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1.1 INTRODUCTION: Finance can be defined as the art and science of managing money. Virtually all individuals and organizations earn or raise money and spend or invest money. Finance is concerned with the process, institutions, markets and instruments involved in the transfer of money among and between individuals, businesses and governments. Finance consists of three interrelated areas: i) Money and capital markets, which deals with securities markets and financial institutions. ii) Investments, which focuses on the decisions of both individuals and institutional services as they choose securities for their investment portfolios. iii) Financial management or managerial finance, which is concerned with the duties of the financial manager in the business firm. Financial managers actively mange the financial affairs of many types of business- financial and non-financial, private and public, large and small, profit-seeking and not-for-profit. Relationship to Economics: The field of finance is closely related to economics. Financial managers must understand the economic framework and be alert to the consequences of varying levels of economic activity and changes in economic policy. They must also be able to use economic theories as guidelines for efficient business operations. Examples include supply and demand analysis, profit maximizing strategies and price theory. A basic knowledge of economics is therefore necessary to understand both the environment and the decision techniques of managerial finance. Relationship to accounting: The firm’s finance and accounting activities are closely related and generally overlap. Indeed managerial finance and accounting are not often easily distinguishable. In small firms the accountant often carries out the finance function, and in large firms many accountants are closely involved in various finance functions. However, there are two basic differences between finance and accounting: i) Emphasis on cash flows. The accountant’s function is to develop and provide data for measuring the performance of the firm, assessing its financial position, and paying taxes. Using certain standardized and generally accepted principles, the accountant prepares financial statements that recognize revenue at the point of sale and expenses when occurred is accrual basis of accounting. The financial manager, on the other hand, places primary emphasis on cash flows. He or she maintains the firm’s solvency by planning the cash flows necessary to satisfy its obligations and to acquire assets needed to achieve the firm’s goals. The financial manager uses this cash basis to recognize the revenues and expenses only with respect
to actual inflows and outflows of cash. Regardless of its profit or loss, a firm must have sufficient cash flows Decision-making: whereas accountants devote most of their attention to the collection and presentation of financial data, financial managers evaluate the accounting statements, develop additional data, and make decisions based on their assessment of the associated returns and risks. Accountants provide consistently developed and easily interpreted data about the firm’s past, present and future operations. Financial managers use these data, either in raw form or after adjustments and analysis, as inputs to the decision making process.
1.2 THE FINANCIAL MANAGER’S RESPNSIBILITIES: The manager’s task is to acquire and use funds so as to maximize the value of the firm. The financial manager’s primary responsibilities include: i. Financial analysis and planning: this is concerned with monitoring the firm’s financial condition, evaluating the need for increased (or reduced) productive capacity, and determining what financial is required. ii. Investment decisions: the financial manager must determine the mix of current and fixed assets and attempts to maintain optimal levels for reach type of current asset. The financial manager also decided which fixed assets to acquire and when existing fixed assets need to be modified, replaced or liquidated. iii. Financing decisions: financing decisions involve two major areas. First, the most a[appropriate mix of short term and long term financing must be established. A second and equally important concern is which individual short term or long term sources of financing are the best at a given point in time. Many of these decisions are dictated by necessity but some require in depth analysis of the financing alternatives, their costs, and their long run implications. iv. Dealing with the financial markets: the financial manager must deal with the money and capital markets where funds are raised, the firm’s securities are traded and its investors either make or lose money. v. Risk management. All businesses face risks, including natural disasters, uncertainties in commodity and security prices, volatile interest rates and fluctuating exchange rates. The financial manager is usually responsible for the firm’s overall risk management, including identifying the risks that should be hedged and them in the most efficient manner. In summary, financial managers make decisions regarding which assets their firms should acquire, how those assets should be financed, and how the firm should manage its existing resources. GOALS OF FINACIAL MANAGEMENT Shareholder wealth maximization: The goal of the firm, and therefore of all managers and employees, is to maximize the wealth of the owners for whom it is being operated. The wealth of corporate owners is measured by the share price of the stock, which in turn is based on the timing of returns (cash flows), their magnitude and their risk. When considering each financial decision alternative or possible action in terms of its impact on the share price of the firm’s stock, financial managers should accept only those actions that are
expected to increase share price. Because share price represents the owners’ wealth in the firm, share price maximization is consistent with owner-wealth maximization. What about stakeholders? Although shareholder wealth maximization is the primary goal, in recent years many firms have broadened their focus to include the interests of stakeholders as well as shareholders. Stakeholders are groups such as employees, customers, suppliers, creditors, owners and others who have a direct economic link to the firm. Employees are paid for their labour, customers purchase the firm’s products or services, suppliers are paid for the materials and services they provide, creditors provide debt financing that is to be repaid subject to specified terms, and owners provide equity financing for which they expect to be compensated. A firm with a stakeholder focus consciously avoids actions that would prove detrimental to stakeholders. The goal is not to maximize stakeholders well being but to preserve it. The stakeholder view does not alter the shareholder wealth maximization goal. Such a view is often considered part of the firm’s social responsibility and is expected to provide maximum long-run benefit to shareholders by maintaining positive stakeholder relationships. Such relationships should minimize stakeholder turnover, conflicts and litigation. Clearly, the firm can better achieve its goal of shareholder wealth maximization with cooperation of-rather than conflict with-its stakeholders. Profit maximization. To achieve the goal of profit maximization, the financial manager takes only those actions that are expected to contribute to the firm’s overall profits. For each alternative being considered, the financial manager would select the one that is expected to result in the highest monetary return. Corporations normally measure profits in terms of EPS, which is calculated by dividing the period’s total earnings available for the firm’s common stockholders by the number of shares of common stock outstanding. But, is profit maximization a reasonable goal? No; it fails for a number of reasons. It ignores the following i. ii. Timing: because the firm can earn a return on funds it receives, the receipt of funds sooner rather than later is preferred. Cash flows: profits do not necessarily result in cash flows available to stockholders. Owners receive cash flow either in the form of cash dividends or proceeds from selling their shares for a higher price than initially paid. A greater EPS does not necessarily mean that a firm’s board of directors will vote to increase dividend payments. Also, a higher EPS does not necessarily translate into a higher stock price. Firms sometimes experience earnings increases without any correspondingly favorable change in stock price. Risk; profit maximization also disregards risk-the chance that actual outcomes may differ from those expected. A basic premise in managerial finance is that a trade-off exists between return (cash flow) and risk. Cash flow and risk affect share prices differently: Higher cash flows are generally associated with higher share prices. Higher risk tends to result in a lower share price because the stockholder must be compensated for the greater risk. In general, stockholders are risk averse- i.e. they avoid risk. When risk is involved, stockholders expect to earn higher rates of return on investments of higher risk and lower rates on lower-risk investments. Thus, differences in risk can significantly affect the value of an investment.
It is clear. community involvement.Social responsibility: Another issue that deserves consideration is social responsibility: should businesses operate strictly in their stockholder’s best interests. Within the financial management framework. and are questionable whether businesses would incur these costs voluntarily. 4 . The role of Ethics. community and stakeholders. or are firms also partly responsible for the welfare of their employees. An ethics program can produce a number of positive benefits: reduce potential litigation and judgment costs. fair employment practices. to engage in fair hiring practices. Ethics are standards of conduct or moral behavior. firms have ethical responsibility to provide a safe working environment for their employees. especially in the area of environmental protection. Business ethics can be thought of as a company’s attitude and conduct towards its employees. For some firms. build shareholder confidence. commitment and respect of all of the firm’s shareholders. and many consumers prefers to by from socially responsible companies rather than from companies that shun social responsibility. by maintaining and enhancing cash flows and reducing perceived risk (as a result of greater investor confidence) are expected to positively affect the firm’s share price. and illegal payments to foreign governments to obtain businesses. the use of confidential information for personal gain. in recent years numerous forms have been voluntarily taking actions. agency relationships exist between shareholders and managers and between shareholders and creditors. customers and communities in which they operate? Certainly. but it does mean that most significant cost-increasing actions will have to be put on a mandatory rather a voluntary basis to ensure that the burden falls uniformly on all businesses. customers. and delegate some decision-making authority to that agent. The goal of these ethical standards is to motivate businesses and market participants to adhere to both the letter and the spirit of laws and regulations concerned with business and professional practice. A firm’s commitment to business ethics can be measured by the tendency of the firm and its employees to adhere to laws and regulations relating to such factors as product safety and quality. because these actions help sales. and produce products that are safe to consumers.3 AGENCY RELATIONSHIPS An agency relationship can be defined as a contract under which one or more people (the principals) hire another person (the agent) to perform some service on their behalf. 1. Today. socially responsible actions may not even be very costly. Ethical behavior is there viewed as necessary for achievement of the firm’s goal of shareholder wealth maximization. fair marketing and selling practices. that if some forms act in a socially responsible manner while other firms do not. Such actions. The implementation of a proactive ethics program is believed to enhance corporate value. then the socially responsible firms will be at a disadvantage in attracting investors because of the extra costs involved. In spite of the fact that many socially responsible actions must be mandated by the government. however. Does this mean that firms should not exercise socially responsibility? Not at all. the business community in general and the financial community in particular are developing and enforcing ethical standards. bribery. socially responsible actions such as these have costs to businesses. maintain a positive corporate image. because the companies often heavily advertise such actions. to ensure that their production processes are not endangering the environment. However. and gain the loyalty.
