BAF-503 Text StudyStrategic Financial Management Study Text ICMA BAF-503 ALL RIGHTS RESERVED: ‘This book and material Including wite-ip, tables, graphs, figures, etc, therein are ‘copyright material ard are protected under Copyright Laws of Pakistan. No part ofthis publcation can be reproduced. stored ina flieval system or ransmied in any physical ‘and 1 oF electronic form or by any otter means Including electronic, mechanical, Photocopying, recording or otherwise without pror written permission of the ICMA Pakistan's Head Office ‘© inatiute of Cost and thenagement ‘Accountants of Pakistan, 2014 ‘oltis pubication, shoukinotbe reed upon asa substveforlogaladce,Contents 1 2 3 5 erry G The Importarce of Fnancla Stratogy 0 ie Btyaraton os abocws 6 The Key Oscsions of Freie Mefnonnond “ Exam Siva Quextons 2B ee ce a4 ‘Overview of Sate 4 pb! Fano " Other Sout of France 6 Tho Lape Versus uy Decision ” The Pole othe 50 anscastng-Profts Gash Flows and the SFP 5 Exam eyo questions 82 ‘Overdew ot Chager ‘ntroucton to te Weighted Average Gost ot Gant (WAGO) ‘The Cost of Equty ko The Cost of Equty ~ Dividend Valuation Moca The Cost of Equty ~ Capital Asset Pricing Model The Cost of Dobra Weighted Average Cost af Captal (WAEC) Wher Can WACE be Used a Discount Rae? Exam Sie Quertons Siseeaees SS 1 Overview of Chapier 2 Changing Captal Sructure 3 Tendlional View 4 Capt Sucre ~ Modglan abe Mikes View 5 Real Word Approscnes tothe Gearing Question 6 lk Adjusted WACC ~ a Project Spectic Coat of Capt 7 Exam Sty Questions 1 Overview of Chapter 2 Investment Appraisal 39 Baal Inveiment Appia Methods 4 Disgourted Cash Flow (OCF) Investment Appraisal Mathods 170 5 Modited RR (MRR) {6 Conchaion Which Investment Appraisal Mathod'Showdbe Used? 102 7 Exam Se Olson Investment Appraisal Techniques 20 1( (versa of Chnpte 208 2S Capt Raion 205 '3\ Diallg was Riek nd Unaortity au 5 Res! Optons ze 6 Act Prosont Vato (APY 20 7 _Urking teestment Asprasa 1 CuatornetFlaulremants ne 8 Conhat ot vextment Projects 2aa Overview of Chapios 24 Intioducton To Buxiness Valaaton 258 The Dtfeont Vanason Marna 256 Hot Asset Bad faiaton 27 \Valuaton of netectul Capea ntangiie Assets Eaminge Based Yatuaton - te Divider V sen 282 Enings asod Vatuation — P/E Mates ae Discounted Cash Fw Method 268 The Erteent Marat Hypotness (Efi) ara m7 Over of Chapter 28 The reasons for growth by soqustton or merger 209 Dotences Ajtinet Hctle Tahsover Side 295 The Foo of Consdation for a Takeover 200 The Regulation of Takeovers 308 The Past-Alergato¢ Post Acqusiton Iteration Process 308 Dwvaereant an Management huyouts 313 Ext Seatagion a8 (Overview af Caper 4 Proteaty Ration as Financial Gearing a8 Stock Maat Ratios 340 Tho Use of Published Account for Rao Analy oa Exam Ste Quesion 36 1. Overview of Chapter a8 2 Basic Foreign Project Appraisal 358 3. Adational Complenties in Foreign NPV Cateutators 289 4 Poin! Rk (or Couriry Pik 65 5 Exam Sive Questions 367 a 1 Overvigw of Capt ae 2 Tho Management of Working Cacia a8 9 The Wong doer 70 4 The Wontng Capita! France Betaion set 8 The Woting Cantal Sic 388 6 Woming Captat Rabe ped 8 Shor Tern Fnanong Opsion soz 9 Exam Sipe Queme 208HOW TO USE THE MATERIAL Lapham bebe lc all anaafch poe elated ‘onthe folowing pater: * Detaled teaming outcomes. You should assintate theses belore beginning Introduction to Financial Strategy Chapter Learning Objectives Upon completion of this chapter you will be able to: Introduction to Financial Strategy ‘Suatagy: A Course of acon, incuding the specticaton of resources required, to ‘achieve &scte objective, ‘Financ Strategy isthe aspect of strategy which fas winin the scope of {fnanciof management. which wil include decisions on invasiment, financing and ‘aevdands. ‘Strategic financial management: The identification of the possible strategies ‘capable of maximizing and entity's net presen value, the allocation of scarce _captal resources amnong the comporting opportun'ias and the implementation and monitoring of the chosen stralegy £0 as to achieve sated abjactves. ‘The Importance of Financial Strategy to the Organization ‘An organization's financial managers must plan ther courses of action to achieve ‘the organization's fnancial objectives, Decisions tha they must take incude: ‘+ From which sources should funds be raliod? ‘Should proposed investments be undertaken? How largo a cvidend should bo pid? ‘How should working capital be controlled ©. should dlacounts be offered {Yo debtors for prompt payment? 4Introduction to Financial Strategy “This Chapter fst defines some ofthe kay terms which wilbe used throughout ‘he sylabus, and than looks at the main decisions (financing decision, vasiment \secition and dhvdend decison) in dota Financial Strategy and Overall Corporate Strategy Each level of a business can have its own strategy. Three levels are commanty ‘entiied: Corporate strategy “This voncerns the decisions to be mace by senior management such as the ‘particu business that tho company isin, and whathor now marks should be ‘entered or curent_ markets withdrawn fom. Business strategy ‘Thes concern the decisions to ba made by the separate strategic busines units ‘within the group. Each unit wil try o maximize s competitive postions within its chosen market. Operational strategy “This concerns how the dierent functional areas within a strategic business unit plan thei operation. to satisty the corporate and business strategies boing ‘otowed. We are of course most interested in the decisions facing me fnance ‘unctions. Objective Financial objectives of profit seeking organizations Decisions to be made depend on the utmate objectives of an organcation ‘Academic studies have shown that organizations ctton have many, sometimes Introduction to Financial Strategy conficting, objectives. ‘is generally accepted hat the primay strategic objective ofa commercial “company's the longterm goal ef the maximization of the wealth of the ‘sharehotders. Howavor. an organization has mary other stakeholders with both long and ehot- ‘tom goal, such as: Equity Investors (ordinary shareholders) The community at large: ‘Company ormplayeos: ‘Company managers / Customers; Suppliers; Finance providers: The government. Examples of stakeholder objective Equity investors (ordinary shareholders) - Wain any economic system, the ‘equty investor, provide the risk finance, There is a vory strong argument for the weak ot equity nvestors. In ordertoattract funds, the company has 40 compete. wth ther risk tke Investment opportunites, eg., goverment ‘secur ‘The community at large - The goals of the community wil be broad but wet \eehudesuch aspects as legal and social responsbilies, pollsion contol ard ‘erplayee weltare ‘Company employees - letuns = wages oF salaries. However, maximizing the retums to employees does assume that rik finance can be raised purely on the ‘basis of satiticng the retums to tnarce providers. ‘Company managers/ lrectors- Such seiov employees rein aniges!posionto {obow thet own airs atthe expense of ther slakenokdes. The goals wie bom tong-term (defending agains! takeovers, sales maximization) and short‘term (profit margins leading to increased bonuses). ‘Customers -Satetacion of customer needs wil be achieved rough he provisen of value for maney products and services, Suppliers - Suppliers to the organization wil have short-term goals such as prompt ‘payment tems alongside longterm requiremans including contracts and regular ‘butiness. The Inportance ofthe naeds of suppers wll depand upon beth thie relative size andthe numberof suppers.Introduction to Financial Strategy Finance providers - Providers ol loan finance (banks, loan crecitors) wil primary 'b interested in the abity of he fim to repay the finance inchiding inteeet. At & ‘put it wi be the fre ality to gonerate cash both long and shot tem that willbe ‘hebasisotthe goals ofthese providers. ‘The government - The government wal have pottcal and franca interests inthe im. Potticaly it wil wish to increase expors nd decrease imports whist ‘mantoring