis.065)2 10-year bond 6 × 6. The returns to the lender are tied to the fortunes and cash flows of the project.84 © Pearson Education Limited 2008 49 . Securitisation Relatively small.041 + 100/(1. Simultaneously.6908 + 100/(1.2 6. Sale and leaseback Assets are sold to financial institutions or another company which releases cash.65 20-year bond 6 × 10. Corporate Financial Management Lecturer’s Guide. 4th edition ■ A project finance loan is provided as a bank loan or bond finance to an entity set up separately from the parent corporation to undertake a project.93 c 2-year bond 6 106 + = £95. – the market-segmentation hypothesis.QXD 29/7/08 17:28 Page 49 Glen Arnold. The term structure of interest rates describes the manner in which the same default risk class of debt securities provides different annual rates of return depending on the length of time to maturity. ■ ■ ■ ANSWERS TO SELECTED QUESTIONS 7 a Yield curve 7.077)20 = £82.097)20 = £67.072)10 = £91.3615 + 100/(1.1 10 Time to maturity (years) 20 b 2-year bond 6 106 + = £99.092)10 = £79.065 (1.085 (1.7 Interest rate % 7.5 2 Fig.CFML_CH11v3. 11.09 1. homogeneous and liquid financial assets are pooled and repackaged into liquid securities which are then sold on to other investors to generate cash for the original lender. There are three hypotheses relating to the term structure of interest rates: – the expectations hypothesis.57 1.

Corporate Financial Management Lecturer’s Guide. f The student should explain the liquidity preference theory.8 1.CFML_CH11v3.53 e The longest dated bond is the most volatile. 4th edition d 2-year bond 6 106 + = £102.6473 + 100/(1. An excellent student will relate the evidence produced in a.045 (1. b and c to illustrate the market risk of bonds of different maturities.057)20 = £103.045)2 10-year bond 6 × 7.QXD 29/7/08 17:28 Page 50 Glen Arnold.7546 + 100/(1.12 20-year bond 6 × 11.052)10 = £106. 50 © Pearson Education Limited 2008 .

The early settlement discount means that taking a long time to pay is not cost free. ■ A – – – – bank usually considers the following before lending: the projected cash flows. compare and contrast the bank overdraft and the bank term loan. ■ ■ ■ KEY POINTS AND CONCEPTS ■ Overdraft A permit to overdraw on an account up to a stated limit. security. – bargaining strength of the two parties. explain the different services offered by a factoring firm. we will go further and explore the appropriate use of these sources in varying circumstances. creditworthiness.QXD 29/7/08 17:29 Page 51 Chapter 12 SHORT-TERM AND MEDIUM-TERM FINANCE LEARNING OUTCOMES This chapter is largely descriptive and so it would be an achievement merely to understand the nature of each form of finance. Advantages of trade credit: – convenient. show awareness of the central importance of trade credit and good debtor management and be able to analyse the early settlement discount offer. – product type.CFML_CH12v3. Drawbacks: – bank has right to withdraw facility quickly. – credit standing of individual customers. Factors determining the terms of trade credit: – tradition within the industry. consider the relative merits of hire purchase and leasing. usually one to seven years. Specifically the reader should be able to: ■ ■ describe. the amount contributed by the borrower. Advantages: – flexibility. ■ ■ ■ ■ © Pearson Education Limited 2008 51 . describe bills of exchange and bank bills and their uses. Trade credit Goods delivered by suppliers are not paid for immediately. informal and cheap. – security is usually required. ■ Term loan A loan of a fixed amount for an agreed time and on specified terms. However. – available to companies of any size. – cheap.

Bills of exchange A trade bill is the acknowledgement of a debt to be paid by a customer at a specified time. – avoid danger of obsolescence with operating lease. – certainty. – fixed-rate finance. that is discount it. with an option or an automatic right to purchase the goods at the end for a nominal or zero final payment. Note that ownership is never transferred to the lessee.CFML_CH12v3. The firm can sell this right. An operating lease commits the lessee to only a short-term contract.QXD 29/7/08 17:29 Page 52 Glen Arnold. – fixed rate of finance. default risk and administration costs. The main advantages: – small initial outlay. – tax relief (operating lease: rental payments are a tax-deductible expense. The supplying firm manages the sales ledger. Factoring companies provide at least three services: – providing finance on the security of trade debts. Usually confidential and with recourse to the supplying firm. – tax relief available. interest is tax deductible. The legal right to receive this debt can be sold prior to maturity. that is discounted. and thus can provide a source of finance. – available when other sources of finance are not. – assessing credit risk. – available when other finance sources are not. to receive cash from another institution. – sales ledger administration. – integration with other disciplines. Capital allowance can be used to reduce tax paid on the profit of a finance house. – certainty. finance lease: capital value can be written off over a number of years. – collecting payment. Hire purchase is an agreement to hire goods for a specified period. 4th edition ■ Trade debtors are sales made on credit as yet unpaid. less than the useful life of the asset. Corporate Financial Management Lecturer’s Guide. ■ ■ ■ ■ ■ Leasing The legal owner of an asset gives another person or firm (the lessee) the possession of that asset to use in return for specified rental payments. Advantages of leasing: – small initial outlay. Acceptance credit A financial institution or other reputable organisation accepts the promise to pay a specified sum in the future to a firm. ■ ■ ■ ■ ■ 52 © Pearson Education Limited 2008 . The management of debtors requires a trade-off between increased sales and costs of financing. Invoice discounting is the obtaining of money on the security of specific book debts. – credit insurance. liquidity risk. A finance lease commits the lessee to a contract for the substantial part of the useful life of the asset. – agreeing terms. which then passes on the benefit to the lessee). Debtor management requires consideration of the following: – credit policy.

000 – 0.36 16.000 × 90 £ 50.068 237.753 365 If 60% of customers now pay on the 20th day.CFML_CH12v3.068 10.000.000 The discount offered is less than the benefit.36 is roughly equivalent to the 18-period annuity factor when the interest rate per month is 1%: (1 + 0.000 Interest saved: 1.000 + 30.000 1.003 × £10m The overdraft due to debtors is currently: = £2.222.918 × 0. 4th edition ANSWERS TO SELECTED QUESTIONS 5 a 20.000 30.121.025 150.7%.000. Corporate Financial Management Lecturer’s Guide.000 × 0.000) 70 365 = £1.127 or 12.068 = Costs: 6.22 = 16.000. © Pearson Education Limited 2008 53 .14 = Total benefits 50.465.000 + 157.QXD 29/7/08 17:29 Page 53 Glen Arnold.000. 12 a Benefits: Collection effort Bad debts 0. therefore accept the junior executive’s proposal.918 157.01)12 – 1 = 0.025 × 6. the overdraft will be reduced by: (6.121.

Don’t forget retained earnings as a financing option: Advantages – No dilution of existing shareholders’ returns or control – No issue costs – Managers may not have to explain use of funds (dubious advantage for shareholders) Disadvantages – Limited by firm’s profits – Dividend payment reduced – Subject to uncertainty – Regarded as ‘free capital’ ■ ■ ■ ■ ■ Treasurers help decision making at a strategic level: e. A balance needs to be struck between fixed and floating interest-rate debt. – flexibility.g. capital structure. understand the working capital cycle. comment on the factors influencing the balance of the different types of debt in terms of maturity. the cash conversion cycle and an inventory model. – the term structure of interest rates. show awareness of the importance of the relationship between the firm and the financial community. 54 © Pearson Education Limited 2008 .CFML_CH13v3. Firms need to consider the currency in which they borrow. demonstrate how the treasurer might reduce risk for the firm. currency and interest rates.QXD 29/7/08 17:51 Page 54 Chapter 13 TREASURY AND WORKING CAPITAL MANAGEMENT LEARNING OUTCOMES This chapter covers a wide range of finance issues. interest and exchange-rate changes. However. mergers. A more conservative policy would finance all assets with long-term finance. ■ ■ ■ ■ KEY POINTS AND CONCEPTS ■ ■ Working capital is net current assets or net current liabilities. from cheque clearance to optimum inventory models. perhaps through the use of derivative products. – the uncertainty of getting future finance. Matters such as the use of derivatives to reduce interest rate risk or foreign exchange risk have entire chapters devoted to them later in the book and so will be covered in a brief fashion here to give an overview. – cost of issue or arrangement. Firms often strive to match the maturity structure of debt with the maturity structure of assets. By the end of this chapter the reader should be able to: ■ describe the main roles of a treasury department and the key concerns of managers when dealing with working capital. In deciding whether to borrow long or short a company might consider the following: – maturity structure of debt. a more aggressive financing policy would finance permanent short-term assets with shortterm finance.

– aggressive – small proportional increases in working capital as sales rise. – acceptable investments. handling and ordering costs. Working capital policies: – relaxed – large proportional increases in working capital as sales rise. An economic order quantity in a world of certainty can be found by: EOQ = 2AC H With uncertainty. Investment policy considerations: – defining the investable funds. Working capital tension Too little working capital leads to loss of production.QXD 29/7/08 17:51 Page 55 Glen Arnold. – speculative motive. – currency risk. It equals the stock-conversion period plus the debtor-conversion period minus the credit period granted by suppliers. Inventory management requires a balance of the trade-off between the costs of high inventory (interest. – number of banks. deterioration. – limits on holdings. storage. The cash-conversion cycle is the length of time between the company’s outlay on inputs and the receipt of money from the sale of goods. The working capital cycle flows from raw materials. valuation and inflation). to finished goods stock.g. © Pearson Education Limited 2008 55 . Baumol’s cash management model: Q* = 2CA K ■ ■ ■ ■ ■ ■ ■ ■ Some considerations for cash management: – create a policy framework. event. default. Too much working capital leads to excessive costs of tying up funds. Overtrading occurs when a business has insufficient finance for working capital to sustain its level of trading. This requires effort – often the treasurer makes a major contribution: – flow of information. ■ ■ ■ In investing temporarily surplus cash the treasurer has to consider the trade-off between return and risk (liquidity. to work-in-progress. e. cash budgets. – transaction banking versus relationship banking. buffer stocks may be needed. – plan cash flows. sales and goodwill. ■ Some of the risks which can be reduced or avoided by a firm: – business risk. The motives for holding cash: – transactional motive. – insurable risk. – control cash flows. insurance and protection costs) against ordering costs and stock-out costs. Corporate Financial Management Lecturer’s Guide. – interest-rate risk.CFML_CH13v3. – precautionary motive. storage. 4th edition ■ Good relationships need to be developed with the financial community. with creditors used to reduce the cash burden. obsolescence. to sales and collection of cash. management.