job security. In addition to their legal voting rights. Thus management can be viewed as agents of the owners who have hired and given them decision-making authority to manage the firm for the owners benefit. Also. and fringe benefits. however. large shareholders are able to communicate with an exert pressure on management to perform ** Another market force that has in recent years threatened management to perform in the best interest of shareholders is the possibility of a hostile takeover. managers are also concerned with their personal wealth. Agency costs are of several types: (i) Monitoring expenditures to prevent ‘satisficing’ (rather than share price maximizing) behaviors by management. all provided at company expense. most financial managers would agree with the goal of shareholder wealth maximization. These outlays pay for auditors and control procedures that are used to assess and limit managerial behavior to those actions that tend to be in the best interests of the shareholders. because the costs will be borne by the shareholders. because less of this wealth will accrue to him/her. country club memberships. 5 . Hostile takeovers typically occur when the acquirer feels that the target firm is being poorly managed and. RESOLVING THE AGENCY PROBLEM Market forces In recent years. and limousines. any manager who owns less than 100% of the firm is to some degree of the owners. as a result. For example. In practice.Shareholders versus managers. the manager may decide to lead a more relaxed lifestyle and not work as hard to maximize shareholder wealth. We have seen that the goal of the financial manager should be to maximize the wealth of the owners of the firm. The constant threat of a takeover motivates management to act in the best interests of the shareholders. Such concerns may make managers reluctant or unwilling to take mote than moderate risk if they perceive that too much risk may result of such a ‘satisfying’ approach (a compromise between satisfaction and maximization) is a less than a maximum return and a potential loss of wealth to the shareholders. the manager may decide to consume more perquisites. such as posh offices. lifestyle. institutions such as mutual funds. these institutions shareholders have actively used their votes to oust underperforming managers and replace them with more competent managers. insurance companies and pension funds that hold large blocks of a firm’s stock have become more active in management. A hostile takeover is the acquisition of the firm (the target) by another firm or a group of firms (the acquirer) that is not supported by management. Agency costs: Agency costs include all costs borne by shareholders to encourage managers to maximize the firm’s stock price rather than act in their own self-interests. Technically. is undervalued in the market place.the lokihood that managers may place personal goals ahead of corporate goals. To ensure management competence and minimize agency problems. In theory. The potential conflict of interest is referred to as the agency problem.
Opportunity costs resulting from the difficulties that large organizations typically have in responding to new opportunities. Managerial incentives. The current view: Although experts agree that an effective way to motivate management is to tie compensation to performance. Incentive plans tend to tic management compensation to share price. Shareholders and creditors 6 . The most popular incentive plan is the granting of executive stock options to management. the options would be valuable if the market price of the stock rises above the option purchase price. bonus. management understands in advance the formula used to determine the amount of performance shares of cash bonus it can earn during the period. the resulting compensation packages allow firms to compete for and hire the best managers available. The firm’s necessary organizational structure. Although in theory these options should motivate. cash payments tied to the achievement of certain performance goals. Performance shares often uses in these plans. decision hierarchy. and so on. Although these sizeable compensation packages may be justified by significant increases in shareholder wealth. and long-term compensation) that many corporate executives receive. The firms using these plans believe that allowing managers to purchase stock at a fixed price would provide an incentive for them to take actions which would maximize the stock’s price. recent studies have failed to find a strong relationship between CEO compensation packages (without corresponding share price performance) is expected to drive down executive compensation in the future.(ii) (iii) Expenditures to structure the organization in a way that will limit undesirable managerial behavior. return on equity. The objective is to give managers incentives to act in the best interests of the shareholders and to compensate them for such actions. Under performance plans. the execution of many compensation plans has been closely scrutinized in recent years. Compensation plans can be divided into two groups. popular and expensive agency costs incurred by firms. The use of performance plans has grown in popularity in recent years due to their relative independence from market forces. In addition. These options allow managers to purchase stock at stock at some time in the future at a given price. They result from structuring managerial compensation to correspond with share price maximization. growth in EPS. such as appointing outside investors to the board of directors.both individuals and institutions have publicly questioned the appropriateness of the heavy compensation packages (including salary. Stockholders. they are sometimes criticized because positive management performance can be masked in a poor stock market in which share prices in general have declined due to economic and behavioral ‘market forces’ outside of management’s control. and control mechanism may cause profitable opportunities to be forgone because of management’s inability to seize upon them quickly.incentive plans and performance plans. These are the most powerful. These plans compensate managers on the basis of their proven performance measured by earnings per share (EPS). Another form of performance based compensation is cash bonuses. return on assets.
through their managers. because the old debt’s bankruptcy protection will be lessened by the issuance of the new debt. the amount of debt financing it uses) Expectations concerning future capital structure changes These are the factors that determine the riskiness of the firm’s cash flows and hence the safety pf its debt issues. In view of these constraints. the goal of shareholder wealth maximization requires the fair treatment of all parties. because of other constraints and sanctions. creditors will protect themselves against such stockholders actions though restrictions in credit agreements. Creditors lend funds to the firm at rates that are based on: (i) (ii) (iii) (iv) The riskiness of the firm’s existing assets. but if things go sour. Expectations concerning the riskiness of future assets additions The firm’s existing capital structures (i. all of the benefits will go out to the stockholders. or community will ultimately be to the detriment of shareholders. if creditors perceive that managers are trying to take advantage of them in unethical ways. Therefore. Now. so creditors base their required rates of return on expectations regarding these factors. Similarly. they will either refuse to deal further with them or else will require a much higher than normal rate of interest to compensate for the risks of such possible exploitation. agents. acting through management. which in turn will cause the value of the outstanding debt to fall. Thus. cause the firm to take on new projects that have grater risks than were anticipated by the creditors. must act in a manner which is fairly balanced between the interests of these two classes of security holders. stockholders will be gaining at the expense of the firm’s creditors.e. the managers. In both of these situations. Similarly. as such attempts are made. either loose access to the debt markets or are saddled with higher interest rates. or stakeholders. suppliers. Second. suppose the stockholders. first. the bondholders will have to share the losses. firms. both of which can lead to a decrease in the long run value of the stock. which try to deal unfairly with creditors. Can and should stockholders. try to exprotriate wealth from the firm’s creditors? In general.A second agency problem arises because of potential conflicts between stockholders and creditors. If the riskier capital investments turn out to be successful. Thus. OVERVIEW OF FINANCIAL MARKETS AND INSTITUTIONS: THE FINACIAL MARKETS: 7 . the answer is no. the value of the old debt will decrease. customers. as agents of both the creditors and the shareholders. if the firm increases its level of debt effort to boost profits. This increases risk will cause the required rate of return on the firm’s debt to increase. whose economic position is affected by managerial actions. it follows that the goal of maximizing shareholder wealth requires fair play with creditors: stockholders wealth depends on fair play abiding by both the letter and spirit of credit agreements. management actions would expropriate wealth form the firm’s employees. because the creditors get only a fixed return.