companies via the Competition Commicsian, FitancialyIrequlresiong- term profits tomaximize taxation income. | ‘Objectives and economic torces, When ‘siting the company’s financial sirategy the financial manager is often constraines by bom ntornal anaexcemal actors For example, signicart expansion and an increase in dividends may not be easibie # the entey hata lack of shiled stat, and may become uneconomic if Intorost rates are sot ori (he increasing the amount payablo to barks and othr abt finance providers}. Internal and external constraints on financialstrategy {Internal constraints on financial strategy ‘Two ofthe main internal constraints on franca! sttatogy are financing and gearing (there are covenants n deb! agreements) “The mein argumentin favor of gearing shat troducing bortomings into the capital ‘structure atracts tax relioton interest payments. The argument agains Borrowings ‘at tintoduces financial isk no the entity. Financial managers have to formutate topalcy hat balances the effects ofthese opposing features. ‘Other intemal constrains on financial strategy inch: ‘+ Therneed to maintain good investor relations and provide a satistactory return ‘oninvestment; + Ashorage of koy sits; “Limited production capacity. External constraints on financial strategy. Major extemal constraints inciude: ‘Limited access to sourcasotinance; + Governmentinflunce (see below); ‘+ Regulatory bodies (see below): ? Introduction to Financial Strategy = Major economic influences, such as interest rates, growth in GDP. ination rates and exchange rates. The elects of intrest rate an inflation changes: ‘nthe economy are coveredbelow: ‘Accounting concepts. (Note: Detaled knowledge of accounting procedures ‘il not be examinedin this paper). ‘Governmentintivence ‘Govemments often play a large part in infvencng "business actively, Some ‘examples otthe way mn which governments cari have.an influence are.as follows: * Empioymentpolcy, Governnnis tay amajrroleinattempingostmuaio ‘employment They can da ts by Binding ocatlonal waning programmers _andtunding employments programs + Regonalpoicy. Goverwrants may make lands avalable fo suppodt regons ‘thigh uneroymert ar sci deprivation * Inflaton policy: Governments may use interest rates to cont lation. Increasing interest aes makes more expensive orgrott making entities to bbortow. also maker borrowing more expensive for consumers, who then hhavelessto spend, This withalpo push prices down. ‘+ Taxeion poy. The goverment rates taxes onthe profs generated by Loi: making ees andon shareholders dividends. * Invernational poy. Governments can promote tat, encourage experts oF ‘The financial manager must ave a proper understanding of hove aspects of segsation wich impact Yoon enties Such leglaten wil clude the Compares ‘Acts, health and safety reguations, laws relating to consumer protection and Consumer rights, laws relating to contract and agency, employment law and laws ‘eating patton! he anurenmertandprometng competion Listed companies also have to comply with Stock Exchange reguistions, anc ‘eis which operaie in sore high role indus wl alo te rear bodys ‘ronvtorng Petr petormance For example, he UK. On locomimenieahons) Olcom (media) and Gtwat (water) have been set up by the government to monitor srdragilan Peirempectiveingssre8Introduction to Financial Strategy 1) Monopoly power ¢ ‘Where market partiopants are judged to possess significant market power, lard where tror0 ino other protection for customers. controls on prices and ‘on quality of service may be coneidared 2) Socialobjectves: ‘Government objects) may include the avaiabity and attordabity of ‘services in pascular ered and to particular groups such as customers in remoteruraaroas, 3) Competition \Wraro 8 rrarhat i not competitive, ori in the eary stages of becoming $0, thsce 6 a eed for regulators whose fle ist fry to balance the nterests of thevarioue stakeholders. ‘emportant issues lor regulation are the prevention ot ‘cross-subsidy’ tha is the transfering oF offloading of portions of overhead costs form lower 10 higher-margin products, tha limitation of nor-pree barriers allecting the erty ‘fnew compatiors, and assurng reasonable quality of product in relaton to price. Non-price barriers couldinclude trade restiictons, orrestcted access tosupplies or estibuton channels. Theetfectotinterest rate anc! inflation changes: ‘Theetfects of interest rate changes [Changes in interest rates aftect the economy in many ways. The folowing ‘consequences are the main etecta ofan increase in ntorest ates: ‘Spending fale - expenditure by consumers, bin individual and business, wil be reduced. Ths occurs because the higher interest rates rive He cost of erect and ‘deter spending. if wa take incomes as tity stable inthe short term, higher interest payments on cred cards / montages, ec, Jeawe less incame for spending on ‘consumer goods and services. This alin spending means less aggregate demand inthe economy anc tus unemployment resus o Introduction to Financial Strategy ‘Asset valves fall - tho marke! valve of Francia! assets wil drop, because of he irvorse elabonan (etwoan bende andtha rat of nlerest oxplanad evi. Ths, int, wil reduce many poopie sweats ikely that they wilreacttomariain he ‘value of htt weath and so may save, thereby tthe reducing expendtrein {he economy. The phenomenon seems fof the UK recession of the early 19808 ‘when the house price slump deepened te economic loom. For many cenawners ‘eaayanouse, rather han bonds, isthe main asset. Foreign funds are attracted into the country * a Yise in intrest rates wt ‘encourage overseas tnancial speculators to depcst oney inthe count barking introns bocause the rate of retun has pcaased relative to that in othor ‘counties. Such funds could be made avalble as loans to fms in that county by thebanking sector. ‘The exchange rate rises ~ he inflow of foreign funds waises demand for ho. domestic cuency and'so jpuehes up the exchange rate. This has the benef of ‘eoworing import prices and thereby bearing down on domestic infation. However. ‘makes exparts more expansive and possibly harder to sell The longer-term atioct ‘on the balance uf payments could be beneficial or harmti depending on the ‘lastly of domandtan euppiytertraded goods. Anftation fas “higher interest rates affect the rate tiation in thras ways. Fes. ‘nas clear inthe ecanomy may encourage producers to lower prices in order 10 ‘sol, This could be achieved by squeezing profit margins and/or wage levels. ‘Second,new borrowings delered by the high interest rates and so demand wil a ‘Thode higher exchango rate wil raize expor prices and thereby threaton sales ‘winch i tum prossurizes producers to cut coals, partcularly wages. workers are {otf then again otal demandis reduced and inflation is Ike ofl ‘Theettects of infiation Inflation ie demand simply as ing prices’ and shows the cost af ng in general tems, 11 the rate of ination is low, then the effects may be beneficial to an economy. ‘Business people are encouraged by faity stable prices and the prospect of higher _Brofts. However, thore is some argument about whether getting inflation Bolow 3% ‘0 say, 2070, fs wort the oconomsc pain (f, say, hignor unemployment). Thore is ‘agreement, though. that inflation above 5% is harmful ~ worse stil is accelerating. The main arguments are that suchinfation: Distorts consumer behavior - people may bring forward purchases because they 10Introduction to Financial Strategy ‘ear higher prices laters. This can cause hoarding and so destablize markets, ‘eraating unnecessary shortages. Redistributes income - people on ixedincomos orthoselacking bargaining power ‘millbeoome relatively worse of, as ther purchasing power tals. This is unfair. _Attects wage bargainers-rados unionists on bhai ct abour may submit higher ‘Saime atmos of high intason, partcuary if previously ey had underestimated the future rice In prices. W employers accept such. cisims this may precipitate a wage: prce spialwhich exacerbates the air arabia, Undermines