366 0.500 0.30 1.667 0.101 1.75 0.700 1.633 0. Event risk – unlikely to be of significance here.715 –0.90 2.00 0.199 2.30 1.00 3.384 3.199 2.30 1.30 1.30 0.667 0.000 2.933 1.433 0. 8 Q= = 2CA K 2 × 200 × 2.667 0.08 = £101.500 0.600 0.x1.30 1.717 0.232 0.40 1.734 3.30 1.715 –0.80 0.667 0. etc.017 –0.00 0.980 Silk plc should draw on these funds every two-and-a-half weeks.10 0.65 0.500 –0.167 2.3.533 1. assuming the firm is able to borrow/lend on the interbank market (creditworthiness.3.95 0.767 0.733 0.134 0.667 0. lend £10.433 0. 7-day lending may be risky because the firm may need cash earlier than anticipated. the risk is not zero.767 0. 4th edition ANSWERS TO SELECTED QUESTIONS 3a Rounded plc Month £m Cash inflows Sales (delivered and paid for in same month) Sales (cash received from prior month’s sales) – one month – two months Total inflows Cash outflows Stock Labour Shops Total outflows Balances Opening cash balance for month Net cash surplus (deficit) Closing cash balance J F M A M J J A S O N D 0.385 0.080.3.600 0.734 3. 3.15 0.332 1. Corporate Financial Management Lecturer’s Guide.3.25 1. Valuation risk – a tradable instrument is not bought or sold and therefore valuation risk is not a problem.30 0.500 0.117 0.500 0.30 1.433 0. Risks: Liquidity risk.533 0.483 –1.5%.CFML_CH13v3.45 1.000 on 7-day interbank market at 5.817 6 Some suggestions.5%.x1.733 0.3.80 0. 5.167 2.000 0.3.667 0.QXD 29/7/08 17:51 Page 56 Glen Arnold.017 –0.75%.x1.x1 and 4.000 2. e.x1 to 11.650 0.00 0.30 1.867 0. 56 © Pearson Education Limited 2008 .433 –0.134 0.): 1.90 0.30 1.533 0.885 –0.30 1.600 0.934 1.g.05 0.733 0.75 0.885 –0.900 2.30 2.000.385 0.20 0.667 0.05 1. Daily surpluses above this figure could be lent on the overnight interbank market at 5.232 0.600 0. place surplus cash in overnight interbank market at 5.x1 and 2.50 0.517 –0.433 0.67%.734 0.633 1.332 1.667 0.384 –0.667 0. Inflation risk – over a short period this is not a great concern. Default risk – highly unlikely that participants in the interbank market will default – however.500 0. borrow on the interbank overnight market at 5.10 0.801 0.233 0.767 0.00 0.533 0.500 0.500 0.30 1.30 1.466 1.95 0.

235 –40 –1.120 950 100 50 40 1.210 –1.205 50 50 810 –1.CFML_CH13v3.010 –500 –560 –1.060 50 50 1.5 650/365 = 29 330 345 270 240 390 360 120 0 450 820 100 440 80 865 800 110 460 330 1.355 360 345 945 660 90 150 50 45 995 –1.200/365 = 84 102 25a Sheetly Cash flow forecast £000s Cash inflows Sales (delivered and paid for in same month) Sales (cash received from prior month’s sales) – one month – two months Total inflows Cash outflows Purchases Labour Tax Vehicles Rent Other Total outflows Balances Opening cash balance Net cash flow for month Closing cash balance May June July Aug Sept Oct Days = 105 550/365 = 70 = 155 550/365 = –103 –33 = 39 650/365 = 22 = 52. Corporate Financial Management Lecturer’s Guide.405 320 270 980 600 110 520 240 1.275 © Pearson Education Limited 2008 57 .405 170 –1.010 –1. 4th edition 23 Rubel cash conversion cycle Raw material stock period: Average value of raw material stock Average usage of raw material per day Less: Average credit granted by suppliers: Average level of creditors Purchases on credit per day Add: Work-in-progress period: Average value of WIP Average cost of goods sold per day Finished goods inventory period: Average value of finished goods in stock Average cost of goods sold per day Debtor conversion period: Average value of debtors Average value of sales per day = 275 1.060 810 90 200 50 60 1.QXD 29/7/08 17:51 Page 57 Glen Arnold.060 –145 –1.160 –1.235 50 60 1.205 –150 –1.355 –50 –1.

– investors need to press for a greater volume of timely information. Semi-strong form efficiency Share prices fully reflect all the relevant. publicly available information.CFML_CH14v3. Security prices respond to news. Weak-form efficiency Share prices fully reflect all information contained in past price movements. Implications of the EMH for investors: – for the vast majority of people public information cannot be used to earn abnormal returns. Implications of the EMH for companies: – focus on substance. Strong-form efficiency All relevant information. Types of efficiency: – operational efficiency. Evidence: substantially in support but there are some anomalies. is reflected in the share price. Evidence: stock markets are strong-form inefficient. Shares.QXD 29/7/08 17:30 Page 58 Chapter 14 STOCK MARKET EFFICIENCY LEARNING OUTCOMES By the end of this chapter the reader should be able to: ■ ■ ■ ■ ■ discuss the meaning of the random walk hypothesis and provide a balanced judgement of the usefulness of past price movements to predict future share prices (weak-form efficiency). The benefits of an efficient market are: – it encourages share buying. Evidence: mostly in support but there are some important exceptions. It is profitable and illegal. – signals from price movements should be taken seriously. – it helps to allocate resources. – the perception of a fair game market could be improved by more constraints and deterrents placed on insider dealers. © Pearson Education Limited 2008 ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ No answers are given in this Lecturer’s Guide for this chapter. Insider dealing is trading on privileged information. provide an overview of the evidence for the stock market’s ability to take account of all publicly available information including past price movements (semi-strong efficiency). – the timing of security issues does not have to be fine-tuned. not on short-term appearances. New information is (a) rapidly and (b) rationally incorporated into share prices. comment on the implications of the evidence for efficiency for investors and corporate management. Behavioural finance studies offer insight into anomalous share pricing. – it gives correct signals to company managers. which is random. outline some of the behavioural-based arguments leading to a belief in inefficiencies. 58 . – pricing efficiency. state whether stock markets appear to absorb all relevant (public or private) information (strong-form efficiency). KEY POINTS AND CONCEPTS ■ In an efficient market security prices rationally reflect available information. other financial assets and commodities move with a random walk – one day’s price change cannot be predicted by looking at previous price changes. – large quantities of new shares can be sold without moving the price. including that which is privately held. – allocational efficiency.

Shareholder-wealth maximisation is the superior objective in most commercial organisations operating in a competitive market for many reasons.g. for example market share targets.g. By the end of it the reader should be able to: ■ explain the failure of accounts-based management (e. – society’s scarce resources can thereby be better allocated. profits. But sometimes the two are contradictory and then shareholder wealth becomes paramount. – the time value of money is ignored. ROE etc. balance sheet assets. Evidence: – most of the value of a share is determined by income to be received five or more years hence. processes. given the finance providers’ opportunity cost of funds. ■ ■ ■ ■ ■ ■ © Pearson Education Limited 2008 59 . However balance sheet figures are often too crude to reflect capital employed. especially with regard to the investment levels used to generate the earnings figures. ■ KEY POINTS AND CONCEPTS ■ Value-based management is a managerial approach in which the primacy of purpose is long-run shareholder-wealth maximisation. The objective of the firm. – hundreds of quoted firms produce zero or negative profits with high market values. earning per share and accounting rate of return) to guide value-maximising decisions in many circumstances.CFML_CH15v3. – owners of the business have a right to demand this objective.) is an attempt to solve some of the problems associated with earnings or earnings per share metrics. That shareholders are interested solely in short-term earnings and EPS is a myth These figures are only interesting to the extent that they cast light on the quality of stewardship over fund providers’ money by management and therefore give an indication of long-term cash flows. For example: – managers not pursuing this objective may be thrown out (e. performance measurement and culture have as their guiding objective shareholderwealth maximisation. its systems. Using accounting rates of return (ROCE. describe the four key drivers of value and the five actions to increasing value. ROI. Using ARRs can also lead to short-termism.QXD 29/7/08 17:30 Page 59 Chapter 15 VALUE MANAGEMENT LEARNING OUTCOMES This chapter demonstrates the rationale behind value-based management techniques. Bad growth is when the return on the marginal investment is less than the required rate of return. Non-shareholder wealth-maximising goals may go hand in hand with shareholder value. – the riskiness of earnings is ignored. strategy. Earnings (profit) based management is flawed: – profit figures are drawn up following numerous subjective allocations and calculations relying on judgement rather than science. analytical techniques. via a merger). This can occur even when earnings-based figures are favourable. – the investment required to produce earnings growth is not made explicit. customer satisfaction and employee benefits. – profit figures are open to manipulation and distortion.

Corporate Financial Management Lecturer’s Guide. influence share prices. in most cases. 4 Planning horizon (for performance spread persistence). earnings can fall due to a rise in R&D spending and yet share prices may rise. Shareholder value is driven by four key elements: 1 Amount of capital invested.QXD 29/7/08 17:30 Page 60 Glen Arnold. – the window dressing of accounts (creative accounting) does not. Performance spread Actual rate of return on capital – required return r–k Corporate value Present value of cash flows within planning horizon Present value of cash flows after planning horizon ■ ■ ■ = + ■ To expand or not to expand? Grow Shrink Value opportunity forgone Positive performance spread Value creation Negative performance spread Value destruction Value creation 60 © Pearson Education Limited 2008 . 3 Actual rate of return on capital.CFML_CH15v3. 2 Required rate of return. ■ Value is created when investment produces a rate of return greater than that required for the risk class of investment. for example. 4th edition – earnings changes are not correlated with share price changes.