real estate. iii. 8 . which in turn sells these same securities to savers. The company sells its stocks or bonds to the investment bank. Money markets are the markets for short term highly liquid debt securities. The following are some of the major types of markets: (i) Physical (real) asset markets are those for tangible assets e. mortgages and other claims on real assets. and facilitates the issuance of securities. Mortgage markets deal with loans on residential. options. without going through any type of financial institution. People and organizations needing money are brought together with those having surplus funds in the financial markets. and industrial real estate. As well as derivative securities e. bonds. commodities. Direct transfers of money and securities. commercial.Financial markets provide a forum in which suppliers of funds and demanders of funds can transact business. education. and on farmland. they gain economies of scale in analyzing the creditworthiness of potential borrowers. (ii) (iii) (iv) (v) FINANCIAL INSTITUTIONS Transfer of capital between savers and those who need capital take place in three different ways: i.g. in processing and collecting loans. futures and others whose values are derived from changes in the prices of other financial assets. financial asset markets deal with securities eg stocks. Examples of intermediaries include: a) Commercial banks ii. The business delivers its securities to savers. The intermediary obtains funds from savers. Capital markets are the markets for long-term debt and corporate stocks. machinery etc. while consumer credit markets involve loans on appliances. who in turn give the firm the money it needs. which occur when a business sells its securities directly to savers. and then uses the money to purchase and then hold a business’s securities. which serves as a ‘middleman. Transfers may also go through an investment bank. issuing its own securities in exchange. Transfers can also be made through a financial intermediary such as a bank or mutual fund. and in pooling risks and thus helping individual savers diversify. Since the intermediaries are generally large.g. Spot markets and future markets are terms that refer to whether the assets are being bought or sold for on the ‘spot delivery’ (within a few days) or for delivery at some future date. Secondary markets are markets in which existing. already outstanding securities are traded among investors. vacation etc. Primary markets are the markets in which corporations raise new capital ie where companies sell new issues of common stock to raise capital.
terminals and electronic network that provide a communications link between dealers and brokers. They also achieve economies of scale. common stock. The two key types of securities exchanges are the organized exchange and over-the-counter exchange. The over-the-counter (OTC) exchange is an intangible market for the purchase and sale of securities not listed by the organized exchanges. Organized securities exchanges are tangible organizations that act as secondary markets where outstanding securities are resold. are linked with purchasers and sellers of securities through telecommunications networks that provide current bid and ask prices of the actively mark-up or profit. known as dealers. These are companies which accept money from savers and then use these funds to buy securities issued by businesses or governmental units. thus.b) Investment banks c) Insurance companies d) SACCOS e) Pension funds which are retirement government agencies for their workers. They also create efficient markets that allocate funds to their most productive uses. EFFICIENT MARKETS 9 . preferred stock. f) plans by corporations or Mutual funds. This is especially true for securities that are actively traded on major exchanges. They pool funds and thus reduce risks through diversification. The OTC traders. create continuous liquid markets in which firms can obtain needed financing. managing portfolios. where the competition among wealth-maximizing investors determines and publicizes prices that are believed to be close to their true value. the several brokers who act as agents in bringing these dealers together with investors. has specifically designated members. which lower the costs of analyzing securities. although bonds. and the computers. Securities exchanges are commonly called stock markets. and a variety of other investment vehicles are all traded on these exchanges. and has elected governing body-its board of governors. Each of the larger ones occupies its own building. Securities exchanges. SECURITIES EXCCHANGES: Securities exchange provide the market place in which firms can raise funds through the sale of new securities and purchasers of securities can maintain liquidity by being able to resell them when necessary. and buying and selling securities. The OTC market thus included the relatively few dealers who hold inventories of OTC securities and are said to ‘make a market’ in these securities. The competitive market created by the major securities exchanges provided a forum in which share price is continuously adjusted to changing demand and supply conditions.
And in fact. Rather than 10 . Many novice investors are surprised to learn that a tremendous amount of evidence supports the efficient market hypothesis. and well-educated investors seeking under and over-valued securities to buy and sell. The efficient market is defined as “A market having a large number of rational profit maximisers. In fact. the more efficient a market should be. the vast majority of studies of technical theories have found the strategies to be completely useless in predicting securities prices. efficient markets depend on market participants who believe the market is inefficient and trade securities in an attempt to outperform the market. Most individuals that buy and sell securities (stocks in particular).An efficient capital market is one in which security prices adjust rapidly to the arrival of new information and therefore. All markets are efficient to a certain extent. then the market would not be efficient because no one would analyze securities. However. actively competing with each trying to predict future market values of individual securities. The debate about efficient markets has resulted in hundreds and thousands of empirical studies attempting to determine whether specific markets are in fact "efficient" and if so to what degree. once an anomaly is discovered. numerous anomalies that have been documented via back-testing have subsequently disappeared or proven to be impossible to exploit because of transactions costs. some more so than others. the current prices of securities reflect all information about the security. Early tests of the EMH focused on technical analysis and it is chartists whose very existence seems most challenged by the EMH. But if markets are efficient and current prices fully reflect all information. The Efficient Market Hypothesis states that at any given time. Theoretically though. security prices fully reflect all available information. In reality. investors attempting to profit by exploiting the inefficiency should result its disappearance. markets are neither perfectly efficient nor completely inefficient. researchers have documented some technical anomalies that may offer some hope for technicians. then buying and selling securities in an attempt to outperform the market will effectively be a game of chance rather than skill Securities markets are flooded with thousands of intelligent. well-paid. The paradox of efficient markets is that if every investor believed a market was efficient. although transactions costs may reduce or eliminate any advantage. The search for anomalies is effectively the search for systems or patterns that can be used to outperform passive and/or buy-and-hold strategies. while securities that they are selling are worth less than the selling price. The implications of the efficient market hypothesis are truly profound. and where important current information is almost freely available to all participants”. In effect. The more participants and the faster the dissemination of information. do so under the assumption that the securities they are buying are worth more than the price that they are paying. Researchers have also uncovered numerous other stock market anomalies that seem to contradict the efficient market hypothesis.
" The Value of an Efficient Market It is important that stock/share markets are efficient for at least three reasons: To encourage share buying – accurate pricing is required if individuals are going to be encouraged to invest in private enterprise. Once prices adjust. and thus attract more of society’s savings for use within its business.being an issue of black or white. In other words. In markets with substantial impairments of efficiency. 2. Government bond markets for instance. are considered to be extremely efficient. To give correct signals to company managers – Since the maximization of shareholder wealth can be represented by the share price in an efficient market. and no further study of old information will yield any more valuable intelligence. In other words. while small capitalization stocks and international stocks are considered by some to be less efficient. market efficiency is more a matter of shades of gray. If a poorly run company in a declining industry has highly valued shares because the stock market is not pricing correctly then this firm will be able to issue new shares. It is important that managers receive feedback on their decisions from the share market so that they are encouraged to pursue shareholder wealth strategies. more knowledgeable investors can strive to outperform less knowledgeable ones. Market efficiency is a description of how prices in competitive markets respond to new information. If shares are incorrectly priced many savers will refuse to invest because of a fear that when they come to sell the price may be perverse and may not represent the fundamental attractions of the firm. Investors need to know they are paying a fair price and that they will be able to sell at a fair price – that the market is a “fair game”. The "Weak" form asserts that all past market prices and data are fully reflected in securities prices. Real estate and venture capital. The "Semistrong" form asserts that all publicly available information is fully reflected in securities prices. In implementing a shareholder wealth-enhancing decision the manager will need to be assured that the implication of the decision is accurately signalled to shareholders and to management through a rise in the share price. This will seriously reduce the availability of funds to companies and inhibit growth. No amount of gnawing on the bone will yield any more meat. Most researchers consider large capitalization stocks to also be very efficient. 3. technical analysis is of no use. To help allocate resources – allocation efficiency requires both operating efficiency and pricing efficiency. In other words. Similarly. 11 . sound financial decision-making relies on the correct pricing of the company’s shares. The "Strong" form asserts that all information is fully reflected in securities prices. even insider information is of no use. which don't have fluid and continuous markets. leaving only the worthless bone behind. Very soon the meat is gone. are considered to be less efficient because different participants may have varying amounts and quality of information.. causing prices to change. all that is left of the information is the worthless bone. when new information reaches a competitive market there is much turmoil as investors buy and sell securities in response to the news. and the water returns to normal. fundamental analysis is of no use. This would be wrong for society as the funds would be better used elsewhere." There are three forms of the efficient market hypothesis 1.