business confidencis wide fyctuations in he inflation rato mak ® consequencesotthe issue; > tature profits; and > future dividers ‘+ Antertne actualissue the market price will normal fall again because: > there are more shares in issue (adverve atfect on eamings per share).and 38‘Sources of Finance and Forecasting > now shares wereissued market pce discount J carmrights Wen sights isve |S announced, ll existing shareholders have the fight to subscribe for new shares, and so there are righis {cum rghis)atiached io the ‘shaven, and he ahares ae tad um ft Exrights ‘On the frst day of dealings nthe newly issued shares, the rights no longer exist and {he od shares are now'raded'exrights'(wihoutngnts atachec). ‘Theoretical prices/ values 2) Theoretical ex ights prices he theoretical price thatthe class of shares wil ‘rade at onthe fret racing day aterisave. his calculated as foloms: x cumrighte pice) + lave price Senn 'b)Theatetioa value of rights pershare Iscaiculated as: ‘Theoretical exrightsprce éesve pice) /N ‘whore Ne no orights requiredto buy 1 share Examplet—Flowor Ltd. 2} Flower Ltd. has 100,000 Rs. 10 ordinary shares quoted at Rs. 45 ox dt. t considering a 1 forSrights issue at Rs. 42per share. Required: Calevlate the theoretical ex nghischare-prce. 1b) Assume that Flower Lid. intends to use the funds raised to finance a project withan NPV of Fs. 300,000. Required: Calculate the theoretical ex rights share price the project is undertaken. 29 ete) sea ‘Sources of Finance and Forecasting ‘Courses of sction opento shareholder Possible actons ora sharehoksor ae: ‘exercise the rights (thatisbuy the shares atthe rights price); renounce the rights and sel them on the market, renounce part the rights and take upthe remade, ‘60 nothing. (Shareholders may be protected from: the consequences of Inacton by the company seling the nghte cn behai{of inactive sharahokders). Implications of arights issue 2) Fromviewpoitotthesharehaiders + havecpson oftuying shares ai pretorentelprce: + have option ofhdamsog cash by seling tro his: * ae abe o mean her ening relative voing positon (oy exercising he ‘opty ©) Fromviewpantotthe company: * is simpla and cheap to implement + isusuadysucceastl + chen proves tavourabe public. 5 Offerforsaleatatixed price ‘Shares are offered forsale to investors, through an issuing howse ata fixed price set ‘bythe company. © Offertor salebytender Investors ae invited fo tender for new shares Issued at ther own suggested price ‘Asharet are subsequently sold atthe bes price at which they wouldibetakon up, D Placing ‘Shares are placed directly wit certain investors (normally nstuttons) on a pre= ‘arranged basis. Pretarenceshares + Alorm of equity that pays.afixed dividend. ry‘Sources of Finance and Forecasting ‘+ Mispaidinpreterence to (before) ordinary shares, hence, thename, ‘+ isnottax efficient any ratumbeing paid outol posttaxincome. + Notvery popula, tis the worst of both words. > Risnottaxeticiont > Iteters no eppartunity for capital gain (xed return). Debt Finance “The loan of funds to a business wihout Confsririg ownership rights. The key eaturos of deb financing arse rom the arm's iength relationship ‘+ Mispaid outot protax protts aan expense ofthe business, * Hicari risk of defaut#inierestand principal payments ave nt met. ‘Securlty charges “The lender of funds wil normally require some form of security agains! which the funds are actvanced. This means that, inthe event of dau, the lander willbe able {otake assats in excrenge of tho amounts owing. There are two types ol ‘charg or ‘secunty tat may be otleradrequired: 1}, Firea charge-The debt secured against a spacttc asset, normally and oF ‘buwsangs. This form of secuery Is preferred because, In the event of Lquidaton, puts the lender al he trantol the queue’ ot creditors. 2) Floating charge - The debt is secured against the general aasate of the ‘business. This form of secunty is not as strong: again eonters a measure of ‘securty on hquidalion aba'prelerred creditor, mearing thelenderiahigher in ‘the ist of creditors than otherwise, ‘A further means of limiting he risk 19 the lender is to restict the actions of the rectors through the moans of covenants, These are specific requirements. of limitations iad down as a condition otaking on debtfinancing. They may include: 1) _Bivend restction - Limitations onthe level of evident a company is permed o pay, This designed a prevent excessive dvend payments which may seriously weaken the company's future cash flows and thereby piacethe lnderai greatersk 2) Financial ratios - Specified levels below which certain ratios may not fall, 29, dbl tonetassets rao, curentiabo “1 et sea ‘Sources of Finance and Forecasting 3) Financial reports - Regular accounts and nancial report lo be provided to the erder to manitot propos 4) Isaue of further debt- The arrount and type of debt that can Be leave’ may be restricted. Subordinated loan stock stock ranking below the existing Unsecured oan stock) can usual stlbe issued. ‘Typesot debt Debt may'be raise rom wo general sources banke orinvestors. Bank finance For companies that are unlisted and for many Isted companies the fist part ot call tor borrowing maney would be the banks. Thaee could be the high street banks or, ‘more ikely fr larger companies. the large number of merchantbanks concentrating ‘on ‘Securtised lending’. The ‘xy advantage of bocrowing from banks is the Contiontalnature ore arrangement. ‘Terms and conditions are negotiable dependant on term amount and the creck ‘aig ofthe company wishing to make the borrowing ‘Traded investments ‘Asan alernative to borrowing funds from a bank the company, ited on the stock ‘exchange, may Issue debt to lwvestors over the long-term. Typical features may sedude ‘The dobt is denominated in units of Rs, 100; this is the value eventual redoomed ‘on maturty is often the value on issue (the cost tothe investor) but he debt may ‘boissuodata scout forless) Interest is paid (normally at athe rather tran Hoating rate) on the nominal ‘valueof the loan. ‘+ Thedodthas aloworriskthan ordinary shares. ‘Types of issued debt ‘They include: + Debentures Debt secured with a charge agains! assais (either fixed or ‘Noating). ‘Unsecured loans No security meaning the dabt is more risky requiring & ‘gher return, They normally require covenants 1o give some measure of a‘Sources of Finance and Forecasting safety tothe dettholder + Mazzanine finance High ek finance issued whan other sources ave ‘unavailable A typical uses to funda management buyout ‘+ Euro bonds The issue of debt in a curency other man that of the county. “This form offnanco's only avalable to he largestintomational corporations. ‘Theyleldon debt ‘Acommon exam question requirement iso calculate Ine "Viel" tothe ender of eb fiance. ‘Ar investor who purchases a tratec: debt inctument (@.g., debenture, bond) receives aretum, known as.a“yiee’ the form ofthe annual interest (or “coupon") [payments and, the debt ts redeemable, the final redemption payrnent. This return {s.also know as the “Yield To Matuny”(YTM), of “redemption yielé on the bond, andtisdetinedas: YTM= ettectve averaze annual percentage retum to the lnvestor, relative to the ‘current marke! value ofthebond. Ittme bonds redeemable, he calciation is very simple, However, the caiclatons ‘ae more compiex f the bond is redeerable, oi it is Genominaied in a foreign currency. ‘Yield on tredeomabie debt Foriitodoomable debt, YTM-= (annual interest recelved/curent market value of debt) « 100% Example ‘Globe Lid. has some 5% coupon, Fs. 100 nominal valve, redeemable bonds in ‘Issue, which have acurrant market valuect i. 85. Required: Calculate he yioktto maturity for these bonds. ‘Yield on releemabie debt Forradeomatio debt, YYTM = the IRR of the bond price, the annual interest received, and the final ry ete) sea ‘Sources of Finance and Forecasting redernption amount, “This ensures thatthe yield calculation incorporates a return i the form othe tna redemption amount as wellas the arwalintares! aroun. Examples ‘Globe Lid. also has some 79 coupon, Rs. 100 nominal vals bonds in issue, which are redeemable ala 10% premium Syears. Thecacrent market value ofthe bonds es. 98, Required: ‘Calculat he yiold to matuityfr these bors “Yield to matusty tortoreign currency bonds Too calouion of Vid To Maturky (YTM) is compleated furor when we look at {oreign currency tans. As above, let's start By considering the impact on iredeomatie bunds, thon move ontolook at radoerabies. Irredeemabie orsign currency bonds ‘Assuime thot Globe Lid. now issues some US$ 100 redeemable bonds at par, witha coupon rae oF 5%. thw exchange ate between the US$ and RS. is expected o stay ‘constant, he YTM caicuation is exactly the same as it was belore. However, a _Bzublem arses when the exchangerate's expectedtochange. For example, tho US § is expected to strengthen by 3% per annum against he Fis. stering, paying the interest in USS each year wil eectvely cost Globe Ltd 35% ‘018 per annum as ime goes by..ontopof the 5% coupon rate payable. “Thus, the YTMon the eradoomable US $ bonds wouldbe: {(1.05x1.03)1]+8.15% poranoum. Redeemable foreigncurrency bands Now, lets calculate the YTM if Globe L1d. issues some § 100, 5% coupon bonds at ‘bar, redeemable in 5 years at $110, and the USS is expected to strengthen by 3% ‘per annumagains! the Rs. Assume thatthe current (spat) exchango rateisRs/USS = 100 thatis, $1 = Rs. 100), Following the example above on redeemable bonds, wo know thatthe TM i he “4‘Sources of Finance and Forecasting IRR of the current market valve, the interest payments and the redemption ammount. ‘Tha complication inthis case's that the cath flows wil fret nasd to be converted into Fa. (Globe Lid's hme currency), using exchange rates which change each yaar, s Exrate(S1 =A) Re s0Curent Mv (390}100 (10,000) interest 5 103 515 ‘Pinorost 5 1069. 5345 ‘Sintorest 5 30027 846.35 interest 5 125558275 \Sintorestend redemeton M6 1583 13.882 ‘Hence the FF (he VIM) cane calcu as fotows: Bs. OF Pv DFIO® Pv 10 (10,000) ’ (10.000) 4 (19,000) 1515 926 47689 = 0909 488,135 25315 087 458066 ©0825 441.407 "3546.35, O78 433000751 41031 862.75 0735 41a62 068s 384.868 813,932 oat 907909 ©0624 8,270.17 61.467 853) Hence, IRR = 8%0[2% x861.$67/(861.467+-16 53) = 9.96% Advantages and disadvantages of using debt. 1) —_Debthaslow costin comparision with eauiy, — Debtatiractstaxbonetts '®) Voting powerot company's nototlered with debt Disadvantages, |) Company needs ia have some assets for securtiy of deb, 4) Moredopendanoe on debt decroases the inorast cover ratio. |W) Company has to repay te debt as they are redeemable. Other Sources of Finance Salo ariiease back CHAPTER 2 ‘Sources of Finance and Forecasting Selling good quality thedassets suchas high steel buisings and Leasing them back overmany years (25). Fundisare released without any loss of use of assets, ‘Any potential capital gain on assets is forgone. {A popular means of funding for retail organizations with substantial high street property e.g, Tesco. Marks and Spencer, Grants ‘+ Otten rated to technology, job creation oF rayonal pokey. + Otparieularimporancetosmallardmeducnsizedbusinesses (e., unlisted) ‘© Thoirkoy advantage is that they do nctneedtoba pad back. = Remember the European driansion with grants alo availase through the European Union. Retained eamings. ‘The single most important source of finance, most businesses use: retained ‘eamings asthe basis of their inarcing neods warrants fn option to buy shares. at a spectied point in the future for a specified (exercise) price. +The warrant offers a potential capital gain where the share price may rise ‘above the exorcico price ‘+ Theholderhasthe option to buy te share, ‘+ Thewarrantnas many uses including: + as adsional consideration when issuing debt Io make it move attractive: © asarmeans of lasing incentives tostatl Convertibieioan stock ‘Similar n tfecttoatiaching a warrantio a debt instrument. + Theconvortbie debt la where the de tsot canbe convertadinto sharesata redeterminedpice ata date orange of datesn te future, ‘+ This has the elect of ging the debt holder a potential capital gain over and above the tum fom the debt interest * ithe value ofthe shares is greater than that ofthe debton the exercise date, 6‘Sources of Finance and Forecasting ‘then conversion willbe made by the investor. “HL bowover, tho share value is lower thae the debs value, the investor may etan tho debt tomatuty ‘The Leasev Buy Decision Leasing is an attomative way of obtaning the uso of toms of equipment for ‘companies which for varying reasons may wigh to avoid acquiting them outright. Terminology 2) Operatingtease Usually fora shor period, whore substantially altho rsks and rewards of ownership, remain wih thelessor 1b) Finance tease Usually fora iong period, where substantall al the risks and rewards of ownership passiothelessie ‘The lype ct eate ha we need to Consider more deals afinance ease because {tis i. an atemative to borrowing some money in the long termin order to purchase aneseet, Reasonstorleasing '8) Tho fu leas ronal abowablo againet tax. Inocest on debt fhancing ia towable agninsltaxbut tho capital repayment not, 1») Misareadiy avalable form of france, especialy fe plant and equipment or rotor vehices. Is, therefore, very convenient for cormparies to enter nto such arangerents, ©) Mremoves the need for a sipuicant capital outey at the begining of projects ie... tavodsthe neediofindtne capa athe ovset. 9) Trmaybe cheaporin nancial orms han conventional debt fancng he ‘fecve interest rate on leasing maybe less than fhe intorest payabe on & foan. “a CHAPTER 2 ‘Sources of Finance and Forecasting Lessevbuy evaluation Hanastetisneededtor a majornew investmont, and the asst can be leased under ‘atinance lease then acstical decison is: 2) should he assotbe leased or B) should the ase! be purchased sd the purctuise cost financed by debt Issue? Inthe oxam you may need to evaiuato the lage againat borrowing to buy option to “determine wach woud be beter in nancial terms. The tracbonal approach tothe ‘evaluation isto determine the present velve cost of leasing and compate this tothe ‘present vate cost ofbarrowing iobuy. Note: 1) Tax reel on jntarest paymonts on dobt Is always takan Into account by ‘obtaining apost tax costof debt 2) Assume lease payments area ahrays allowable in fll against chargeable profits unless old otherwise (soe notes after the nextexample). Example 4-Pen itd. PenL id wists io investinrew equipment costing Rs. 130,000. The equipmenthas 4 lle of four years and no scrap proceeds are expected to be avaliaie after his ‘petlod. Wrteg down aowances are avallable at 25%. cn a reducing balance basis. “The company can borrow at 12% pre-tax. ‘The equipment could alternatively be leased for a coat of Ri. 40,000 per annum ‘payable in arrears over four years. Assume that the fll lease payment Is a tax ‘deductible expense. Taxis 33% payable ono yoarin arroars Required: Determine whether the company shouldlease or purchase the asset. Further calculations cn lease interest Inthe above example, we were told apeciicaly that the ful laate payment was lobe treated as a tax deductible expense In some questions, you wil be told to assume that just the interest element ofthe ease payments tax eductibe. In thi caso, thotiret stop is to calculate tho ntorost ‘|lemantusing ether the actuarial math. or the sum of digits method. 48‘Sources of Finance and Forecasting “The following ilusration shows how bot methods wark ‘mustration 1 ‘Assume atk Company has the option to buy an asset for As 100,000, or olense iRby paying Re. 29.500 per yearin arrears for 4 years. Clearly thainterestclomentin the lease amounts to (4 x Rs. 29,500) Rs. 100,000.= Rs. 18,000 in total. This Interest can be aloceted to years using either the actuarial method, or the sum of ‘Sgitsmetod. Actuarial method Hore theimpiied interest rates foundiby using an IAA approach, ‘As a shortcut, tho 4 yaar annuity tact at tho IRR can be found by dividing the cost ‘af the asset by the annual rtecest payment (e:, 190,000729,500). This gives a 4 ‘year annuty factor of 2.390, which (rom tables) is very close to the 7% factor, Hence, the implediniaraat raisin the lease is (approximately) 7% Now, the intet@stcan be allocated to individual years using he folowing table: _——— a Veart Year? Vear3).