670 1.QXD 29/7/08 17:30 Page 61 Glen Arnold.316 1 2 3 4 5 6 7 1.500 1.000 1.270 1.135 1.5 1.350 1.700 Debtor increase 0 4 4 9.5 1.600 1.000 1.321.800 Discounted cash flow 877 796 766 752 763 761 5.200 1. 4th edition ■ The value action pentagon 1 Increase the return on existing capital 5 Lower the required rate of return VALUE 2 Raise investment in positive spread units 4 Extend the planning horizon 3 Divest assets from negative spread units to release capital for more productive use ANSWERS TO SELECTED QUESTIONS 7 Company A Year 1 2 3 4 5 6 7 Profit (£000s) 1.035 1.148 1.700 Company A creates most value.670 1.470 1.100 1.800 Debtor increase 0 35 35 70 70 70 0 Inventory increase 0 30 30 60 60 60 0 Cash flow 1.080 1.CFML_CH15v3.800 1.532 10. © Pearson Education Limited 2008 61 .477.858 10.000 1.573 Company B Year Profit (£000s) 1.400 1.5 10 0 Inventory increase 0 8 8 19 15 20 0 Cash flow Discounted cash flow 877 822 775 782 767 761 5. Corporate Financial Management Lecturer’s Guide.700 1.5 7.000 1.068 1.160 1.

249.000/0.120.077 Alternatively: Investment + value within planning horizons + value after planning horizon 8.077 + £16.640.124 707.848 = 16.000 × 5.000 × 5.472.0386 2.4331 1.000 × 3.215.659 2.176.14 (1.000/0.056 £ 13.000.000.792 £ 1. Corporate Financial Management Lecturer’s Guide.0188 1.632 2.966.800.CFML_CH15v3.154.000 × 4.215.QXD 29/7/08 17:30 Page 62 Glen Arnold.373.000 × 3.708 62 © Pearson Education Limited 2008 .000 + 20.15)10 Alternatively: 12.080.000.15 (1.216 16.000 + 840.000 × 4.021. 4th edition 10 Busy plc a Polythene Discounted cash flow within planning horizon: 880.4331 + 0 = Paper 2.000/0.949 7.128 £ Discounted cash flow after planning horizon: = 4.783 = £25.16)7 = = = = 7.848 + £2.176.772 Total value of firm: £7.16 (1.0386 320.000 – 240.0188 Cotton 340.080.176.772 Alternatively: 2.080.14)5 Present value of future cash flows = 3.215.

1 Consult chapter.2 Paper 0. Corporate Financial Management Lecturer’s Guide.QXD 29/7/08 17:30 Page 63 Glen Arnold.08 –3 1 Cotton 7 Performance spread: percentage points Polythene 0. 4th edition b Value creation and SBU performance spreads Value creation (£m) + 4. 15. © Pearson Education Limited 2008 63 .CFML_CH15v3.82 – c Fig.

Strategic assessment focuses on the three determinants of value creation: – industry attractiveness. – systems and processes. – financial policies. and (b) they will have greater ‘ownership’ of the subsequent chosen strategy. Strategy means selecting which product or market areas to enter/exit and how to ensure a good competitive position in those markets or products. describe a system for making strategic choices that requires both qualitative thinking and quantitative analysis.CFML_CH16v3. discuss the main elements to examine when evaluating alternative strategies for the business from a value perspective. SBU managers should be involved in strategy development because (a) they usually have great knowledge to contribute. Strategic analysis has three stages: – strategic assessment.QXD 29/7/08 17:31 Page 64 Chapter 16 STRATEGY AND VALUE LEARNING OUTCOMES By the end of this chapter the reader will be able to: ■ ■ explain the extent of the ramifications of value-based management. Competitive resource analysis can be conducted using the TRRACK system: – Tangible – Relationships – Reputation – Attitude – Capabilities – Knowledge. describe the four main tasks for the corporate centre (head office). – strategic choice. map business activities in term of industry attractiveness. – strategic implementation. © Pearson Education Limited 2008 ■ ■ ■ ■ ■ ■ ■ 64 . A review of current SBU activities using value-creation profile charts may reveal particular product or customer categories which destroy wealth. ■ ■ KEY POINTS AND CONCEPTS ■ Switching to value-based management principles affects many aspects of the organisation. – corporate strategy. – culture. – life-cycle stage of value potential. – competitive resources. A strategic business unit (SBU) is a business unit within the overall corporate entity which is distinguishable from other business units because it serves a defined external market in which management can conduct strategic planning in relation to products and markets. competitive advantage within the industry and life-cycle stage and make capital allocation choices. – incentives and performance measurement. These include: – strategic business unit strategy and structure.

© Pearson Education Limited 2008 65 . both qualitative judgement and quantitative valuation are important.12 External value metrics: TSR. Strategy implementation is making the chosen strategy work through the planned allocation of resources and the reorganisation and motivation of people. SVA. managing strategic value drivers shared by SBUs. 4th edition ■ A company’s SBU positions with regard to these three value-creation factors could be represented in a strategy planes diagram. cost of output. The corporate centre has four main roles in a value-based firm: portfolio planning. Sustainable competitive advantage is obtainable in two ways: – cost leadership.g. Corporate Financial Management Lecturer’s Guide.CFML_CH16v3. MV A. incentives and rewards should be based on metrics appropriate to the level of management within the firm as shown in Exhibit 16. The product and/or market segment within SBUs can also be shown on strategy planes. structuring the organisation so that rules and responsibilities are clearly defined. EVA ■ ■ ■ ■ ■ – – – – ■ Senior management SBU management Operational functions Operating value drivers: e. with clear accountability for value creation. MBR Discounted cash flow. WAI. In the evaluation of strategic options. – differentiation. Targets. The short-listed options can be tested in sensitivity and scenario analysis as well as for financial and skill-base feasibility. EP. providing and inculcating the pervading philosophy and governing objective.12.QXD 29/7/08 17:31 Page 65 Glen Arnold. To make good strategic choices a wide search for alternatives needs to be encouraged. ■ Exhibit 16. customer satisfaction No answers are given in this Lecturer’s Guide for this chapter.

■ 66 © Pearson Education Limited 2008 . The planning horizon. – liquidation. Fixed capital investment. then discounting these cash flows at the weighted average cost of capital. – trade sale or spin-off. Shareholder value analysis simplifies discounted cash flow analysis by employing (Rappaport’s) seven value drivers. – makes value drivers explicit. – new operating strategy.QXD 29/7/08 17:32 Page 66 Chapter 17 VALUE-CREATION METRICS LEARNING OUTCOMES By the end of this chapter the reader will be able to: ■ describe. ■ provide a brief outline of economic value added and cash flow return on investment (CFROI). Tax rate. – consistent with share valuation. Rappaport’s seven value drivers: 1 2 3 4 5 6 7 Sales growth rate. Working capital investment. It requires the calculation of future annual free cash flows attributable to both shareholders and debt holders. KEY POINTS AND CONCEPTS ■ Discounted cash flow is the bedrock method underlying value management metrics. Investment after the planning horizon does not increase value. Shareholder value from operations equals present value of free cash flows from operations minus debt. Total shareholder value equals shareholder value of free cash flows from operations plus the value of non-operating assets. Corporate value (Enterprise value) equals present value of free cash flows from operations plus the value of non-operating assets.CFML_CH17v3. explain and use the following measures of value: – discounted cash flow – shareholder value analysis – economic profit. Operating profit margin. The required rate of return. – able to benchmark. ■ ■ ■ ■ ■ ■ ■ At least four strategic options should be considered for an SBU or product and/or market segment: – base-case strategy. the first five of which change in a consistent fashion from one year to the next. Merits of shareholder value analysis: – easy to understand and apply.

A major advantage over shareholder value analysis is that it uses accounting data. © Pearson Education Limited 2008 67 ■ . Economic profit (EP) is the amount earned after deducting all operating expenses and a charge for the opportunity cost of the capital employed. costs and capital to business units. – open to manipulation and arbitrariness.CFML_CH17v3. – can lead to poor decisions if misused. – Can be used to look back at past performance. Drawbacks of EP: – the balance sheet does not reflect invested capital.QXD 29/7/08 17:32 Page 67 Glen Arnold. The entity approach to EP a The profit less capital charge method Economic profit (Entity approach) Operating profit before interest deduction and after tax deduction ■ ■ = – Capital charge Economic profit (Entity approach) = Operating profit before interest deduction and after tax deduction – Invested capital × WACC b The ‘performance spread’ method Economic profit (Entity approach) = Performance spread × Invested capital Economic profit (Entity approach) = Return on capital – WACC × Invested capital ■ The equity approach to EP Economic profit (Equity approach) Operating profit after deduction of interest and tax Invested equity capital Required return on equity = – × Economic profit (Equity approach) = Return on equity – Required return on equity × Invested equity capital ■ Usefulness of economic profit: – Managers become aware of the value of the investment in an SBU. product line or entire business. – Economic profit per unit can be calculated. – Can be used to evaluate strategic options. – problem with allocating revenues. 4th edition ■ Problems with shareholder value analysis: – constant percentages unrealistic. Corporate Financial Management Lecturer’s Guide. – high economic profit and negative NPV can go together. – data often unavailable.