In the most basic sense.CHAPTER 2. More formally. Assets having greater chances of loss are viewed as more risky than those with lesser chances of loss.1 INTRODUCTION To maximize share price. risk is the chance of financial loss.RISK AND RETURN 2. 12 . the term risk is used interchangeably with uncertainty to refer to the variability of returns associated with a given asset. Each financial decision presents certain risk and return characteristics. and the unique combination of these characteristics has an impact on share price. the financial manager must learn to assess two key determinants: risk and return.
0 19.05 12.2 PROBABILITY DISTRIBUTIONS: In general.0 14.84% 0.50 0.5 8. risk refers to the profitability that some unfavourable event will occur.3% 19. these managers require higher expected returns to compensate them for taking greater risk. the return does not change as risk increases. The three basic risk preference behaviours are: • For the risk – indifferent manager. with a probability of occurrence attached to each outcome.0 9. the required return increase in risk because they shy away from risk. • For the risk – averse manager. because they enjoy risk.39% 0.20 4. • For the risk – seeking manager. the expected values are expected rates of return.The return is the total gain or loss experienced on an investment over a given period of time. RETURN ESTIMATES ON THREE ALTERNATIVE INVESTMENTS State of the probability of economy Occurrence project 1 project 2 project 3 Deep recession Mild recession Average economy Mild boom Strong boom 0.0 26.0 12. Theoretically.0 10.0 15. A probability distribution Is defined as a set of possible outcomes.0% 6.0 11. 2.09 -3. no change in return would be required for the increase in risk clearly. required return decreases for an increase in risk. The weights are the probabilities.40 Expected Rate of Return Variance Standard deviation Coefficient of variation 13 .31 4. In essence. RISK PREFERENCE Feelings about risk differ among managers and firms. this attitude is nonsensical in almost any business context.2% 0.20 0.0% 9.71% 0.0 8. If we multiply each possible outcome by its probability of occurrence and then sum these products. these managers are willing to give up some return to take more risk.82% 0.0% 10. However. Since the outcomes are rates of return. expressed as a percentage of the rate of return earned on any asset over period t.20 0.0% 23.43 -2. is commonly defined as: Kt = Pt – Pt-1 + Ct Pt-1 Where K is the actual or expected rate of return during period t Pt Is the price (value) of an asset at time t Pt-1 Is the price of an asset at time t-1 Ct Is the cash flow received from the asset investment in the time period t1 to t.05 0. It is commonly measured as the change in value plus any cash distributions during the period. and the weighted average is defined as the expected value.0 9. we have a weighted average of outcomes. such behaviour would not be likely to benefit them.0 12.
ASSET HELD IN ISOLATION VARIANCE AND STANDARD DEVIATION Variance is an a measure of the dispersion of a distribution around its expected value. is computed as an alternative measure of risk. project 3’s required rate of return is computed as follows: E(R) = = R1(P1)+R2(P2)+R3(P3)+R4(P4) = -2. CV=Standard deviation = π Expected return E(R) The CV shows the risk per unit of return. is a measure of relative risk that is useful in comparing the risk of assets with different expected returns. and provides a more meaningful basis for comparison when the expected returns on two alternatives are not the same.0%(0. As an example.50(12-12)2 +0.82% COEFFICIENT OF VARIATION The coefficient of variation.50)+155(0.As an example. n Standard deviation = √Variance= √π2 = π= √ΣPi (Ri-E(r) i=1 The standard deviation for the other projects can be similarly computed and are shown in the table above. CV.05)+9. the variance for project 3 is computed as follows: π2 = Pi (Ri-E(R)]2 =0. The larger the variance.2 The variance for the other two investments can be similarly calculated and are shown in the above table Since it is difficult to attach meaning to a squared percentage. The CV of project 3 is calculated as: CV= 4.05) = 12. 14 .0-12)2 +0. π=√232 = 4.0% The CV for the other two investments can be similarly computed and are shown in the table above. the square root of the variance.82% = 0.40 12. the greater the dispersion.20(15-12)2 + 0.05(-2.0%(0.20)+12.0% The expected rates of return on the other two investment alternatives can be similarly calculated and are shown in the table above.05(26-12)2 = 23. standard deviation.20)+26%(0. the variance is the sum of the squared deviations weighted by each deviations probability of occurrence. Variance is computed by the formula Variance =π 2 (Ri-E(R)]2 In words.0(0.
THE MEAN –VARIANCE CRITERION: The mean –variance criterion is one possible decision rule that can be used to choose among possible investment alternatives.e. project 3 dominates 2 as an investment. The decision maker is risk averse. However. The mean – variance criterion is based on a comparison of expected returns and standard deviations and can be stated symbolically as follows: Alternative X is preferred to alternative Y if and only if either E(R)X > E(R)Y AND SD(X)< SD(Y) E(R)= Expected Return OR E(R)>E(R)Y AND SD(X)SD(Y) <SD = Standard Deviation Applying this criterion to the three investments above. E(Rp) = Σ Wi Ri i=1 15 . a loss. EXPECTED RETURN FOR A PORTFOLIO The expected rate for a portfolio is simply the weighted average of the expected rates of Return for the individual investments in the portfolio. For example. along with other more tangible factors. so managers often substitute their own preferences. This criteria is based on two assumptions: 1. albeit low. project 3 is clearly preferred to 2 because it has a higher outcome for each possible state of economy. the financial manager is unwilling to accept any chance of a loss. regardless of which state of economy occurs we would always get a higher rate of return from project 3 than from 2 i. The distributions being evaluated are approximately normal distribution. The first assumption is certainly true for the average investor: the second condition generally holds well for securities such as stocks and bonds. However. For example. 2. application of the mean – variance criterion to non – normal distributions may result in an anomaly called the mean variance paradox. but it does not always hold for physical asset investments.e. But. Thus. then he/she may well reject what seems on paper to be the best alternative. and hence would reject that alternative. Is he/ she equally confident of the accuracy of the probability distributions of all three alternatives or is there reason to be more confident in one alternative or another? If the decision maker “doesn’t trust the numbers”. of rate of return of – 20% i. financial managers generally cannot measure stockholders’ risk aversion. the choice should be made on the basis of risk aversion of the owners of the firm. What about a choice between projects 1 and 3? Theoretically. the financial manager must consider his or her confidence in the estimated rates of return. The weights are the proportions of the total value of the investment. project 3 has a probability. because the alternatives with the higher variances also have higher expected rates of return. A portfolio is a combination or collection of assets or securities. we have concluded that neither project 2 nor 3 is preferred under the mean variance criterion. we find that no one alternative is necessarily preferred to any other alternative. a situation in which the mean variance criterion leads to incorrect decisions. Also. Perhaps.
variance indicates that there is no relationship between the variables. the variables are independent.Where W1 = is the percent of the portfolio invested in asset I Ri – is the expected rate of return for asset i 2.e.B)= √ABπAπB πAπB The Terry Corporation is considering three possible capital projects for next year.25 10% 9% 14% 0. co-variance and correlation. meaning the returns for the two stocks move together in a completely linear manner. Standard deviation and co-efficient of variation. i. CO. b) Apply the Mean – Variance criterion to the alternative projects.50 14 13 12 0.RA) (RBi-RB) I=1 √AB = Cov (A.VARIANCE of Returns: Co-Variance is a measure of the degree to which two variables “move together” over time.25 16 18 10 REQUIRED a) Compute each project’s Expected rate of return. A negative Co-variance indicates that the Rates of Return for two investments tend to move in different directions during specified time intervals over time. variance. In portfolio analysis. CORRELATION CO-EFFICIENT: Standardizing the Co-variance by the individual Standard deviations yields the correlation co-efficient (√AB) which varies in the ranger -1 to +1. Each project has a 1 – year life. A zero Co.3 RISK OF A PORTFOLIO Two basic concepts in statistics.B). A positive Co-variance means that the rates of return for two investments tend to move in the same directions during the same time period. Do any of the projects dominate any of the others according to this criterion? 16 . and project returns depend on next year’s state of the economy. must be understood in order to understand portfolio risk. the other stock’s rate of return will be below its mean by the comparable amount. The estimated rates of return are shown in the following table State of the Economy Recession Average Boom Probability of Rates of return if state occurs occurring A B C 0. Thus Cov (A. A value of +1 indicates a perfect positive correlation. Cov (AB)= Σ Pi(RAi . we are usually concerned with co-Variance of rates of Return. A value of -1 means that there is a perfect negative correlation between the two return series such that when one stocks rate of return is above the mean .