~—Veard Openingbatance 300000 7.500 53425 27,665 ‘= inlorest(7%xOpBa) 7,000 $428 3.740 1.997 Leasofayment (29500) (29,500) (29,500) (29,500) ‘losing balance Tso | 5342527665 102 Note: Tho closing balance atthe end of yaar 4 should be zero. The dtfronce s ue torounding. ‘The loase intrest payments have Now boon allocated te yaars, so can bo used 0 calculate he tax reef each year ‘Sumot digits method ‘This a simplor way ot alocating Interest, based onthe sum ol cgi formula ninety In this example, the lease payments are to be made over 4 perisds, so the sum of ‘gis is 10 working: 4x5 /2= 10) ‘Hence, ne interest alocations 4“ CHAPTER 2 ‘Sources of Finance and Forecasting Years -ar10%Rs. 18,000 Yeaez ‘Q10.xRs. 18,000 Years BOA 18,000 Yeard 110 =Fia 18.000 ‘Once again the taxi onthe lease ntorest can now be caicuatod easly. ‘The Role of the Treasury Function ‘Anenit's weasuny uncon has responsibilty for the provision and use of hance.” ‘Thomain tunctions ofa treasury deparmaniinclige: + estabishmant of corporate fnénci objectives. ‘© managemert ne ents kquid assets (8 9.,cash and marketable securties) + management of the eritys fundeg determination of policies. identitying sources and types of funds. © currency managernént fn a muitnations!) dealing in foreign curencies and hheogng.curency risks. (See detais below) ‘2 Shouts the Treasury functions bea cost centre or aproftcentre? » Vinalig te company's objective? + Whalis te departments objective? [Rie Generaly thought beter for treasury partments to operate as cost contres as thes reduces the levelof isk given the high evel otiqud assets n easy ‘Centralization v decentralization (Centralized advantages ) Greater kquidty / volumes; §) Bukbortowing: |) Foreign cumency risereduced; ™) — Expertsavaiabe. Contraizedisadvantagos ‘Transter responsiblity /controtaway Irom local managers. ®) Creates bureaucracies; 1h) Peformance evaluation of foreign managers dificult, ™)__Impracticaltohavenocash balances al subsidiary level 0‘Sources of Finance and Forecasting Financialrisk canbe hedgedin following way 1) Hedging with forwards ‘The forward markets where you can buy and sella currency /eommodiy, at axed ‘uturedate fora predstormined rata, ie. the forward ate of exchange. 1) Money markethedge ‘Tne money markets are markets for wholesale ferjo-scale) landing anc borrowing, cetrading ® shortormfinancialinairuments, Mary comparses are abe to borrow oF ‘depositunds through their banikin the ony makes, Wi) Financial derivates a) Future Futures are the a formar contract in that: | theconipany's positon's osedby the rale of exchangeinthe itures contract: Mga binding contract ‘Autres contract sites roma forward contractin he folloning ways: “+ tures arefor standardized amounts; « tuures canbe vadedin matket ‘Because each contract is form standard amount. and witha xed maturty date, they rarely oover the exactexposure, 1b) Options ‘Options ar similar to forwards but with one Key etlerence. They phe the righ but ‘at the obligation to buy of Sol currency otc. at some point in the future at a ‘predetermined rate Forecasting-Protfits,Cash Flows andthe SFP Planning ‘Al businesses need to plan. They need to identity exactly whal ther business wil ‘ook iko nancial should they choose to go ahaad with a paricular strategy, 51 CHAPTER 2 ‘Sources of Finance and Forecasting ‘Onjectve of ptanning to allow an organization to influence As own future by thinking andactinginadvanes, ‘A very popular exam area is the requirement to calculate a forecast income ‘statement, statement of financial positon and cash flow. ti looked ain ths wecton ‘because many of the exam questions ask fr a forecast and follow up with some form of raising captal writen aspect. Atthough the forecasting of the income ‘statement wil rot cause difiely, the approach ane presentation needs thought land some practco. Forecasting ncome statementand statement of nancial positon valves ‘Tr 16.2 very simple process. For example, i sales are currently Rs. 10 m and growth is forecast tobe 5%, future walescan ba forecast as! Year t:Rs, 10x 1.05 As 105m ‘Year2: Rs. 10 mx('.08)2 Fis 11.025 m Taxadjustmerts “This (& the inain source of cimicuy In many questions. The tax should not be changed directly on the accounting profits. Insioad. the firm's depreciation should bo ‘added backardtnen the capital allowances daducted to give taxable prot 1ownich ‘tetaxyatocan be applied. Example 5~Tax adjustments Flow Lid's depreciation on ts plant and machinery next year wil be Ra. 2m on a ‘staght line basis. For tax purposes, captal allowances can be ciaimed at arate of 25% pa. (reducing balance basic). The current Dook valve, and tax writen down, value, ofthe plants Rs. 10m. The expected accounting profit forthe eoming years Fs. 8m. Corporationtaxis 90%. ‘Required: (Calculate the expected tax charge for nest year Exam style questions ‘Test your understanding 1-ABCLid. “Thedlroctors of ABC Lid a congfomaraie lated on a stock exchange, are appraising ‘one of heir wholly-owned subsiaris, XYZ Lid. with a vow to disinvestment. The 8‘Sources of Finance and Forecasting ‘subsidiary is primary Involved in the manufacture and dstibuton of car care products Financia data forXYZ Lic. are shown nthe table below. Required: 8) Catelate ve ratios for each of the two yeas 20X1 and 20X2 which you onside! fo be appropriate forthe evaluation of he subsdar'sethoency. (profitability ard liquidity over the two year period. Your selection af ratios ‘should ensure measurement of he companys performance in al mee (1omarks) b)Preparea report fr the marnagememt of ABC Lid. Ths report should viscuss ‘the folowing: 1) the performance st the subsiciary during the past two years, using the ratios ‘caleviatedinpart(2)o guide your comments; |) thelim®ations othe type of historical analysis you have just provided: '8) suggestions ortho parent company's future cours of action in raspect ot the _sutsichary, including comment on an appropriate procedure for valuing the company, Fv), nontinanciat information which woukdbe usetto the drectors of ABC {Li before trey make any decision. (1Smarks) (Total: 25 marks) ‘Summary accounts for XYZLId. ‘Statement of financial positionat 31 December 20K. 0x1 fs'000°Rs.'000" Non-current assets (plant & equp) 26502285 ‘Otnerlong-term assets (Note #) 750 875 Cash andmarkotabie secures, 195 162 Receivables, 765 lnventoryand workin progress 1,250 ‘Omrercurrentassets 150 Total assets 5,760 CHAPTER 2 ‘Sources of Finance and Forecasting ‘Shareholders funds 2520 1728 [Longetorm dat 2250 ©1876 ‘Otherlong-erm ables (Note 2) 276 206 ‘Currentiabities 18 ea Total equty& abilities 5760 4.562 Extracts trom the income statements forthe yearsendac 31December 0x2 0x1 ‘Rs."000" Rs. "000" Tumover 6575918 ‘Cost of goods sold 5918 Saad Omer expenses 668 S82 ‘Otperincome B 2 Eamings before nance charges and tax 2 (98) Finance Charges 95 0 ‘Taxon ordinary activites (Note) (12) (149) Netioss (253) (288) 1). Otherlong-term assets are motor vehicles andotice equioment. 2) Otheriong-term habites are tinancelases. 