588 –0.910 0.122 –0.000m £10.294 1.336 –0.342 1.806 + 3 22.642 –0.876 –0.718 5+ 40.260 1.76 4.813 + 4 26.512 –0. 2 Year Sales Profit Tax IFCI IWCI Operating free cash flow Discounted cash flow Present value of cash flows Add Current value of marketable securities 1 28.070 –0.504 1.164 –1.250 2.592 + 0.620 –1.820 5 30.118 –0.QXD 29/7/08 17:32 Page 68 Glen Arnold.385 0.404 –0.835 + 2.798 + 2 19.832 0.921 1.976 –0.738 –0.000m £29.394 1.076 –1.248m 68 © Pearson Education Limited 2008 .228m 3 B division Year Sales Profit Tax IFCI IWCI Cash flow Discounted cash flows 1 17.332 1. 4th edition ■ Economic value added (EVA®) is an attempt to overcome some of the accounting problems of standard EP.048 0.225 0.235 3.349 7+ 34.264 –0.076 –1.696 4.228m £5.098 2.264 £15.137 + 3 36.381 –0.76 4.849 –0.825 –0.291 –0.148 –0.700 1.000m £20.827 + 6 34.204 0.812 + 10.25 2.453 1.387 –0.CFML_CH17v3.331 1.838 2.358 –0.291 Present value of cash flows Current value of marketable securities Market value of division A £14.192 –0.118 + 4 40.696 4.607 –1.873 9.457 –0.293 –0. Corporate Financial Management Lecturer’s Guide.738 –0.516 –0.164 –1.07 3.248m £5.157 + 2 31.170 3. EVA = Adjusted invested capital × (Adjusted return on capital – WACC) or EVA = Adjusted operating profit after tax – (Adjusted invested capital × WACC) ANSWERS TO SELECTED QUESTIONS For possible action consult the section of Chapter 15 containing the value action pentagon.445 –0.375 1.813 2.298 1.259 1.990 –0.92 3.

501m £5.478 1.642 1.174 3 41.47 5.785 2.363 1.607 1.122m £5.863 –2.930 –1.54 –1.707 Discounted cash flows (16%) 1.921 1.128 –1.627m £5.803 –1.941 –0.892 1 2 3 4 5+ 5 57. 4 a Four-year planning horizon and 14% discount rate: Year Operating free cash flows Discounted cash flows (14%) PV of cash flows Marketable securities £16.157 1.000m £19.147 1.000m £23.19 6.812 11.QXD 29/7/08 17:32 Page 69 Glen Arnold. Corporate Financial Management Lecturer’s Guide.816 –1.797 –0.239 1.528 –0. 4th edition Retention of both divisions Year Sales Profit Tax IFCI IWCI Cash flow Discounted cash flow 1 29.897 1.195 £18.205 4.177 –1.564 1.665 2.CFML_CH17v3.165 2 34.128 Present value of cash flows Current value of marketable securities Four-year planning horizon and 16% discount rate: Year 1 2 1.704 6+ 57.168 1.061 5+ 9.700 1.405 1.331 1.308 –0.627m Conclusion The strategic option which will produce the most shareholder value is to sell division A and continue with division B.097 –0.109 –0.50 3.504 1.19 6.147 PV of cash flows Marketable securities £14.501m 1.137 2.295 –0.000m £21.08 4.122m © Pearson Education Limited 2008 69 .184 4 48.863 –2.089 4 1.118 3 1.675 –0.81 4.735 12.

079 3.118 1.137 1.205 –1.504 1.157 £16.606 –1.137 1.049 5.534 6+ 46. 4th edition Five-year planning horizon and 15% discount rate: Year Sales Profit Tax IFCI IWCI Operating free cash flow Discounted cash flow (15%) PV of cash flows Marketable securities 1.591 10.999m Summary table Required rate of return (£m) Planning horizon 4 years 5 years 6 years 14% 21.098 1.583 –0.228 21. Corporate Financial Management Lecturer’s Guide.205 –1.614 £16.921 1.999 16% 19.614 –0.428 Six-year planning horizon and 15% discount rate: Year Sales Profit Tax IFCI IWCI Operating free cash flow Discounted cash flow (15%) 1.000m £21.178 10.453 1.061 4.123m 1.049 5.331 1.079 1 2 3 4 5 46.122 70 © Pearson Education Limited 2008 .098 1 2 3 4 5 46.700 1.350 7+ 52.060 3.123m £5.501 15% 20.999m £5.QXD 29/7/08 17:32 Page 70 Glen Arnold.659 –0.000m £21.123 21.428 –0.157 PV of cash flows Marketable securities 1.479 2.606 –1.CFML_CH17v3.171 1.118 1.061 6 52.061 4.424 2.

© Pearson Education Limited 2008 71 . 4th edition Comment: Both factors examined have a significant effect on value created.QXD 29/7/08 17:32 Page 71 Glen Arnold.248 is so much greater than the figures shown in the table that it is highly unlikely that the planning horizon can be extended or the discount rate reduced sufficiently to make the base case strategy the best alternative. Alongside these figures management needs to consider the likelihood of either the discount rate or the planning horizon changing. Corporate Financial Management Lecturer’s Guide. in order to judge the overall significance of the data generated. The value generated by selling division A and concentrating on division B at £29. The table does not contradict the conclusion from Question 3.CFML_CH17v3.

wealth added index. Less required rate of return Market value added (MVA) MVA = market value – invested capital or. excess return. ■ Wealth added index (WAI) WAI = Change in market capitalisation over a number of years Less net additional money put into business by investors after allowance for money returned to investors by dividends.QXD 29/7/08 17:32 Page 72 Chapter 18 ENTIRE FIRM VALUE MEASUREMENT LEARNING OUTCOMES By the end of this chapter the reader will be able to explain the following value metrics. market value added.CFML_CH18v3. pointing out their advantages and the problems in practical use: ■ ■ ■ ■ ■ total shareholder return. KEY POINTS AND CONCEPTS ■ Total shareholder returns (TSR) Single period: dividend per share + (share price at end of period – initial share price) TSR = ––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––– initial share price Multi-period: Allow for intermediate dividends in an internal rate of return calculation. market to book ratio. if the market value of debt (and preference shares) equals the book value of debt (and preference shares): Equity MVA = Ordinary shares’ market value – Capital supplied by ordinary shareholders Excess return (ER) Excess return expressed in present value terms Actual wealth expressed in present value terms Expected wealth expressed in present value terms ■ ■ ■ = – 72 © Pearson Education Limited 2008 . etc.

plus the current market value of the shares. Corporate Financial Management Lecturer’s Guide. 4th edition Expected wealth is calculated as the value of the initial investment (plus any other monies placed in the business by shareholders) in present value terms if it had achieved the required rate of return over the time it has been invested in the business. Each cash flow received in past years needs to be compounded up to the present: Present value of dividends if the money received was invested at the required rate of return between receipt and present time Actual wealth = + Current market value of shares (market capitalisation) ■ Market to book ratio (MBR) market value MBR = ––––––––––––––– capital invested An alternative is the equity MBR: market value of ordinary shares MBR = –––––––––––––––––––––––––––––––––––––––––––––––– amount of capital invested by ordinary shareholders No answers are given in this Lecturer’s Guide for this chapter. Actual wealth is the present values of cash flows received by shareholders.CFML_CH18v3.QXD 29/7/08 17:32 Page 73 Glen Arnold. © Pearson Education Limited 2008 73 .

The cost of debt capital. describe the difficulties in estimating the equity cost of capital and explain the key elements that require informed judgement. describe the evidence concerning how UK companies actually calculate the WACC. explain the outstanding difficulties in this area of finance. both before and after tax considerations. The weighted average cost of capital (WACC) is calculated by weighting the cost of debt and equity in proportion to their contribution to the total capital of the firm: WACC = kEWE + kDATWD The WACC can be lowered (or raised) by altering the proportion of debt in the capital structure: Investors in shares require a return. plus – a risk premium. which provides for two elements: – a return equal to the risk-free rate. and: – adjust the average premium to suit the risk on a particular share. ■ ■ ■ ■ An alternative method for calculating the required rate of return on equity is to use the Gordon growth model: d1 kE = ––– + g P ■ The cost of retained earnings is equal to the expected returns required by shareholders buying new shares in a firm.CFML_CH19v3. The cost to the firm is reduced to the extent that interest can be deducted from taxable profits: kDAT = kDBT (1 – T) The cost of irredeemable constant dividend preference share capital is: d1 kp = ––– Pp ■ ■ 74 © Pearson Education Limited 2008 . kE. The most popular method for calculating the risk premium has two stages: – estimate the average risk premium for shares (rm – rf). kD. The CAPM using a beta based on the relative co-movement of a share with the market has been used for the second stage but other risk factors appear to be relevant. calculate the weighted average cost of capital (WACC) for a company and explain the meaning of the number produced.QXD 29/7/08 17:33 Page 74 Chapter 19 THE COST OF CAPITAL LEARNING OUTCOMES By the end of this chapter the reader will be able to: ■ ■ calculate and explain the cost of debt capital. ■ ■ ■ KEY POINTS AND CONCEPTS ■ The cost of capital is the rate of return that a company has to offer finance providers to induce them to buy and hold a financial security. is the current market rate of return for a risk class of debt.

5313 110 × 0.25% © Pearson Education Limited 2008 75 .0 = 12. operating gearing. with similar risk to that of the existing set. obtaining the risk free rate.5771 110 × 0. unreliability of the CAPM’s beta.850 106. etc.48% kDAT = kDBT(1 – T) = 8. Difficulties remaining: ■ ■ ■ ■ ■ ■ ■ estimating the equity risk premium.QXD 29/7/08 17:33 Page 75 Glen Arnold.CFML_CH19v3.48 (1 – 0. Corporate Financial Management Lecturer’s Guide. Companies use a mixture of theoretically correct techniques with rules of thumb to calculate hurdle rates of return.237 Try 8% 10 × 2.771 80.621 8+ 1. Calculating a cost of capital relies a great deal on judgement rather than scientific precision. etc. of a different risk level from that of the firm.621 ? 105 9% 103.237 8% 106. 4th edition ■ ■ The weights in the WACC are based on market values. But there is a theoretical framework to guide that judgement. use the WACC.313 77. which is based on the target debt to equity ratio.7084 25. not balance sheet values.30) = 5.384 (9 – 8) = 8. For projects. ■ Fundamental beta is based on factors thought to be related to systematic risk: ■ ■ ■ ANSWERS TO SELECTED QUESTIONS 1 Burgundy plc a Cost of debt capital 105 = 10 1+r + 10 (1 + r)2 + 10 (1 + r)3 + 110 (1 + r)4 Try 9% 10 × 2. SBUs.85 × 5.94% b Cost of equity capital kE = rf + β (rm – rf) kE = 8 + 0. financial gearing.924 103. Do not use the cost of the latest capital raised.621 3.735 25. type of business. For projects. raise or lower the discount rate in proportion to the risk.