σp would decline to somewhere in the vicinity of 15 percent.45 5.16 Calculate the average rate of return for each stock during the period 1984 through 1988.00% 19. Year 1984 Portfolio AB’s Return.67 35.45% + 5.09 1.9 or to -0.82% + 28.55 44.24% 23. The average rate of return for each stock is calculated by simply averaging the returns over the five-year period.20 21. The average return for each stock is 16. would you guess that the correlation coefficient between returns on the two stocks is closer to 0.1 a. what is the most accurate statement of what would happen to σp? σp would remain constant.62% 17 .24% + 23.20 percent. What would have been the realized rate of return on the portfolio in each year from 1984 through 1988? What would have been the average return on the portfolio during this period? Now calculate the standard deviation of returns for each stock and for the portfolio.9? If you added more stocks at random to the portfolio.30%)/5 = 16. kAB -8. On the basis of the extent to which the portfolio has a lower risk than the stocks held individually. σp would decline to zero if enough stocks were included SOLUTION ST. kA Stock B’s Returns.QUESTIONS AND ANSWERS ST-1 Stocks A and B has the following historical returns: Year 1884 1985 1986 1987 1988 Stock A’s Returns. calculated for Stock A as follows: kA vg = (-12.67% + 35.82 28. kB -12.30 -5.20% The realized rate of return on a portfolio made up of Stock A and Stock B would be calculated by finding the average return in each year as kA (% of Stock A) + kB (% of Stock B) and then averaging these yearly returns. Assume that someone held a portfolio consisting of 50 percent of Stock A and 50 percent of Stock B.
35 4 = 19.73 kA vg = 16.3 percent: σA = √(-12.3 18.3 to 18.77 3.51 24. In fact. were equal to zero and a large number of stocks were added to the portfolio. The standard deviation of returns is estimated.000) ($100.000 20.9. or if the proper proportions were held in a two-stock portfolio with r = -1.9 percent).2)2 + (23.000 40. the risk reduction would be much larger. using Equation 4-3a.9 c.61 39.000 30. d. the most likely value of the correlation coefficient is 0.000 40.24 – 16. r. as follows : Estimated σ = S = √Σ(kt – kAvg)2 N–1 (4-3a) For Stock A.000 18 .20% b. 1985 1986 1987 1988 ST 2 The staff of Scampini Manufacturing has estimated the following net cash flows and probabilities for a new manufacturing process: Year 0 1 2 Net Cash Flow_______________ P = 0.2)2 + … + (28.3 19.3% The standard deviation of returns for Stock B and for the portfolio are similarly determined.30 – 16.2 P = 0.2)2 5–1 = √1. and they are as follows: Stock A Stock B Portfolio AB Standard deviation 19. If the correlation coefficient were -0.489.6 P = 0.0.9.7.67 – 16. σp would decline to zero only if the correlation coefficient. which is most unlikely. σp would remain constant only if the correlation coefficient were +1.0. see Figure 4.93.000) 20. σp would decline to somewhere in the vicinity of 15 percent. the correlation coefficient between Stocks A and B is 0. the estimated σ is 19.000) ($100. If more randomly selected stocks were added to the portfolio. Since the risk reduction from diversification is small (σAB falls only from 19.2___ ($100.000 30.21.
if the coefficient of variation is less than 0.000) = $30.10)3 + $30. and Line 5* contains the estimated salvage values.000 + $30.000 (1.8 to 1. 1 percentage point is deducted from the cost of capital. a. case.000 40. Find the expected NPV. 2 percentage points are added to the firm’s cost of capital.000 (1. Scampini’s cost of capital for an average risk project is 10 percent. Lines 1 through 5 give operating cash flows.000 40. the cash flow values from the cash flow column farthest on the left are used to calculate NPV: NPV = $100.000 + $30. (2) the most likely.000 20.000 + $20.6.000 + $30. (Hint: Use expected values for the net cash flow in each year. What is the probability of occurrence of the worst case if the cash flows are perfectly dependent (perfectly positively correlated) over time? If they are independent over time? c.000 40.2(-$100.10)4 (1.000 0 30.000 30.000 2 $30. Find the project’s expected NPV.2(-$100.6($20. determine the NPV based on the expected cash flows: NPV = -$100.2($40.000 + $18.000 + $20.000) + 0.000 Next. If the coefficient of variation of a project being evaluated is greater than 1.10)1 (1. that is.000) = ($100. What is the project’s cost of capital? Should Scampini accept or reject the project? ST-2 a.000 30.2.0.000) = $18.000 + $30.3 4 5 5* 20.6($30.000 5 $30.10)3 19 .2($30.000) + 0. its standard deviation.000 + $20.000 (1.000 5* 0. respectively.000) + 0.000 30.900 b.000 Line 0 gives the cost of the process. These cases are represented by each of the columns in the table.000 20. and (3) the best case.2. First. or base.000) + 0. Similarly. Find the best case and worst case NPVs. Assume that the project has average risk. For the worst case.10)2 (1. with probabilities of 0. d.000) + 0.2($20. and its coefficient of variation. there are only three possible cash flow streams over time: (1) the worst case.0.000 4 $30. find the expected cash flows: Year Expected Cash Flow 0 0.10)5 = $24. and 0.) b.000) 1 0. The coefficient of variation of Scampini’s average project is in the range 0.000 20.000 3 $30. 0.10)1 (1. Assume that all the cash flows are perfectly positively correlated.6(-$100.2($0) + 0.10)2 (1.8.
Since the project’s coefficient of variation is 1. As is generally the case.25 = 0.261. the probability of the worst case occurring is the probability of getting the $20.2(-$24.142 0.20.6 26.032% c. and therefore the project should be accepted.2(0. but using a 12 percent discount rate. for the best case.357. or average. high.904: σ2 NPV = 0.10)4 (1. If the cash flows are independent. and the probability of getting all low cash flows will be: 0.2(-$4.10)5 = $24. 20 .900)2 + 0.000 + $0 (1.2)(0.142.142) + 0. then the low cash flow in the first year will mean a low cash flow in every year.900)2 = $894. the NPV is as follows: P NPV 0. the cash flow in each year can be low.2 70. The base case NPV is found using the most likely cash flows and is equal to $26.900)2 + 0. the project is riskier than average. use the values from the column farthest on the right.$24. The project now should be evaluated by finding the NPV of the expected cash flows.184 similarly.261. If the cash flows are perfectly dependent.900.904/$24.2(70. d.20.184) + 0. The risk-adjusted NPV is $18.184) 0. CV.000 + $20.6($26.2($70.259.900 because the Year 5 cash flows are not symmetric. Thus.6($26. the expected NPV is the same as the NPV of the expected cash flows found in part a.142 .904.00032 = 0. The coefficient of variation.2)(0.+ $20.259 . This value differs from the expected NPV of $24.900 = 1.2)(0.$24.126 σ2 NPV = √$894.126 = $29.2) = 0. and hence the project’s risk-adjusted cost of capital is 10% + 2% = 12%. Under these conditions. The standard deviation is $29.184 . the expected NPV is 0. Here the NPV is $70.2 ($24.$24. as in Part a. or 20 percent.000 net cash flow in Year 1. is $29.259 Thus.259) = $24.