5) The tax shown in the 2031 income statement extract wil be recovered in ar, ‘Otnertinanclal information Res, 000" Depreciation 20x2 175 Not reaisabie valve finventory 1.001 NNetrealisable valve of plant and equipment 3.907 Seventory and workin progress at 1 January, 20X1 850 Feceivables at} January, 20X1 435 ‘Test your understanding 2-GSD Ltd. {GSO Lid. a prvate company owned by the two tarnitos hat started the businessin ‘20K0. Tha company produces organic food products fr distrbution in the domestic ‘madkat using food products from farms. The company is experiencing a period of rapid growth, with revenue expected to rise by 15% in each of the folowing fe years. o‘Sources of Finance and Forecasting “The company is honing to retain a proft margin (profit before interest and taxes vided by ravenus) of 30% toughout the nast five years. The rato of working capital 12 revenue i expected to remain constant, where working capil ‘inventories plus trade receables lesstrade payabies. Interests paid onthe overdrat and bank loan at 6% per annum. Interest onthe bank Jean and overdrait is calculated on the balance outetanding atthe beginning ot the Year. Comporation lx i paid one yearn arrears al 3 rae of 30%, wity a 100% tax allowance tor capital expendture in the yea F which ft incurted I arriving at ‘operating peoft, deprecation s charged at 25% on @ reducing balance basis based on year end balances. Extracts trom the management accounts cf GSD Lid. on 31 December, 20X4 areas follows: Statemect of financial pasition sat 2/Decembor, 208 Property plantansemsipmaert 8 Woningoote 9 24 Share captal (Rs. 10 ordinary) 10 Ratainedeamings ‘ \Lonmlermborrowings (bankioan) 8 “Short-term borrowings (overdraft) 1 ‘Current tax payable ; 4 Income statement forthe year ended 31 December, 20%4 Revenue 450 Profitbetoreinterestandtaxes 135 Dividendpaidin-20x4 Rs 10ashare Capital expenditure plans ae for expenditure on property. plant and equipment of Fs. 10min 20XS, Fis. 10 min 20X6 and Rs. 7 m in each of years 20X7 to 20X9. No ‘Ssposais of propery plantand equinment are expectedin his period. ‘Shareholders expecta year on year increase_n dvdonds of 5%. Ary tunds deft in the year wil be funded by overdrat and any surplus funds used to reduce the ‘overdraft. However, with the increased demands on the funds of the business to ‘Sources of Finance and Forecasting ‘tnanca growth, tha drectors are concemed tha! they may exceed the overdraft init ‘of a. 1.5m. They may, tharelore, ned o nagotiate an increase inthe bank loan. though the bank has indicated that would not accept gourng higher than 70% ‘based on book values where gearing is defined as long and short-teem borrowings {including overdrat) divided by equity. Te shareholders have indicated hat they co ot wich fo inect any adtional capital iniathe business. Required: 8) Consructtine statement ot irancial stitemant, income statement anda cash flow analysis ofthe company tor each of the years 20XS and 20X6 and achise the company on the extent of arty adetional funding requirement in that ered. In youranawer, round figutesto the nearaat Fis. 10,000. (16marks) 1») Discuss tha interlationshirs: between financing, iwastmant and dividers _stratages with raterence to the Iquicty requirements of GSO Lid. Include ‘your discussion how each could be adapted to meet the company’s lquity requirements inthe yaars 20X5 and) 20X6 and provide a recommendation. (Totat:25 marks) Further bigillustraion of forecasting ‘Question {Back ground tothe company ‘Catton Lic operates a chain of fast food cutlets. Some are company owned ard some are operated under franchise, Two colleagues who were made redundant from one of the maior asl food companies slated the company 15 years ago. Initaly they opened outlets in smaller towns and ctes where there was limited compeition. The company experienced rapid growih in the frst ten yoars of ‘operations. Over the past five years, growth haa stabilized and the company may ‘nowbe facing a downlumin business caused primary by increased competion. ‘Financing history and current situation he original owners cbtained a isting on the stock market eight years ago when 40% ofthe 20 milion Re. 1 shares in issue were oflered forsale at Rs. 2.60 per ‘share, Further capital was raised four yours ago by means of #1 fr 4 nights sve, ‘As a resut of a series of share disposals, the orignal owners’ combined 56‘Sources of Finance and Forecasting ‘shareholding has falen to 35% of the shares currenty in issue. Insitutonal investors now own the majorty, although a numberof employes are shareholders 38 4 fost ol the company/s share option acheme. A summary af the company’s ‘most recent fancial statements is shown in Table 1 below. The company's ‘shareholders have, historical, required aretum on thelr equty of 84%. Financing alternatives ‘At a recent meeting between the company's drectirs, financial analysts and ‘nstutional investors, it was suggested that the ‘company should consider a ‘programme of expansion by extending the rane to otherlocatons fitstoretum, Yogrowth However, ts uniksly lo beable to undertake major expansion out of cash Arighisissueol 1 for Sats 5 Alternative 2 ‘A foating tate ian of Ri. 25 milion at an inal rate of 8% per annum. The loan ‘would befor eight years, repayable on matury and secured against the freehold {an anabuildings onned by Cifton Lid. However, the bank has imposed a condtion thal he company/s gearing. measured bythe book value of total det oftal debt ‘us equty ino more han 80% throughou the period othe lan. this condtion is infnged then the bankhas he righo callin he foanatree months neice. Cilton ic. can purchase a our yoars intrest eap al 10% tor an immadate prem os ‘tthe intial amount of the loan. This expense wil be amorised over the ie othe ‘ap. (Tutoriai note: Take theinerostiobe 8.5%) Profitimprovement scheme ‘The directors recognize that raising new captal, especialy # It's by moans at a rights sue, wil peed to be justiied terms of beats to shareholders. The costs and benefits of the proposed expansion yet to be fuly evaluated but as a broad ‘cbjective the ditectors alm to increase tumover by 10% per annum for the foreseeable fuure. ita expected that direct costs other tan depreciation wit, on average, ncrease by only 8%. par annum as a resi of Cost reduction programma and new supper contacts Indirect expenses are expected to hold constant as a regult of ntomal restructuring. Other relevant information is. as follows: 7 ‘Sources of Finance and Forecasting ‘= The ratios of recelvabies fo Sales and payables to dtect costs (excluding depreciation willremain the samme asin the yea to 30 Api, 2000. * Depreciation on assets wasting at 30 Api, 200088 forecast tobe Rs. 9 milion Inthe year ending 30 Apel, 2001 and Fs. 7 milion the year after that. New {xed assets wl be purchased to the value of is. 25 miion inthe year Yo 30 ‘Apel, 2001 nd Rx. 20 mation inthe year to 30 Apri. 2002, Depreciation on these new assets wil be 20% per annum straight line starting in the year of purchase, Assume capital alowances aregivalable ale same ate. ‘Note: This ina simplification, for examination purposes, ofthe existing tax situation. ‘+ is. 1orillon of ational stock wil ela be purchasedin the yearto 90 Apr, 2001. Assume thiaiathecriy changein the stock level fr 2000/2001, ‘+ Taxis payable ata margiral rate o! 30% per annum in the yearn which the ‘iabity arises, * Dividends are payatie tia yaar ater hey are declared. Assume the company ‘maintains the 185/200 payoutratioin 2000/2001, ‘Share buy back proposal “The finance doctor of Cifton Ld. is particularly skoptical of atomative 1. a righs ‘issue. anclbetis a debt alteriative is much io be prefered atthe present time: He ‘gus thal deb i cheaper than equily but also tha, given the depressed current [pree ofthe company/s shares, the company shouldbe considering a share buyback ‘raherthana share sue. t money were raisedby 2 loan, he recommmands that some ‘tt houldbe used to buy back he maximum amount shares permed by law. ‘Table 1 Summary financial statements Income Statement for yearto:30 Api, 2000 s."000° Tumover +435,000 rect costs (Noto 1) 85.500 Indtectoosts| 20,000 France charges 2.500 Prot betore tae 27,900 Taxon proftat30% 6.100 Prot attertax 18900 Dividends dectared me‘Sources of Finance and Forecasting ‘Statement of financial position at 30 April, 2000, Rs."000" As, 000" ‘Assets Non-current assets 117,000 ‘Cunrontassets Inventory 17.500 Rocowabies 24,500 Cash atbank 5.250 a2 “Total assets 104.250 Equity ancabitios Captal ard vosorves ‘Orcnary share capital (Re. 1 share) Reserves tote 3} 106.410 Noncurrent lables 10% debentures 2005 25,000 ‘Current esities Payables ‘Otnere (Mote 2) 11340, 32,640 Totatagquiy and abies 164.250 Notes: 1) tectudes depreciation ofRs. 8,500,000. her curnt aes re died 4 payable. Includes revaluation reserve of is 25,000 000, ‘Share price movements during the year: igh Rs. 6.20 Low Fis. S50 Asal today (23 May, 2000) is. 6.6. Required: Pate (b), (c)and (d)cf the question relate specticaly tothe scanario, ‘Answers part (a) shouldbe generat terms, although the scenario detals may be refered toin your answers, 48) Discuss the issues to be considoved by the reasurer of a protabie but low ‘7owth company When determining financing statogas in a parod of near Zeroinlaion and, asa consequence, low andtaling interest ates. (Grmarks) CHAPTER 2 ‘Sources of Finance and Forecasting 15) Forte two tnancing atematives being considered by the clrectors of Citton Ud provide forecast ) Income statements forthe yearlo 30 Apr, 2001; ®) Statement of nancia postions at 30 Api 2001 and IM) cashflows forthe yeart0 30 Api, 2001. Notet: ——Ignote Wansaction costs en the isuiny of new capital and retums on ‘surplus cash invested short-term. \Nota?: You are not required to adopt thé reandard format forthe cash flow forecasts, bul may dosollyou wien, (14marksy ©) Assume you area managemant accountant wit Cit Ltd. Wie a report to the directors tha evaluates the proposed methads offinancing. Voushould: 1) base your evahualion oe thw forecast you have provided in part (0) of the question but include whatever additonal calculations you think necessary ‘and appropriate to aid the evaluation; |] ciscuss the advaniages and disadvantages ofthe two methods of fnancng boing evaluator and comment briety on alemative types of finance which migtibe considered sutable nthe circumstances; &) ism s} 10% 8) None ofthe above Example 1 R16 Ks to = Rs.20 Example 2 Rea ws —_ om Rs. 40-Rs 3 10‘The Weighted Average Cost of Capital ‘The Weighted Average Cost of Capital A Example 3 Fy carves mae ‘a -my ee eas a eon i ae By waren Bennie cm one a) exo mes wats Re eaemneas >) = 148% Year 5 Rs 100 — een: oma WK Dea Ui fe, rome ha Pat Prose aah ssene 1) aan esac are | Rs. 1.3. 1.0625 q vexn b) kk = ————— + 0.0625 = 11.26% ~ 10% mae mim 0° (e509 1000 soy s000 5.0) ED. conse a i ra ie +s a ate maemo 2) 9 = 12KH30K = 38% me 5 1 07 | 747 at a.t0 rs an re < ¢ Aleve ed OE cee ree real ie on <—ae Want 5 0K ON) x wate oara po = aysaen tes aa am na‘The Weighted Average Cost of Capital ‘The Weighted Average Cost of Capital > od hence, g=0.28x09=0078. ‘Drédond int your = Cue dividend (1+ 9) = 120.000 1078 =F 104040 MW (Ex Div = 60,000 Re. 048 =a. 1,740,000 “The market value Is ex dv since the eevdend has just beon paid asco es +0078 wace = 1325% ‘7000 | FE) rte entertaining = bea = 18 say 10% 1) hee 24/28-4.2.4) = 10% 4 Aeeee e 2) k= Ra, 919(1-0.90) Rs. 90 = 7.78% seat 2) Market values: Equity 15/10 » Rs. 24 = Rs. 36m fu) p= ——_———-# 12.80%, sey 12.7% toa, 000 eet 10 (90/10) = Rs, 8m & gay ond Debt = Ra 457m rm 4) WAC 40% (85) + 7 7 « (045) = 065 «) ~The DVM gives th mate value of dobartires: ah prasnt ale (t a the dobentie elder requ aa freuen oh payments o Brest your understanding 2 Wahab Lid. F bene holers gross of ax F Tae cantow OF 1H BVO IN (0) singe Ont Vtaten Made (OVM) S by cnn ter 18 ret s0,000 se «3,600 nee ag 4 Redemption 1080000 OM 5,700 iw eDw rt ae . Wer west 67.280 rare 9 = row rate =, and ew (rena on nee remaster 0-28) d) The cost of debt kd is equal to the discount rate which, when applied to = propane oaminge = 0.3 thane! fows nt fax anh recon cots prices PY of a 867380, "3 "4‘The Weighted Average Cost of Capital ie. the intemal rate of retum ofthe fotowing tows: Tene Cashtow OF @ 7% Rs, ° Market valve (967,380) 18 Not interost 2.000 | 6.971 8 Redemption 1,050,000 0.882 pve Rs. (287,380) 310402 611,100 saare We chose 7% as our rt extirate oft IR since 119%.» (10.35) = 7.155 ‘Since the resul is postive, ths second estimate is higher, say 8%. Time Cash flow DF e@ 8% pvess fe Pe ° (067.380) 1 (267,380) 18 62,000 8767 298,644 4 1,080,000 0540 567,000 (1.596) Hence, IRFtis approximately 8%. Market value Cost of capital Weighted cost Fs * % Enuity 1,740,000 19 1234 Pratecance 71,000 127 4 Debentures 987,380 4 288 Total 678,380 1827 "6 [arrest e) CHAPTER 3 ‘The Weighted Average Cost of Capital tall tots, «ELIE oreo (2) kd ~ redeemable debt ~ IRF of Market Value, ret intenest and redemption amount: Coshilow DF pv oF e10% 210% 0 Market value: (900) 1,000 (90.00) 1.000 164 Interest payments 42. 1331 3,546 3.170 4° Capialapayment 100.0 0.683 68.90 0.823 C if ne oe mem Stun Se = i: = 16 py. (90.00) 1489‘The Weighted Average Cost of Capital (wave F 790) ($99 - (Saxe) (& wm) (8 sont aan) 100% Test your understanding 4~WAGG and financing discussion 8) Gearing = debt / (debt + equity) Using book values. goaring = 8,000 / (8.000+ 40,650) = 43% (assuming tha the pretererce shares aro wredeemable and theretore treated as ‘Tutorial note: Gearing measured Es (ded! / equty} would be equally accaptabio. ‘Show your workings clearly Market valves Orcinary shares 2m (1 95 /0.28) 10:800.000 Preterence shares 1 mx 0.77 70,000 Debentures 8m» 80% 6.400.000 17,970,000, $0, ping = 6.400 /(6400.+ 770 + 10800) = 26% ©) Cost of equlty Cost of capital Weighted % . 174 103 on a4 "7 [arrest e) CHAPTER 3 ‘The Weighted Average Cost of Capital 6,400,000 as 18 Total 17,870,000 123% ©) The dobontures aro a cheaper source a nance than the preference shares. The interest isa taxcdecuctoie expense, whereas ihe preference dividend is ‘an aopmopnation fom post tax profs. “The debentures wil be secured on the company’s assets, which makes them more active loinvestors han prelerence shares. Proterence shares cannot be secure. [Debenture holders wil rank belore prelerence shareholders in a liguidation )—Armerchant barik may have provided the following services advice on the type uf capital to be issued, that is debt, equity ot prelerence shares; ‘advice on the loem of debt as ued, that is wecured or unsecured. and on the use of sweeteners such as a conversion aption of warrants, ‘Advising on the coupon rate, issue price and maluny ofthe debenture: Ahachating and adminiatraion othe li: ‘onttying potental investors, ecommendatons about any derivatives that may be available hedge interest rato exposure * onguring that 0 Co, compiled wih any statutory and regulatory requeements relaing io he new ieau0. ‘Test your understanding 1 ~ Management of risk ‘Memorandum ‘To: Tho Board of Directort From: The Company Accountant ‘Date: X June 20%% ‘Subject: Investing funds in a postolio of secures ‘a) This memorandum starts with some detinitons: ne‘The Weighted Average Cost of Capital Systematic risks risk hat canno! be efminated by diversification LUnsystematic risk risk tat canbe ehmnated by alversitcation, ‘otal riskis the sum of systematic and unsystamatic isk. ‘Those definitions can be explained as follows. There wil Be some uncertainty ormally inherent in the future relums of any ivestrent that i made. This ‘an be measured as the ota rsk of he investment by calculating the standard euiation othe investments possible thu ‘Some of tis total risk can be diverstied away ty combining the investment with ‘other dierent investments; this component of total isk is called unsystematic risk ‘and relates tofactors. unique ia the company isa othe business sector tis in ‘The tomarder of he total nk carrot be diverssted away; tis companant of total ‘isk is called systomatc risk ard rolatos to factors affecting the stock markt as. whole g.theriskthatintarestrates iso. Totalnshis measured.as the standard devation of investment returns. 1 future returaa are unclear, the standard deviation of past retums over recent periods can he calculated asa measure ofthe investments otal isk. Systomoic risk is measured by looking at an lavesiment’s beta value. An Invostrenet with no systematic risk has abeta valve of zero. An investment with the ‘same gsiematic ris asthe market as a wholehas abeta lone. An investment with ‘gystematircktwice thatof he marketasawholehas.abetaof two, ct. Unwystematc risk is normaty measured as the cfference betwuon systematic risk and total sk ie., as a balancing figure, although it is possibie 1o calculate i separately. 