76 © Pearson Education Limited 2008 .QXD 29/7/08 17:33 Page 76 Glen Arnold.94 × 0.43 5.CFML_CH19v3. Corporate Financial Management Lecturer’s Guide.65% d Consult Chapter 19.25 × 0. 4th edition c WACC WACC = kE WE + kDATWD Weights: Equity Debt Weight 4/9.25 = 0.25 = 0.25m WACC = 12.00m œ – qpt ππ × £5m = £5.57 £4.25/9.25m £9.57 = 8.43 + 5.

b investors interested in allocating savings.QXD 29/7/08 15:11 Page 77 Chapter 20 VALUING SHARES LEARNING OUTCOMES By the end of this chapter the reader should be able to: ■ describe the principal determinants of share prices and be able to estimate share value using a variety of approaches. The past is only useful to the extent that it sheds light on the future. Disadvantages: – excludes many non-quantifiable assets. Asset values are given more attention in some situations: – firms in financial difficulty. for example in property investment companies. Share valuation requires a combination of two skills: a analytical ability using mathematical models. use valuation models to estimate the value of shares when managerial control is achieved. – when discounted income flow techniques are difficult to apply.CFML_CH20v3. demonstrate awareness of the most important input factors and appreciate that they are difficult to quantify. investment trusts. b good judgement. ■ ■ KEY POINTS AND CONCEPTS ■ Knowledge of the influences on share value is needed by: a managers seeking actions to increase that value. – less objective than is often supposed. A constant dividend valuation model: d P0 = 1 kE The dividend growth model: d1 P0 = kE – g This assumes constant growth in future dividends to infinity. Advantage: ‘objectivity’. discounted to a present value. – takeover bids. Income flow valuation methods focus on the future flows attributable to the shareholder. The net asset value (NAV) approach to valuation focuses on balance sheet values. resource-based firms. ■ ■ ■ ■ ■ ■ ■ © Pearson Education Limited 2008 77 . The dividend valuation models (DVM) are based on the premise that the market value of ordinary shares represents the sum of the expected future dividend flows to infinity. These may be adjusted to reflect current market or replacement values.

on a long-term view. – g cannot be greater than kE. more risk. adjustment for over or under-paying of director-owners. less marketable. 4th edition ■ Problems with dividend valuation models: – highly sensitive to the assumptions. – the quality of input data is often poor. ■ The more complete PER model: d /E P0 = 1 1 E1 kE – g This is a prospective PER model because it focuses on next year’s dividend and earnings. – the company has been performing poorly. but then. has low historic earnings. – evaluate the management. b Focus on the economy. may involve ‘golden hand-cuffs’ or ‘earn-outs’. – the rate of return earned on existing assets. – extrapolate historic dividend growth. Factors determining the growth rate of dividends: – the quantity of resources retained and reinvested. machinery and working capital needed for the firm to maintain its long-term competitive position and its unit volume and to make investment in all new value-creating projects. The linking factor is the anticipation of high future growth in earnings. but is expected to improve. Additional factors to consider when valuing unquoted shares: – – – – – lower quality and quantity of information. Corporate Financial Management Lecturer’s Guide.CFML_CH20v3. How to calculate g – some pointers: a Focus on the firm: – evaluate strategy. The historic price-earnings ratio (PER) compared with PERs of peer firms is a crude method of valuation (it is also very popular): Historic PER = Current market price of share Last year’s earnings per share ■ ■ ■ ■ Historic PERs may be high for two reasons: – the company is fast growing. Risk is also reflected in differences between PERs. – the rate of return earned on retained resources. ■ 78 © Pearson Education Limited 2008 . ■ The discounted cash flow method: P0 = ∑ (C/(1 + kE)t) t=1 t=n For constant cash flow growth: P0 = ■ C1 kE – g The owner earnings model requires the discounting of the company’s future owner earnings which are standard expected earnings after tax plus non-cash charges less the amount of expenditure on plant. – financial statement evaluation and ratio analysis.QXD 29/7/08 15:11 Page 78 Glen Arnold. it would not be.

15 = 0. competitive position. Firms subject to a takeover bid.: V= C1* kE – gc* ■ ■ ■ Alternatively. the incremental flows expected to flow from the company under new management could be discounted to estimate the bid premium (d1*.792m kE – g 0.0696) P0 = = = £24.g.0696 10 Dela plc a Net asset value Shareholders’ funds Add additional fixed assets Less overstated stocks overstated debtors Net asset value £m 130 50 180 –30 –30 120 b Value to Lanes Value in present state Value of annual savings 1 + 0.0696 or 6. 4th edition ■ Some companies are extraordinarily difficult to value.0 C1 1. natural resources companies).QXD 29/7/08 15:11 Page 79 Glen Arnold.2 + 0. brand values.CFML_CH20v3.792 10. – advertising agencies: annual billings.4(1.13 – 0. investment trusts.96% 1.13 Distribution depot 24. Some firms are more appropriately valued by NAV (property investment firms. © Pearson Education Limited 2008 79 . e. Therefore a share may be more highly valued if control is achieved. Control over a firm permits the possibility of changing the future cash flows. many are subjective estimates with potential for cynical manipulation).800 £36. and g* are redefined to be incremental factors only): P0 = d1* kE – g* or V = C1* kE – gc* ■ Real options or contingent claim values may add considerably to a share’s value. Corporate Financial Management Lecturer’s Guide.4 – 1 = 0.g.385 1. Accounts are not designed to display up-to-date values (fixed assets are usually historic. c ■ ■ ■ Firms in financial difficulties. therefore proxies are used for projected cash flow. the determinants of value are future income flows. C1*. A firm’s assets are more than its balance sheet entries. – fund managers: funds under control. homes served or doors passed. such as: – telemedia valuations: multiply the number of lines. most of the time. – hotels: star ratings and bedrooms. e.977m b Drawbacks of NAV In most firms. ANSWERS TO SELECTED QUESTIONS 8 Lanes plc a Value to Roberts 5 g= 1. A target company could be valued on the basis of its discounted future cash flows.

9687 + 1.1041 = 23.1041) = = 528p kE – g 0.47 kDAT = 9.CFML_CH20v3.328.328 5.9687 = 9.5 + 1.0658 × 5.1041 d1/E1 kE – g = 10(1 + 0.25m £5.280.28 × 1.QXD 29/7/08 15:11 Page 80 Glen Arnold.125 – 0.1041) 0.9687 9+ 0.4(1 – 0.124 or 12.50 Debt 50 × 100 £5.50 + 8 8 108 + + 1+r (1 + r)2 (1 + r)3 10 –1. 4th edition d kE = rf + β(rm – rf) = 6.30) = 6.1041 5 d0(1 + g) 10(1 + 0. Corporate Financial Management Lecturer’s Guide.2(5) = 12.00m £48.000m = 96.4% 80 © Pearson Education Limited 2008 .58 Equity £5.125 – 0.4 0.47 9 0.9 = –96.125 × 5.25m WACC = kE WE + kDAT WD = 0.5% 7 g= P0 = e P0 E1 f 10 – 1 = 0.1041)/20(1 + 0.280 48 + 0.328 = 0.

or are met with difficulty. in worlds with and without tax. describe the underlying assumptions. Operating gearing refers to the extent to which the firm’s total costs are fixed. By the end of the chapter the reader should be able to: ■ ■ discuss the effect of gearing.CFML_CH21v3. of secondary consideration behind strategic and operational decisions. However. and differentiate business and financial risk. In Modigliani and Miller’s perfect no-tax world three propositions hold true: 1 The total market value of any company is independent of its capital structure. explain the relevance of some important. if wealth can be increased by getting this decision right managers need to understand the key influences. rationale and conclusions of Modigliani and Miller’s models. influences on the optimal gearing level question. For example: 1 Long-term debt Shareholders’ funds 2 3 Long-term debt Long-term debt + Shareholders’ funds All borrowing All borrowing + Shareholders’ funds Long-term debt Total market capitalisation 4 ■ Income gearing is concerned with the proportion of the annual income stream which is devoted to the prior claims of debt holders. In an MM world with tax the optimal gearing level is the highest possible. 2 The expected rate of return on equity increases proportionately with the gearing ratio. Financial risk is the additional variability in returns to shareholders due to debt in the financial structure. 3 The cut-off rate of return for new projects is equal to the weighted average cost of capital – which is constant regardless of gearing. The effect of financial gearing is to magnify the degree of variation in a firm’s income for shareholders’ returns. ■ ■ ■ ■ ■ ■ © Pearson Education Limited 2008 81 . for most firms. but often non-quantifiable. Financial distress is where obligations to creditors are not met. ■ KEY POINTS AND CONCEPTS ■ ■ ■ Financial gearing concerns the proportion of debt in the capital structure. Capital gearing can be measured in a number of ways. The risk of financial distress is one factor which causes firms to moderate their gearing levels.QXD 29/7/08 15:11 Page 81 Chapter 21 CAPITAL STRUCTURE LEARNING OUTCOMES The level of debt relative to ordinary share capital is. Business risk is the variability of the firm’s operating income (before interest).