Lending is only worthwhile if the return is at least equal to that which can be obtained from alternative opportunities in the same risk class.CHAPTER 3 . it would be good to know what the present value of the future investment is. you must get some compensation. Decisions on investment.CAPITAL BUDGETING 3. FV consists of: i) the original sum of money invested. The general formula for computing Future Value is as follows: FVn = Vo (l + r)n where Vo is the initial sum invested r is the interest rate n is the number of periods for which the investment is to receive interest. have to be based on the returns which that investment will make. The interest rate received by the lender is made up of: i) The time value of money: the receipt of money is preferred sooner rather than later. the greater the potential for increasing wealth. hence the return must be commensurate with the risk being undertaken. Borrowing is only worthwhile if the return on the loan exceeds the cost of the borrowed funds. which take time to mature. Thus we can compute the future value of what Vo will accumulate to in n years when it is compounded annually at the same rate of r by using the above formula. it is unwise to invest in it now. The time value of money Recall that the interaction of lenders with borrowers sets an equilibrium rate of interest. This uncertainty requires a premium as a hedge against the risk. ii) The risk of the capital sum not being repaid. It could be much more profitable putting the planned investment money in the bank and earning interest.INVESTMENT DECISIONS . and ii) the return in the form of interest. or how long it will take to mature (give returns). he/she will be worse off when the loan is repaid than at the time of lending the money. if the investment is unprofitable in the long run. If the lender receives no compensation. Often. to forego the use of money. a) Future values/compound interest Future value (FV) is the value in dollars at some point in the future of one or more investments.1 Future values/compound interest i) What is the future value of $10 invested at 10% at the end of 1 year? ii) What is the future value of $10 invested at 10% at the end of 5 years? We can derive the Present Value (PV) by using the formula: FVn = Vo (I + r)n By denoting Vo by PV we obtain: FVn = PV (I + r)n by dividing both sides of the formula by (I + r)n we derive: 21 . Money can be used to earn more money. The earlier the money is received. The lender must be compensated for the declining spending/purchasing power of money. or investing in an alternative project. Unless the project is for social reasons only. Thus. iii) Inflation: money may lose its purchasing power over time.1 INTRODUCTION Capital budgeting is vital in marketing decisions. Exercise 6.
c) Annuities N.B.Rationale for the formula: As you will see from the following exercise. an individual (or firm) should never offer (invest) more than $10.3 Net present value A firm intends to invest $1. Introduce students to annuity tables from any recognised published source.B.2 Present value i) What is the present value of $11. second and third years respectively. given the alternative of earning 10% on his money.10 at the end of 5 years? b) Net present value (NPV) The NPV method is used for evaluating the desirability of investments or projects. Exercise 6.000 in a project that generated net receipts of $800. $900 and $600 in the first. At this point the tutor should introduce the net present value tables from any recognised published source. 22 . The discount factor r can be calculated using: Examples: N. where: Ct = the net cash receipt at the end of year t Io = the initial investment outlay r = the discount rate/the required minimum rate of return on investment n = the project/investment's duration in years. Should the firm go ahead with the project? Attempt the calculation without reference to net present value tables first. Do that now.00 to obtain $11.00 at the end of one year? ii) What is the PV of $16.00 with certainty at the end of the year. Decision rule: If NPV is positive (+): accept the project If NPV is negative(-): reject the project NExercise 6.
9091 + 0.72 d) Perpetuities A perpetuity is an annuity with an infinite life.9091) + $400(0.00 = $194.72 Alternatively.7513) = $400 x 2.72 .A set of cash flows that are equal in each and every period is called an annuity.56 + $300.8264) + $400(0.10) = $400 (0. PV of an annuity = $400 (PVFAt.72 NPV = $994.8264 + 0.7513) = $363.$800.72 NPV = $994. It is an equal sum of money to be paid in each period forever.i) (3.$800. Example: Year Cash Flow ($) 0 1 2 3 -800 400 400 400 PV = $400(0.00 = $194.4868 = $994.52 = $994.64 + $330.0.72 . where: C is the sum to be received per period r is the discount rate or interest rate 23 .
where r = IRR IRR of an annuity: where: 24 . • The IRR is the break-even discount rate. • The IRR is found by trial and error.666. What price (PV) should you be willing to pay for this income? = $4.10 = $7.Example: You are promised a perpetuity of $700 per year at a rate of interest of 15% per annum. • The IRR is the discount rate at which the NPV for a project equals zero. This rate means that the present value of the cash inflows for the project would equal the present value of its outflows. How much would this income be worth when discounted at 15%? Solution: Subtract the growth rate from the discount rate and treat the first period's cash flow as a perpetuity.67 A perpetuity with growth: Suppose that the $700 annual income most recently received is expected to grow by a rate G of 5% per year (compounded) forever. = $735/0.350 e) The internal rate of return (IRR) Refer students to the tables in any recognised published source.
project is worthwhile.= Cn).. it is profitable to undertake. So.000 6. i.000 a) Try 20% b) Try 27% c) Try 29% Net present value vs internal rate of return Independent vs dependent projects NPV and IRR methods are closely related because: i) both are time-adjusted measures of profitability. and ii) their mathematical formulas are almost identical.. Example: What is the IRR of an equal annual income of $20 per annum which accrues for 7 years and costs $120? =6 From the tables = 4% Economic rationale for IRR: If IRR exceeds cost of capital.4 Exercise 6..e.r) is the discount factor Io is the initial outlay C is the uniform annual receipt (C1 = C2 =. 25 . which method leads to an optimal decision: IRR or NPV? a) NPV vs IRR: Independent projects Independent project: Selecting one project does not preclude the choosing of the other.000 8.Q (n. Now attempt exercise 6.4 Internal rate of return Find the IRR of this project for a firm with a 20% cost of capital: YEAR CASH FLOW $ 0 1 2 -10.
Figure 6. NPV is positive and IRR > k1: accept project. in this case both NPV and IRR lead to the same accept/reject decisions. NPV is negative and IRR < k2: reject the project. i.1 NPV vs IRR Independent projects If cash flows are discounted at k1. Since the numerators Ct are identical and positive in both instances: • implicitly/intuitively R must be greater than k (R > k). • Hence. the NPV must be positive. If cash flows are discounted at k2. Mathematical proof: for a project to be acceptable. Similarly for the same project to be acceptable: where R is the IRR. IRR and NPV lead to the same decision in this case. b) NPV vs IRR: Dependent projects 26 .With conventional cash flows (-|+|+) no conflict in decision arises. • If NPV = 0 then R = k: the company is indifferent to such a project.e.
2-1 27 .000 Assume k = 10%.500 Project B -15.363.500 18.000 = $15. The following information is available: Initial Investment Outlay Net Inflow at the Year End Project A -9.500 (1 +RA) = 1.NPV clashes with IRR where mutually exclusive projects exist. Example: Agritex is considering building either a one-storey (Project A) or five-storey (Project B) block of offices on a prime site. which project should Agritex undertake? = $954.000 11.21-1 therefore IRRA = 21% IRRB: $18.500 = $9.64 Both projects are of one-year duration: IRRA: $11.55 = $1.000(1 + RB) = 1.
therefore project B is preferred to project A. See figure 6. Beyond the point ko: project A is superior to project B. Figure 6. Example: 28 .2 NPV vs IRR: Dependent projects Up to a discount rate of ko: project B is superior to project A. therefore project A is preferred to project B The two methods do not rank the projects the same.55): Agritex should choose Project B. both projects are acceptable because: NPVA and NPVB are both positive IRRA > k AND IRRB > k Which project is a "better option" for Agritex? If we use the NPV method: NPVB ($1. If we use the IRR method: IRRA (21%) > IRRB (20%): Agritex should choose Project A. Differences in the scale of investment NPV and IRR may give conflicting decisions where projects differ in their scale of investment.2.64) > NPVA ($954.363.therefore IRRB = 20% Decision: Assuming that k = 10%.
NPVA = $1.00 = $1.500 x 2.500 1.000 7.3. as: NPV prefers B to A IRR prefers A to B NPV IRR Project A $ 3.500 1.67. 29 .730.Years 0 1 2 3 Project A -2.500.409.000 = $3.50.000 7.00.487 = $17.730.50 36% Project B $17.500 x PVFA at 10% for 3 years = $1.000 x 2.000 x PVFA at 10% for 3 years = $7. IRRA = = 1.230.400.50 .00 21% See figure 6. Therefore IRRA = 36% (from the tables) IRRB = = 2.0 Therefore IRRB = 21% Decision: Conflicting. NPVB == $7.000 Assume k= 10%.487 = $3.500 Project B -14.500 1.$2.409 .$14.000 7.