1b) The expected retur trom any investment should compensate for its risk. It {he investment is held alone, ts the total risk that rekevant. But H the investment is held as one unt in a widely dversiied portfolio, the lunaystamate rik willbe eliminated, and it's ony the systematic risk that is relevant ‘Thus, i is accoplable 10 buy investments with expected returns less than the ‘expected retum on the market as a whole, as iong as those investments possess les risk than the masket as a whole, might be fo prudent, for example, to hold a ‘proportion ata porto in cash on deposi, effectvaly asa risk-ree asset, although She expected eto belower hen neu expeced oinvestg in shares on the stock market. "0 CHAPTER 3 CHAPTER 3 ‘The Weighted Average Cost of Capital Mis even acceptable to buy investments wih expected retus ess than the isk tee ‘ate of retum. as fong as those investments contrbute suficiently 10 the overall Gversication of the portfolio held. Investments wih negative beta values fail ‘paticulaty into this category, thei expected retum is low but they offer substarsial ‘Gwersication opportunities, ‘AnsweretoMCas: ) b jz © 120Capital StructureCapital Structure Chapter Learning Objectives. Upon completion of this chapter you will be able to: 123 rT) CHAPTER 4 Capital Structure Overview of Chapter ‘Ghanging Capital Structure ‘When @ business changes its capital structure, there wil be an impact on ratio ‘analysis especially tw gearing rato and animpacton th business's WACC., “The impact ofa change in capital structure on rato analysis the gearingratio ‘Twokey measures ol gearing: Debt__ Contaigouna aar* 100 oR Exyty 70° Note: Bath of those measures ara used in practice, but the frst one is more commonly wed, 28; | Capital Structure (Cleaty ta business changes its captal structure by raising new finance as ether db or aquly, these gearing ratios wilchange. Exam questions may tat the calculation of gearing raios belore and ater a change incapitalstructure. Wlustration 1-Gearing ratiocalculation PPP is considering raising Fis. 250 milion new tance to fund the aoquisiton of C00, 000s considered iohave avakue li FPP of 270milion, Exvacts tom PPP's statement financial posifon show: fs.inm Long-term borrowings 950 Share capital As. 10 shares} 500 Retanedresarves 400 ‘The directors of PPP have not yet cecided whether debt or equity finance should be sed to fun te takeover. However, equity Is 0 be used, the new shares wil be leaued at a pica ot Pa, 26 por shave, The current market share price is Re, 29 por share, Required: Calculate me gearingratlomeasuredas (se0V(seot ~ equity): 4) betoro tha acquisition of 320, 'b} after the acquiion, assuming that dab nance a ised to fund the takeover, ©} afer the acquisition, assuming thal equiy finance is used to lund the takeover, Inallcases, present your calewabions usingbolh book values and markat values. ‘Solution: Gearing basad on book valves: re acquisition 850/950 + (500 + 400)} = 51.4% Post acqusiton using debt (950+250) (@50+250)+(500s-400+20 (W1))] =56.6% Postacquisiion using equity 950/[950 + (500+ £00 +250 +20 (W1))}= 44.8% (Wt) Since QQ is wortn Rs.270 mo PPP butthe purchase price iss, 250m, the ‘value of PPP's equity wil increase by Fs. 20 m respective of how the purchase is francod 125 rr) Capital Structure Gearing based on market values (W2) re acqusiton 980 (950. ,450}=30.0%6 Post acqulstan using debt (850+250) /|(950+250) + (1.480420) = 44.9% Post acquttion using equly 950/990 + (1,450+250 + 20}}=98.6% (072) Market vaivo of exiting sharos = Re. 29 x 50m» As. 1,450 Note: The issue peice of the new shares (Rs. 26) sitelevant when calculating he Gearing ratios. OF course the issue price das attect ine number of shares issued ‘and therefore other ratios such as EPS (se0 tuttex examples below), but gearing ‘aos are calculated based ontotal valves of equity and debt sothe issue price isnot rolevantore. limpacton other ratios [A change of capital structive may alto impact other rallos (such as earnings per ‘share, earings void an interest cover) tthe change i tinancing is associated wih a ew project which increaces profits. Miuatration2 ‘SeediCo. isconsidnng investment of Rs. 20m whichis expectedtohave an NPV of ‘Rs. 8 nd is expected to increase prot botore inarast and tax by Ra. 4m por Enact trom the most recent financial statements of Seed Ca. ‘Statement of nancial position extracts Rsinm ‘Sharecaptai (Re, 1 shares) 16 Rosarvos 48 Cong tormbnctowings | 56 Income statement extracts Rs.inm Proftbetore meres! andi 150 Aorest 9) Prolitbetoretax 110 Taxat0% 3) Profitattortae (earings) “The curent share price of Seed Co. is Re2.70pershare. “The directors of Seed Co. are considering two alternative ways of financing the new sovestment, 128; | Capital Structure ‘+ Borowihe Rs. 20malaninterestrate 6% per annum, ‘+ Raise the funds using | for righiskssue ati. 2 50per share. Required: 8) Prepare profit forecasts for Seed Co. for next year undar Both financing ‘options, assuming that the new project goes head. Use the forecasts 10 Ccaiulate the impact of the project and each financing option on Sead Co.'s Intorest cover, earings per share and earings yield ratioe. 'b) Based on the results of your calculations, iacuss the tiely reaction ofthe “sharohoide's andthe leedars to eavh othe pessibiefrarcing optons, ‘Solution 8) Preprojectratios. Interostcover = Ris 1SiVFla Am =3.75 times Eamingspershare (EPS) =Rs.7.7m/ 16m =48.1 cents per share Earnings yield = EPS/ Share price = Rie. 0.481/Rs.2.70=0.178,0r17.8% Income eistoment Rs.inm-debtused Re. inm-rightsiesue torecante Profitbelor interest 130 190 anctax (Rs. 15m Res 4m) ‘interest 8) 62) re) Protbeloretax 138 150 Taxalsor ay (3) Profitaftertax (earrings) a7 105 {(W1) interest on tho naw debts 65% of Fi, 20 mL... As. 1.2m, Assume that interest on the existing borrowings staysconstant. Share price workings Fights issue tthe rights issue goes ahead, the valve ofthe shares after the rights issue willbe the ‘Theoretical Ex-Rights Price (TEAP), which was iroducedin Chapter 4 TERP = [(N-xcurnrghts price) +isave pice] /(Ne1) H(2x2:70)+2.50)3=Rs.263 war rr) Capital Structure However since the rights issue wil be used to fund the new projact wih an NPV of Ra. 8 m, the value of the project will also be reilected in tha now share price, ‘eereating the share pricata Fis 2.63 (Fs. 6m /(16mshares + 8mnewshares}] =F, 2.96 Debt finance Geb finance is used to fund the new project. the-share price should rise after the Droject has been taken on, toretect the NPY a he sew project Expected share price Rs.2.70 + (Rs, 8e5/ {6 marares) =Fis 3.20 Post projectratioe using debt finance Interestcover = V19m/Ra. 5.2 3.654imes [Eamings Per Share (EPS) = Rs. 9.7 m/ 16m 60.6 cantsper share Eamings yield =Re.0.606/Rs.3.20=0,189,0r 189% Post projectratios -using equity finance Intereetoover =F, 18m/ Ris. 4m=4.758imes Eaminge per ahara (EPS) = Rs, 105mn/(16m-+8m) =43.8cents per share ' ‘Eamings yield = Re.0.498/Rs. 2.96 =0.148,0° 14.8% 18} Debttinancing option dott is used to tund the naw project, the shareholders ae likely to see the change sEPSandeamings yield as postive. The EPS increase trom 48.1 cents per share to 60.6 cents per share, and the ‘earings yield increases form 17.8% to 18.99%. This indicales that Seed Co, will ppolentallyoabie to pay out arigher divider otha sharahoisers inate. ‘On me other hand, he reduction in interest caver indicates that Seed Co. wilface a righer level of risk fe dob f.ancing option is used Lo, the chance of Seed Co, ‘beng Unable to meat its interest obigations \ higher. The higher «isk to ‘shareholders could lead toa fain the share price I consideredio be signticant. However npracice tis unlikely that this issue wil worry othor the sharehokdars or the londors greatly. given that the movement in interest cover ia extremly email (875103. 05tmes). 128