QXD 29/7/08 15:11 Page 82 Glen Arnold. The reasons for the pecking order: – equity issue perceived as ‘bad news’ by the markets. The source of finance chosen may be determined by the effect on the control of the organisation. or if a smaller group of shareholders are given the incentive to monitor and control managers. such as legal fees. It is argued that operating and strategic efficiency can be pushed further by high gearing. loss of managerial freedom of action and opportunities forgone. Corporate Financial Management Lecturer’s Guide. lenders).g. Tax exhaustion (profit insufficient to take advantage of debt’s tax shield benefit) may be a factor limiting debt levels. – the liquidity and marketability of the firm’s assets. for example monitoring costs. restrictive covenants. However. Financial distress and agency costs eventually outweigh the lower cost of debt as gearing rises causing the WACC to rise and the firm’s value to fall. ■ ■ ■ ■ ■ ■ ■ Market timing theory is founded on the observation that firms tend to issue shares when their share price is high and repurchase shares when it is low. There is often a managerial preference for a lower risk stance on gearing. – line of least resistance. Financial distress risk is influenced by the following: – the sensitivity of the company’s revenues to the general level of economic activity. managers) act in the best interests of principals (e. – transaction costs. customers and employees. Agency costs are the direct and indirect costs of ensuring that agents (e. (The trade-off theory) Borrowing capacity is determined by the assets available as collateral – this restricts borrowing. It is suggested that high gearing motivates managers to perform if they have a stake in the business. 4th edition ■ The indirect costs of financial distress.CFML_CH21v3. such as deterioration in relationships with suppliers. Reinvestment risk is diminished by high gearing. Managers may be tempted to adopt the industry group gearing level. the evidence suggests that in the medium or long term firms do move towards a target optimal debt/equity ratio. – the cash-generative ability of the business. 3 new issue of equity. – the proportion of fixed to variable costs. shareholders. This leads to the idea of an absence of a movement towards an optimal capital structure in the short or long term. Signalling An increased gearing level is taken as a positive sign by the financial markets because managers would only take the risk of financial distress if they were confident about future cash flows. ■ ■ ■ ■ ■ ■ ■ ■ 82 © Pearson Education Limited 2008 . Financial slack means having cash (or near-cash) and/or spare debt capacity so that opportunities can be exploited quickly (and trouble avoided) as they arise in an unpredictable world and to provide a contingency reserve – it tends to reduce borrowing levels. can be more significant than the direct costs.g. The pecking order of finance: 1 internally generated funds. 2 borrowings.

798 + 4.7% Apparently relatively low gearing levels/low financial risk. present a different picture.798 = = 26. (However.300 = 19. most of Vodafone’s ‘assets’ are goodwill arising from acquisitions.4% Shareholders’ funds 67. Income gearing: Interest charges Profit before interest and taxation Interest cover: Profit before interest and taxation Interest charges Comments ■ = 1612 9200 = 17.5% = 9200 1612 = 5.798 Capital gearing (2) = = 20.1% Note: Some students may include ‘other non-current liabilities’ – this is acceptable.QXD 29/7/08 15:11 Page 83 Glen Arnold. Should be focused on market values rather than on balance sheet values.798 + 67.293 Long-term debt = 17. 4th edition ANSWERS TO SELECTED QUESTIONS 1 Vodafone plc Capital gearing ratios: Capital gearing (1) = Long-term debt 17.293 All borrowing 17.CFML_CH21v3.2% All borrowing + shareholders’ funds 17.293 Capital gearing (4) = Long-term debt Total market capitalisation = 17. Corporate Financial Management Lecturer’s Guide. if included. Off-balance sheet finance could.798 + 4.) Very difficult to measure gearing with precision due to the alternative inputs and metrics.798 93.817 + 67. ■ ■ ■ © Pearson Education Limited 2008 83 .9% Long-term debt + shareholders’ funds 17.817 Capital gearing (3) = = = 25.

This ‘resolution of uncertainty’ argument has been attacked on the grounds that it implies an extra risk premium on the rate used to discount cash flows. or in the near future. UK-quoted companies generally pay dividends every six months – an interim and a final. the policy on dividends is irrelevant to shareholder wealth. An unexpected change in dividends is regarded as a signal of how directors view the future prospects of the firm. therefore they prefer a higher near-term dividend – a ‘bird in the hand’. Modigliani and Miller proposed that. By the end of this chapter the reader should be able to: ■ ■ ■ explain the rationale and conclusion of the ideas of Modigliani and Miller’s dividend irrelevancy hypothesis. discuss the role of scrip dividends and share repurchase (buy back). there are some important arguments which should inform the debate within firms. Investors are able to manufacture ‘homemade dividends’ by selling a portion of their shareholding. Firms are able to finance investments from retained earnings or new share sales at the same cost (with no transaction costs). describe the influence of particular dividend policies attracting different ‘clients’ as shareholders. The clientele effect is the concept that shareholders are attracted to firms that follow dividend policies consistent with their objectives. In a world with no external finance. dividend policy will be influenced by. discuss the impact of agency theory on the dividend decision. as well as the concept of dividends as a residual. Dividends can act as conveyors of information. by Myron Gordon) that investors perceive more distant dividends as subject to more risk.CFML_CH22v3. the ‘dividends as a residual approach’ to dividend policy.g. ■ ■ ■ ■ ■ ■ ■ ■ 84 © Pearson Education Limited 2008 . However.QXD 29/7/08 17:33 Page 84 Chapter 22 DIVIDEND POLICY LEARNING OUTCOMES This area of finance has no neat over-arching theoretical model to provide a simple answer. dividend policy should be residual. have much more value than those in the far future because of the resolution of uncertainty and the exceptionally high discount rate applied to more distant dividends. Taxation can influence the investors’ preference for the receipt of high dividends or capital gains from their shares. the effect of taxation and the importance of dividends as a signalling device. but not exclusively determined by. They may only be paid out of accumulated profits. It has been argued (e. The clientele effect encourages stability in dividend policy. outline the hypothesis that dividends received now. ■ ■ KEY POINTS AND CONCEPTS ■ Dividend policy concerns the pattern of dividends over time and the extent to which they fluctuate from year to year. in a perfect world. In a world with some transaction costs associated with issuing dividends and obtaining investment finance through the sale of new shares.

A share repurchase is when the company buys a proportion of its own shares from investors. A special dividend is similar to a normal dividend but is usually bigger and paid on a one-off basis.QXD 29/7/08 17:33 Page 85 Glen Arnold. ■ ■ ■ © Pearson Education Limited 2008 85 . Corporate Financial Management Lecturer’s Guide. A scrip dividend gives the shareholders an opportunity to receive additional shares in proportion to their existing holding instead of the normal cash dividend. 4th edition ■ The owner control argument says that firms are encouraged to distribute a high proportion of earnings so that investors can reduce the principal–agent problem and achieve greater goal congruence. this subjects their plans to scrutiny.CFML_CH22v3. Managers have to ask for investment funds.

■ ■ ■ ■ ■ ■ ■ ■ 86 © Pearson Education Limited 2008 . – tax advantages. KEY POINTS AND CONCEPTS ■ Mergers are a form of investment and should. for example using NPV. acquisition and takeover. describe the merger process and the main regulatory constraints. Synergistic merger motives: – market power. It is difficult for many practical purposes to draw a distinction between merger. – internalisation of transactions. – risk diversification. – power. A vertical merger is when the two firms are at different stages of the production chain. comment on the question: ‘Who benefits from mergers?’. theoretically at least. A horizontal merger is when the two firms are engaged in similar lines of activity. – hubris. – remuneration.CFML_CH23v3. A merger is the combining of two business entities under common ownership. Cash is the most common method of payment except at the peaks of the cycle when shares are a more popular form of consideration. there are complicating factors: – the benefits from mergers are difficult to quantify. – free cash flow. – entry to new markets and industries. However. This chapter provides an overview of the subject and raises the most important issues. Managerial merger motives: – empire building. – economies of scale.QXD 29/7/08 17:34 Page 86 Chapter 23 MERGERS LEARNING OUTCOMES The study of mergers is a subject worthy of a textbook in its own right. – undervalued shares. – acquiring companies often do not know what they are buying. Merger activity has occurred in waves. – status. discuss some of the reasons for merger failure and some of the practices promoting success. express the advantages and disadvantages of alternative methods of financing mergers. – survival. be evaluated on essentially the same criteria as other investment decisions. By the end of the chapter the reader should be able to: ■ ■ ■ ■ ■ describe the rich array of motives for a merger. A conglomerate merger is when the two firms operate in unrelated business areas. Bargain-buying merger motives: – elimination of inefficient and misguided management.

– Greater chance of early success. © Pearson Education Limited 2008 87 ■ ■ ■ ■ ■ ■ . – The PER game can be played. A stake of 30% usually triggers a bid. or B’s. Its objective is to ensure fair and equal treatment for all shareholders. – targets identified. – Greater risk of overpaying. Disadvantages – Dilution of existing shareholders’ control. – appraisal. – negotiate. Cash as a means of payment For the acquirer Advantages – Acquirers’ shareholders retain control of their firm. Corporate Financial Management Lecturer’s Guide. It applies to quoted and unlisted public companies.QXD 29/7/08 17:34 Page 87 Glen Arnold. – approach target. ■ Shares as a means of payment For the acquirer Advantages – No cash outflow. or be shared between the two. For the target shareholders Advantages – Postponement of capital gains tax liability. – Unquoted acquirers may not be able to do this. Disadvantages – Cash flow strain. ■ The City Code on Takeovers and Mergers provides the main governing rules. Disadvantages – Uncertain value. – Able to spread investments. For the target shareholders Advantages – Certain value. are now treated as one large holding for the key trigger levels. – Not able to spread investment without higher transaction costs. 4th edition ■ Third-party merger motives: – advisers. Concert parties. A ‘dawn raid’ is where a substantial stake is acquired with great rapidity. – at the insistence of customers or suppliers. It is self-regulatory with some statutory back-up – but powerful. Pre-bid: – advisers appointed. Value is created from a merger when the gain is greater than the transaction cost. Shareholdings of 3% or more must be notified to the company. but each remains below the 3% or 30% trigger levels. – Target shareholders maintain an interest in the combined entity. ■ Disadvantages – May produce capital gain tax liability. ■ ■ The winner’s curse is when the acquirer pays a price higher than the combined present value of the target and the potential gain. The Office of Fair Trading (OFT) and the Competition Commission investigate potential cases of competition constraints. PVAB = PVA + PVB + gain The gain may go to A’s shareholders. where a group of shareholders act as one.CFML_CH23v3.