A) = B d) Choosing the bigger project B means choosing the smaller project A plus an additional outlay of $11. for a discount rate below 20% ii) the NPV is superior to the IRR a) Use the incremental cash flow approach.500 5.500 5. 0 Project B Project A 1 2 3 .000 7.500 30 .000 7.500 5.500 1. "B minus A" approach b) Choosing project B is tantamount to choosing a hypothetical project "B minus A".500 "B minus A" .2.3 Scale of investments To show why: i) the NPV prefers B. the larger project.000 .11.500 1.500 IRR"B Minus A" = 2.000 7.Figure 6.500 1.09 = 20% c) Choosing B is equivalent to: A + (B .14.
NPVB = 0. Note that initial outlay Io is 0 Project A Project B 1 the same. most companies set their goals in absolute terms and not in % terms.of which $5. • This justifies the use of NPV criterion. 2 . Advantage of NPV: • It ensures that the firm reaches an optimal scale of investment. g) But.5 million.A") the company should accept project A.2 THE TIMING OF THE CASH FLOW The IRR may give conflicting decisions where the timing of cash flows varies between the 2 projects. f) Given k of 10%. e) The IRR"B minus A" on the incremental cash flow is 20%.e.100 100 31. Disadvantage of IRR: • It expresses the return in a percentage form rather than in terms of absolute dollar returns. i. target sales figure of $2.g. therefore must be accepted. this is a profitable opportunity. h) At the point of intersection.80 88.25 . indifferent to projects A and B. the IRR will prefer 500% of $1 to 20% return on $100.15 "A minus B" 0 Assume k = 10% NPV IRR 31 . i) If k = 20% (IRR of "B . e. NPVA = NPVB or NPVA .g. However.500 will be realised each year for the next 3 years. then reject project.100 20 125. 3. e. if k were greater than the IRR (20%) on the incremental CF.00 .
4 Timing of the cash flow The horizon problem NPV and IRR rankings are contradictory..6 IRR prefers B to A even though both projects have identical initial outlays. See figure 6.4. 0 1 2 3 4 Project A -100 120 .Project B -100 . that is B + (A . Figure 3.0% 16.7 25..174 Assume k = 10% NPV IRR 32 .3 20.B) = A. Project A earns $120 at the end of the first year while project B earns $174 at the end of the fourth year. So. the decision is to accept A.Project A Project B 17.9% "A minus B" 0.0% 10.
Io = 0 PV = Io Dividing both sides by Io we get: PI of 1.500. usually expressed in years'.5 33 . we have: NPV = PV . The payback period (PP) The CIMA defines payback as 'the time it takes the cash inflows from a capital investment project to equal the cash outflows.PI This is a variant of the NPV method.Project A 9 Project B 19 Decision: 20% 15% NPV prefers B to A IRR prefers A to B.2 means that the project's profitability is 20%.500 Decision: Choose option B because it maximises the firm's profitability by $1. accept the project PI < 1.0 1. Disadvantage of PI: Like IRR it is a percentage and therefore ignores the scale of investment. Example: PV of CF Project A 100 Project B 1. Decision rule: PI > 1.000 1. The profitability index . reject the project If NPV = 0. When deciding between two or more competing Io 50 PI 2.
$7.000 250.projects.000. the usual decision is to accept the one with the shortest payback.000 .000 2. and so it would reject a capital project unless its payback period were less than a certain number of years.500 = 2.000 250.000 250. By this. Example 1: Years 0 1 2 3 4 5 Project A 1.000 + $2.000 For a project with equal annual receipts: = 4 years Example 2: Years 0 1 2 3 4 Project B .000 Payback period lies between year 2 and year 3.500 4. the cash flows after the end of payback period and therefore the total project return.000 5. Sum of money recovered by the end of the second year = $7.000 250.10. ($5.625 years Disadvantages of the payback method: • It ignores the timing of cash flows within the payback period. Payback is often used as a "first screening method". we mean that when a capital investment project is being considered. the first question to ask is: 'How long will it take to pay back its cost?' The company might have a target payback.e. 34 .500) Sum of money to be recovered by end of 3rd year = $10.500 = $2. i.000 250.000 1.500.
Example: A project has an initial outlay of $1 million and generates net receipts of $250. If it exceeds a target rate of return. Advantages of the payback method: • Payback can be important: long payback means capital tied up and high investment risk. the project will be undertaken. The method also has the advantage that it involves a quick. The accounting rate of return .(ARR) The ARR method (also called the return on capital employed (ROCE) or the return on investment (ROI) method) of appraising a capital project is to estimate the accounting rate of return that the project should yield. to get a return of $1. Note that net annual profit excludes depreciation.000 per year: = 15% 35 .30 in a year's time. An investor who has $1 today can either consume it immediately or alternatively can invest it at the prevailing interest rate. • It is unable to distinguish between projects with the same payback period.000 for 10 years. This means that it does not take into account the fact that $1 today is worth more than $1 in one year's time. simple calculation and an easily understood concept. Assuming straight-line depreciation of $100. • It may lead to excessive investment in short-term projects.• It ignores the time value of money. say 30%.
000. The mover’s basic price is $ 50. to evaluate the proposed acquisition of new earthmover.000 to modify it for special use by Ellis Construction. and it will require an increase in net working capital (spare parts inventory) of 36 . • It implicitly assumes stable cash receipts over time. • It takes no account of the length of the project. The payback and ARR methods in practice Despite the limitations of the payback method. • It provides an important summary method: how quickly will the initial investment be recouped? QUESTIONS AND ANSWERS – INVESTMENT DECESIONS ST-1 You have been asked by the president of Ellis Construction Company. There are a number of reasons for this: • It is a particularly useful approach for ranking projects where a firm faces liquidity constraints and requires fast repayment of investments. • It is based on accounting profits and not cash flows.000. and it will cost another $10. It will be sold after 3 years for $ 20. Accounting profits are subject to a number of different accounting treatments. headquartered in Toledo.= 30% Disadvantages: • It does not take account of the timing of the profits from an investment. • It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment. it is the method most widely used in practice. • The method is often used in conjunction with NPV or IRR method and acts as a first screening device to identify projects which are worthy of further investigation. Assume that the mover falls into the ACRS 3-year class. • it is easily understood by all levels of management. • it ignores the time value of money. • It is appropriate in situations where risky investments are made in uncertain markets that are subject to fast design and product changes or where future cash flows are particularly difficult to predict.
600 .000 10. Thus.000. Should it replace the old machine? SOLUTIONS – INVESTMENT DECESIONS St-1a.$2. but accounts payable would simultaneously increase by $ 500.600 c.000 3.000) Modification (10. Its current book value is $ 2.500 per year.000 per year in before tax operating costs. the new machine’s much greater efficiciency would still cause operating expenses to decline by $ 1. the annual depreciation expense is ($ 2. what are the Year 0 cash flow?) b) What are the operating cash flows in Years 1. 2. and its cost of capital is 15 percent.000) b. This machine falls into the ACRS 5. depreciation b 19. and under current law it does not qualify for investment tax credit.000 12. Elli’s marginal federal–plus–state tax rate is 40 percent.000. an estimated useful life of 6 years. so sales would raise by $ 1.920 3.800 $ 15.000 27.Year class. and an estimated salvage value of $ 800.Project Cash Flows: 37 .000 at this time. Dauten is offered a replacement machine has a cost of $ 8. mainly labor. The earthmover purchase will have no effect on revenues. should the earthmover be purchased? ST-2 The Dauten Toy Corporation currently uses an injection moulding machine that was purchased 2 years ago.000) Total investment ($62.000) Cnange in net working capital (2. The new machine would require that inventories be increased by $ 2. After-tax cost savings a $ 12. even so. depreciation tax savings c 7.000 per year. Dauten’s marginal federal-plus-state tax rate is 40 percent. End–of. The replacement machine would permit an output expansion.600.800 $ $ 22.$ 500)/6 = $ 350 per year. This machine is being depreciated on a straight line basis toward a $ 500 salvage value. and it ha 6 years of remaining life.000 2. 3? c) What are the additional (none operating) cash flows in Year 3? d) If the project’s cost of capital is 10 percent. estimated investment requirements: Price (50. Operating Cash flows: Year 1 Year 3 Year 2 1.800 9. a) What is the company’s net investment if it acquires the earthmover? (That is.000. but it is expected to save Ellis $ 20.600 Net cash flow (1+3) $ 39. and it can be sold for $ 3.920 $ 12.