These stages are: – preparation. – negotiation and transaction. directors of acquirers and advisers gain significantly from mergers. ■ ■ ■ ■ ■ ■ ■ ■ ANSWERS TO SELECTED QUESTIONS 1 Large plc a Value gain = £110m – £60m – £30m – £3m = £17m Bid premium is greater at £20m and therefore the merger does not create value for Large plc. Most attention should be directed at the first and third. human elements often determine the success or otherwise of mergers. Target shareholders. ‘soft’.90 © Pearson Education Limited 2008 . but this does not seem to happen. For the directors of targets and other employees the evidence is mixed. – target management responds to offer document. – failure of integration management. Target firms are not on average poor performers relative to others in their industry.11p £110m –£60m –£50m –£3m £3m c If cash is paid: £107m – £50m 30m 88 = £1. The shareholders of acquirers tend to receive returns lower than the market as a whole after the merger. – integration. but can be frequently revised and thereby kept open for up to 60 days (or longer if another bidder enters the fray). Corporate Financial Management Lecturer’s Guide.QXD 29/7/08 17:34 Page 88 Glen Arnold.CFML_CH23v3. – offer document sent within 28 days. the acquirer is making a firm offer and no better offer is to follow. – overoptimism. – offer open for 21 days. Mergers fail for three principal reasons: – the strategy is misguided. There are three stages of mergers. Post-bid – When a bid becomes unconditional (usually at 50% acceptances). Non-quantifiable. However. Large plc shareholders lose value: Value after merger Less value before merger price paid transaction costs Loss of value b £50m 45m = 111. 4th edition ■ The bid – notice to target’s board. Society sometimes benefits from mergers but most studies suggest a loss. many acquirers do create value for shareholders. often through the exploitation of monopoly power.

05 Value of a share in B after merger: P = 5(1.727m b £1. Value of one share in High: £20m × 22 = £4.CFML_CH23v3.727m c Value of two-thirds of merged entity: 0.2 × 12 × 1.64 × 100m = less previous value £2.4 × 100m = or 24p per share or 10% c £40m × 22 160m = £5.05) d0 (1 + g) = = 75p kE – g 0.485m Value created for Box’s shareholders: £114.727m) = £114.08 Total value creation: 135p × 3m Less transaction costs Less value prior to merger 75p × 3m Value creation = £4.25 5 a Value of a share in B prior to merger: P = 5(1.11 – £1m = £21.000/5)3 = 600 shares in High.40m £3.50 £2. Corporate Financial Management Lecturer’s Guide.12 – 0.QXD 29/7/08 17:34 Page 89 Glen Arnold. = £4. 4th edition 3 a £2.5m 0.40 × 600 = Value of holding before £0.640 £2.484m – £100m = £14.6667(£100m + £50m + £21.05m – £0.65m £2.25m £1.40 £100m Value of holding after acceptance £4.400 £240 £264m £240m £24m d 40m × (22 × 0.5) 160m e Consult chapter.40m © Pearson Education Limited 2008 89 .5 + 12 × 0.08) = 135p 0.000 = Wealth increase b Bid premium Value of offer £2.485m 4 High plc a (1.12 – 0.

809m (a reduction of £0.CFML_CH23v3.42857m = £8.65m Number of shares: 3m 5m + ––– = 5.42857m × £8.QXD 29/7/08 17:34 Page 90 Glen Arnold.75 – 1.45m £0.75m Value per share = £46.45m more than previously.962 = £44.85m Total number of shares = 5m + 3m 7 = 5.85m 5.42857m = £3.20) Less transaction costs Loss in value Share offer Value of combined company = £9 × 5m + £0.6987m.5908m) d Cash offer B’s shareholders: 3m (1.75) A’s shareholders: 3m (1.20 – 0.6303 B’s shareholders hold 0.35m £0.00m £1.05m c Value of combined company = £3.6303 × 0.35m = –£1. Value gain = £1.6303 Previous value Loss in value = £43.1908m) Shareholders in B now have a holding of: 0.35 – 1.42857m 7 Value of each share: £48.20) Less transaction costs Value for A = = = £1. A’s shareholders: 5m × £8.35m = –£0.15m 45.962 = £3.85m 90 © Pearson Education Limited 2008 .75) A’s shareholders: 3m (0.42857m shares in A with a value of £8.42857m = £1.40m = £1.42857m = £8. 4th edition b B’s shareholders: 3m (1.40m £0.75 × 3m – £0.65m + £45m = £48.65m/5. This is £1.8408m (a rise of £1.45m.962 Shareholders in A now have a holding of : 5m × £8.4m = £46. Corporate Financial Management Lecturer’s Guide.20 – 0.

QXD 29/7/08 15:12 Page 91 Chapter 24 DERIVATIVES LEARNING OUTCOMES This chapter describes the main types of derivatives. An option is a contract giving one party the right. at or before a specified date. An out-of-the-money option is one that has no intrinsic value. A writer of a put is obligated to sell. Time value arises because of the potential for the market price of the underlying. – taking control of a company. – commodity options. at a given price. futures. – convertible bonds. At the end of this chapter the reader should be able to: ■ explain the nature of options and the distinction between different kinds of options. FRAs. over the time to expiry of the option.CFML_CH24v3. A forward contract is an agreement between two parties to undertake an exchange at an agreed future date at a price agreed now. to buy (call option) or sell (put option) a financial instrument. – warrants. allowing flexibility. and demonstrate their application in a wide variety of areas. Share options can be used for hedging or speculating on shares. Share index options are cash settled. swaps. – protecting the company from foreign exchange losses. but not the obligation. commodity or some other underlying asset. American-style options can be exercised at any time up to the expiry date whereas European-style options can only be exercised on a predetermined future date. Share index options can be used to hedge and speculate on the market as a whole. Corporate uses of derivatives include: – share options schemes. ■ KEY POINTS AND CONCEPTS ■ A derivative instrument is an asset whose performance is based on the behaviour of an underlying asset (the underlying). The writer of a call option is obligated to sell the agreed quantity of the underlying some time in the future at the insistence of the option purchaser (holder). – real options. show the value of the forwards. to change in a way that creates intrinsic value. – share underwriting. – rights issues. Forwards are tailor-made. Continued innovation means that the range of instruments broadens every year but the new developments are generally variations or combinations of the characteristics of derivatives discussed here. ■ ■ ■ ■ ■ ■ ■ ■ ■ © Pearson Education Limited 2008 91 . caps and floors markets by demonstrating transactions which manage and transfer risk. An in-the-money option has intrinsic value.

They allow perfect hedging. Hedgers enter into transactions to protect a business or assets against changes in some underlying. – delivery dates. They are exchange-traded instruments with a clearing house acting as counterparty to every transaction standardised as to: – quality of underlying. An interest-rate swap is where interest obligations are exchanged. A swap is an exchange of cash payment obligations. Then in March close the position by buying 598 March contracts. greater regulation.1% to 15%) is required from each buyer or seller. In a currency swap the two sets of interest payments are in different currencies. 4th edition ■ Futures are agreements between two parties to undertake a transaction at an agreed price on a specified future date. and variation margin is payable by the holder of the future who loses. Forward rate agreements (FRAs) are arrangements whereby one party compensates the other should interest rates at some point in the future differ from an agreed rate. Corporate Financial Management Lecturer’s Guide. Over-the-counter (OTC) derivatives are tailor-made and available on a wide range of underlyings. Exchange-traded derivatives have lower credit (counterparty) risk. The majority of futures contracts are closed (by undertaking an equal and opposite transaction) before expiry and so cash losses or profits are made rather than settlement by delivery of the underlying. A collar is a combination of a cap and a floor. higher liquidity and greater ability to reverse positions than OTC derivatives. sell 30. Some motives for swaps: – to reduce or eliminate exposure to rising interest rates. – to exploit market imperfections and achieve lower interest rates. standardisation can be restrictive. – trading times. Arbitrageurs exploit price differences on the same or similar assets. Short-term interest-rate futures can be used to hedge against rises and falls in interest rates at some point in the future. low regulation and frequent inability to reverse a hedge. ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ■ ANSWERS TO SELECTED QUESTIONS 6 a In October. initial margin (0. The price for a £500. The cap seller and the lender are not necessarily the same. Speculators accept high risk by taking a position in financial instruments and other assets with a view to obtaining a profit on changes in value.QXD 29/7/08 15:12 Page 92 Glen Arnold. However. – to match interest-rate liabilities with assets. 92 © Pearson Education Limited 2008 . – quantity of underlying. A floor entitles the purchaser to payments from the floor seller should interest rates fall below an agreed level.CFML_CH24v3. For futures. Each day profit or losses are established through marking to market. However they suffer from counterparty risk. Some futures are settled by cash only – there is no physical delivery.000/(5020 × 10) = 598 March future contracts @ 5035. – margins. – legal agreement details.000.000 notional three-month contract is expressed as an index: P = 100 – i As interest rates rise the value of the index falls. An interest rate cap is a contract that gives the purchaser the right effectively to set a maximum interest rate payable through the entitlement to receive compensation from the cap seller should market interest rates rise above an agreed level.

189.574 Loss on futures: Able to buy @ 6000 598 × 10 × 6000 Able to sell @ 5035 598 × 10 × 5035 Loss on futures 35.QXD 29/7/08 15:12 Page 93 Glen Arnold.095. 4th edition b FTSE 100 Index @ 4000: Loss on shares 1020 × 30.000. Corporate Financial Management Lecturer’s Guide.000 6.19 5.700 = £85.109.920.000 = £6.856.77 Futures 12.300 £5.856.000 30.07 Loss Fig.109.300 – 6.189.618 = £93.770.000 = £5.CFML_CH24v3.874 c Profit and loss diagram for future’s strategy Profit £m 11.880.700 Overall gain 5.300 Overall gain 6.000 5.1 © Pearson Education Limited 2008 93 .1 5.770.1 3. 24.000 Index level Combination 7.8 Share portfoilio 6.020 6.682 FTSE 100 Index @ 6000: Gain on shares 980 5020 × 30.000 4.000 30.000.574 – 5.618 5020 Gain on futures: Able to buy @ 4000 598 × 10 × 4000 Able to sell @ 5035 598 × 10 × 5035 Gain on futures 23.095.9 0.300 £6.

00.1 4.000 0 Interest rates at 9% Gain on the underlying: _ &e& ∑ 20.2 8 a FRA The treasurer agrees a 6 against 9 FRA whereby the counterparty will pay compensation to the company should interest rates fall below 8%.020 5. the rise in the value of the future will offset the fall in the interest on deposited money.000 = £50.000. Corporate Financial Management Lecturer’s Guide. Certainty is achieved.01 × œ The counterparty pays compensation to equal this loss Overall loss due to interest rate changes = –£50. if interest rates rise above 8% the company will pay compensation to the counterparty such that the company effectively receives 8% return on deposited money. If interest rates fall.19 0.000 5.035 6. b FRA Interest rates at 7% The loss on the underlying: _ &e& ∑ 20.QXD 29/7/08 15:12 Page 94 Glen Arnold.000.77 Fig.000 –£50. 4th edition Futures hedging – total values £m 35.01 × œ = The counterparty receives compensation to equal this gain Overall loss due to interest rate changes 94 £50.000 Index level Futures 5. However.000. therefore 40 contracts are bought to hedge the full £20m. Each contract is for a nominal £500.90 6. These payments will exactly offset any loss of interest below 8%.CFML_CH24v3.000 × 0. 24. Interest rate future Three-month sterling interest future contracts (September contracts) are bought at 92.000 × 0.86 Share portfolio 30 Combination 23.000 0 © Pearson Education Limited 2008 .

24. © Pearson Education Limited 2008 95 .5 b ■ ■ ■ ■ –£50.5 50. legally binding contracts) may be considerable.095) Black pays interest @ 11 + 1.00 in September 100 ticks × £12. This will impose an opportunity cost of entering the swap arrangement.CFML_CH24v3.5% Black Fixed interest 9% Libor + 150 b.000 0 White Fixed interest @ 9% Bank B Future variable interest rates may fall below 9% (i.000 (0.5% Bank A Fig. c The cap seller compensates Black: 50. Chapter 24.p.000.000 × 0.000 £50.000 –£50.5% to Bank A: £6. Currently 9.g. Corporate Financial Management Lecturer’s Guide.5 = 9.000 12.p.000. 4th edition Interest rate future Interest rates at 7% Loss on the underlying Futures sold at 93.50 × 40 Overall loss due to interest rate changes Interest rates at 9% Gain on the underlying Futures position is closed by selling at 91.00 in September Loss: 100 ticks × £12.250. Currently 8 + 1.QXD 29/7/08 15:12 Page 95 Glen Arnold.000 0 £50. Libor @ 7.125 = = = £750.11 – 0.5%).50 × 40 Overall loss due to interest rate changes 9 Black plc and White plc a Libor + 150 b. Black must accept the possibility of counterparty default. Transaction costs (e.000 The compensation from the cap seller means that Black will not pay more than £5.e.5m (net) d Consult main text. Black needs to consider its overall asset and liability profile.

when translated into home-currency terms. consider methods of dealing with the risk that assets.CFML_CH25v3. Economic risk Forex movements cause a decline in economic value because of a loss of competitive strength. – netting. Spot market transactions take place which are to be settled quickly (usually one or two days later). – the valuation of foreign assets and liabilities. – amounts paid for imports. or for which the firm is likely to have a commitment.200bn is traded each day. The foreign exchange market grew dramatically over the last quarter of the twentieth century. describe hedging techniques to reduce the risk associated with transactions entered into in another currency. are distorted. income and liabilities denominated in another currency. – the acceptability of an overseas project. – the long-term viability of foreign operations. – do nothing. ■ ■ ■ ■ ■ ■ ■ 96 © Pearson Education Limited 2008 .QXD 29/7/08 17:34 Page 96 Chapter 25 MANAGING EXCHANGE-RATE RISK LEARNING OUTCOMES By the end of this chapter the reader should be able to: ■ ■ ■ explain the role and importance of the foreign exchange markets. In the forward market a deal is arranged to exchange currencies at some future date at a price agreed now. Over US$1. Translation risk arises because financial data denominated in one currency then expressed in terms of another are affected by exchange-rate movements. – matching. ■ ■ KEY POINTS AND CONCEPTS ■ ■ An exchange rate is the price of one currency expressed in terms of another. describe techniques for reducing the impact of foreign exchange changes on the competitive position of the firm. import/export) reasons. Transaction risk strategies: – invoice customer in home currency. Transaction risk is the risk that transactions already entered into. – forward market hedge. in a foreign currency will have a variable value. – leading and lagging. outline the theories designed to explain the reasons for currency changes. – money market hedge. Exchange rates are quoted with a bid rate (the rate at which you can buy) and an offer rate (the rate at which you can sell). Forex shifts can affect: – income received from abroad. Most of this trading is between banks rather than for underlying (for example.

then: qtp &^& Sterling income &– = £18.75m Income due to forward commitment = £20. Amount borrowed now 150m 1 + 0.00m ‘Gain’ due to forward contract £1. The Fundamental Equilibrium Exchange Rate (FEER) is the exchange rate that results in a sustainable current account balance.5 If spot rate in three months is R7.00/£ and the exchange was made at spot rate.CFML_CH25v3. In an inflationary environment the relationship between two countries’ inflation rates and the spot exchange rates between two points in time is (with the USA and the UK as examples): 1 + IUS 1 + IUK = US$/£1 US$/£0 ■ ■ The interest rate parity (IRP) theory holds true when the difference between spot and forward exchange rates is equal to the differential between the interest rates available in the two currencies. Corporate Financial Management Lecturer’s Guide. advertising campaign. The purchasing power parity (PPP) theory states that exchange rates will be in equilibrium when their domestic purchasing powers at that rate are equivalent.25m (ii) Money market hedge Borrow in Rand now an amount which. Using the USA and the UK currencies as examples: 1 + rUS US$/£F = 1 + rUK US$/£S The expectations theory states that the current forward exchange rate is an unbiased predictor of the spot rate at that point in the future. – currency option hedge. with accumulated interest. ■ ■ One way of managing translation risk is to try to match foreign assets and liabilities. Exchange this sum at the current spot rate for sterling. location of sources of supply). 4th edition – futures hedge. then: qtp &¨&& = £21. will become R150m in three months.000m ‘Loss’ due to inability to exchange at spot £1.025 = R146.3415m 97 © Pearson Education Limited 2008 . ■ ■ ■ ■ ANSWERS TO SELECTED QUESTIONS 4 a (i) Forward market hedge Agree to buy R150m of sterling three months forward 150 = £20m 7. marketing (for example.00/£ and the exchange was made at spot rate.428m If the spot rate in three months is R8. The currency markets are generally efficient. pricing) and finance (currency). but there is evidence suggesting pockets of inefficiency.428m Sterling income &– Income due to forward commitment = £20. In three months pay lender with sum received from customer. The management of economic exposure requires the maintenance of flexibility with regard to manufacturing (for example. Flows of money for investment in financial assets across national borders can be an important influence on forex rates.QXD 29/7/08 17:34 Page 97 Glen Arnold.

000. Forward market hedge At the current time agree a forward contract whereby Lozenge plc will purchase 12 × 50.00/£: qtp &¨&& Exchange R150m at spot &– (let the option lapse) less cost of option (premium) If spot rate R8.CFML_CH25v3. it would pay only ypp – – ¨ ppp && && = £85.– at a cost of ypp – †.341 7.400m £21.885 forgone by entering into the forward contract.599 – £85. However.028m – ¨.00/£: ‘Loss’ due to lost opportunity to exchange at spot £21.00/£ which would have produced merely £18.3415m × 1. Then.600m This is better than having to exchange @ R8.8668m = £1. if the Malaysian dollar rises against sterling in the intervening period.000 in three months. £110. In three months consider whether to exercise this in the light of knowledge of spot rates.00/£ and the firm was able to exchange at the spot .025 Repay lender with amount received from customer If exchange rates move to R7. the firm cannot take advantage of a favourable forex move.46 Exchanged at spot for sterling = £19.714. To do this it will need to provide ypp in three months.ππ ppp – = £150. but not the obligation. to sell sterling and buy Malaysian dollars . Corporate Financial Management Lecturer’s Guide. 9 Lozenge plc Numerical aspects only. Option hedge An option permits the firm to benefit from a favourable exchange rate while hedging against an unfavourable movement.599 to the counterparty M$600.75m.8112m = = R150m R150m (iii) Option hedge Buy Rand put sterling call option.75m (plus interest on sterling for three months) = £0. Hedging has ‘saved’ the firm a sum of £150.– ®∑† ppp = £110. Lozenge will not have to pay more than £110.000m £0.00/£: = £21. Lozenge could purchase the right.5/£ qtp less cost of option (premium) £20.400m £19.000 – £110.599. Say the exchange rate moved to M$4. They should consider the advantages and disadvantages of each – for more details of these consult the chapter).– –– †.. which reduces net income.† Exercise option to exchange @ R7.714 = £24. (Students should also describe and explain instruments and methods used.00/£: ‘Gain’ due to money market hedge £19.599.6168m – £18.00/£: an unhedged Lozenge would –– ®.) In three months: Amount owed to lender 146.000 = .– rate. If the Malaysian dollar had weakened to M$7.®œ¥† 98 © Pearson Education Limited 2008 .– . .®∑† ppp = £110. a premium has to be paid. On the other pay ypp hand.6168m (less interest on sterling for three months) If exchange rates move to R8. Thus. 4th edition 146.428m – £19.6168m (Note: Certainty about income from the export deal because sterling is received now.769.599 for a premium of – † qt ppp – = £2. If spot rate R7.428m £0.QXD 29/7/08 17:34 Page 98 Glen Arnold.

00/£.000 – £110.000 with accumulated interest in three months: 600.524 5.425/£. but more expensive (due to the option premium) than if a no hedge approach were adopted.632 compared with a no hedge policy.524 1.773 In three months: Pay supplier with Malaysian dollars already purchased (including accumulated interest) M$600. Money market hedge Exchange sterling now for Malaysian dollars. 7 This is cheaper than if a forward contract approach or money market approach were adopted.CFML_CH25v3.4165 = £107. so that there will be M$600.000 = M$582.03 Sterling required = 582.000.00/£.000 + 2.769 = £88. 4th edition If the Malaysian dollar strengthens to M$4.546 (1. then Lozenge will abandon the option and exchange at the spot rate.QXD 29/7/08 17:34 Page 99 Glen Arnold. © Pearson Education Limited 2008 99 .599 – £2.546 If the sterling is borrowed. then Lozenge will exercise the right to purchase at M$5. Cost of imports: 600. we need to increase by three months’ interest: £107.769 = £36.483. If the Malaysian dollar weakens against sterling to M$7. This will ‘save’ £150.03) = £110. then to be comparable with the alternative hedging approaches (which involve the handing over of sterling in three months). Corporate Financial Management Lecturer’s Guide.