500) b Total investment ($ 6. there is a $ 400 recapture of depreciation and Dauten would have to pay 0. it should not be purchased.500 38 .000 .800 = $ 4.600 = $ 400 above the book value. b Now.$ 55.660) The market value is $ 3.547 Because the earthmover has a negative NPV.000) Sale of old machine 3.000 + $ 19.Salvage value $ 20.320) Net working capital recovery 2.000 $ 15.10)1 (1.320 Book value = Deprectable basis – Accumulate depreciation = $ 60. Project NPV: NPV = .800 + $31.000 .40 ($ 400) = $ 160 in taxes. ST-2 First determines the net cash flow at = 0: Purchase price ($ 8.000 Tax on sale of old machine ( 160) a Change in net working capital ( 1.$ 62.500 Increase in pre-tax operating revenues $ 2.$ 2. Thus.10)3 = .200 Taxable income $ 15.10)2 (1.920 + $ 22. which totals to $ 1.200 d.000 Less book value $ 4.800 Tax at 40% $ 6. The change in net working capital is a $ 2.000 increase liabilities.000 Tax on salvage value a (6.680 Sale price $ 20. examine the operating cash inflows: Sales increase $ 1.000 Cost decrease 1.280 (1.500.$ 1.
QQUESTIONS .500 3.384 $1.968 (500) $1. The Director of capital budgeting has asked you to analyze two proposed capital investments. since the machine would be fully depreciated. $ 1.000 Depreciation expense in each year equals depreciable basis times the ACRS percentage allowances of $ 1. and it would also receive $ 800 from the sale of the replacement machine.CAPITAL BUDGETING ST-1 You are a financial analyst for Porter Electronics Company.560 350 $ 2.500 Depreciation tax savings 500 884 468 244 212 52 Working capital recovery 1.210 $ 884 3 4 $ 1. No tax would be due. when discounted at 15 percent. Thus.520 $ 960 350 $1. The projects’ expected net cash flows are as follows: Expected Net Cash Flow Year project S Project L 0 ($10. projects S and L. the firm must pay 0.660) After-tax revenue increase $1.744 $1. because the $ 500 salvage value would equal the old machine’s year 6 book value.500 39 .500 $1.500 Salvage value on new machine Tax on salvage value machine Net cash flow $3.000) ($10.000 $2.335. by undertaking the replacement now. However.170 $ 610 $ 468 5 6 $ 880 $ 480 350 350 $ 530 $ 130 $ 212 $ 500 $ 244 52 Depreciable basis = $ 8.712 800 (320) The Net present value of this incremental value of this incremental cash flow stream.660) $2.005.000) 1 6. the replacement should be made. each project has a cost of $10.500 $1.500 $1.40 ($ 800) = $ 320 in taxes on the sale.000. Also.250 Depreciation Tax savingsb $ 2 $ 2.Depreciation: Year 1 Newa $ 1.500 $1.032 ($6.500 $1.600 Old 350 Change $ 1. the firm forgoes the right to sell the old machine for $ 500 in year. Finally: place all the cash flows on time line a 0 1 2 3 4 5 Net investment ($6. and the cost of capital for each for each project is 12 percent.
000) 1 ( 3. construct the cumulative cash flows for each project: Cumulative Cash Flow Year Project S Project L 0 ($10. Payback: To determine the payback.86 years $3.12)3 (1.000) ($10.72 $3. Net present value (NPV).000 PaybackS = 2+ $500 = 2. b.000 + $6. How might a change in the cost of capital produce a conflict between the NPV and IRR rankings of these two projects? Would this conflict exist if K were 5%? (Hint: Plot the NPV profiles.500 + $3.000) 3 2.12) (1.17 Years $ 3.500) 2 ( 500) ( 3.000 + $3.500 Net Present Value (NPV): NPVS = -$10. Which project or projects should be accepted if they are independent? c.000 3.000 = 2.2 3 4 3.12)4 NPVL = $10.500 500 4 3.12)4 Internal Rate of Return (IRR): 40 .500 2 3 (1. Why does the conflict exist? SOLUTIONS ST-1 a.) e.000 + $3.500 3. Calculate each project’s payback period.000 PaybackL = 2+ $3.000 + $1.500 $3.500 4.000 3. Which project should be accepted if they are mutually exclusive? d.500 a. and modified internal rate of return (IRR*). internal rate of return (IRR).12)1 = $630.500) ( 6.12)2 (1.12)1 (1.12) (1.000 (1.500 (1.500 $3.000 1.500 3.
000 = $17.500 = $16.500(1. begin by finding each project’s terminal value (TV) of cash inflows. TVS = $6. a.500(1.000(1.73% The following table summarizes the project rankings by each method: Project Which Ranks Higher Payback NPV IRR IRR* S S S S Note that all methods rank Project S over Project L.12)3 +$3.12)2 + $3. both projects are acceptable under the NPV. $ 10. Part II Strategic Long-Term Investments Decisions b.12)3 + $3.255.500(1.727.500(1.23 TVL = $3. To determine the effects of changing the cost of capital. or project S.0% IRR*L = 15. NPV profiles for S and L NPV $ 41 . In this case.12)1 + $1.12)1 + $3.To solve for each project’s IRR.0% Modified internal Rate of Return (IRR*): To obtain each project’s IRR*.61% IRR*L = 13.65 Now.000(1. Thus.000. we would choose the project with the higher NPV at K = 12%. find the discount rates which equate each NPV to zero: IRR*S = 18. plot the NPV profiles of each project. in addition. both projects should be accepted if they are independent. IRR and IRR*criteria.12)2 + $3. IRR*S = 14. each project’s IRR is that discount rate which equates the PV of the TV to each project’s cost. The cross over rate occurs at about 6 to percent.
83%: hence the modified IRR ranks the projects correctly. while IRR assumes reinvestment at the (generally) higher IRR.500 4 2.705 1.707 12 966 16 307 18 5 NPV $ 4.2% 5 10 15 IRRL 20 Cost of Capital (%) Cost of capital NPV 0% $ 3. a conflict would exist. Note. that when K = 5.000 2. NPV assumes that cash flow can reinvested at the cost of capital. if k were 5 percent.592 631 (206) (585) If the firm’s cost of capital is less than 6 percent. The high reinvestment rate assumption under IRR makes early cash flows especially valuable and hence short – term projects look better under IRR.000 * NPVS NPVL Crossover Rate = 6.0%. a conflict exists because NPVL>NPVS.000 1.000 2.000* 3.544 8 1. Therefore. IRR*L = 10. but IRRS> IRRL. however.000 0 1. c) The basic cause of the conflict is differing reinvestment rate assumptions between NPV and IRR. 42 . even if K is to the left of the crossover point.4.
This is a mess. It's more like reading. which is 10% Market Interest rate of 8% = The Present Value of the Coupon Payments (an annuity) + The Present Value of the Par Value (time value of money) The Present Value of the Coupon Payments (an annuity) = $399. Preferred stock is basically a perpetuity. Rate The Present Value of a Bond Example • • • • Par Value = $ 1. like every 6 months or every year. and when the money (par value) will be paid back to the bondholder. This. that is one method: check the price of the stock in the paper or on the internet. if a company doubles in size every 5 years. but they don't give Nobel Prizes for reading.27 + $ 680. We assume that they are both rational people and both know something about the company and its future plans and profit potential. And I don't know if you realize this or not. by the way.000. It's not really finance. (because the world population isn't doubling ever 5 years).TIME VALUE OF MONEY 4.CHAPTER FOUR. I mean. You know.86 What is the value of Preferred Stock? This is easy. 43 . A written agreement between the company and the bond holder. is impossible. it can't grow forever. So there are other ways of doing stock valuation too. They talk about how much the coupon payments will be.58 = $1. The Gordon Growth Formula. The legal stuff. So. also known as The Constant Growth Formula assumes that a company grows at a constant rate forever. The company makes regular payments to the bondholders.2 What is the value of Common Stock? This is not easy.1 Bond Par Value Coupon Payments Indenture Maturity Date INTRODUCTION When a company (or government) borrows money from the public or banks (bondholders) and agrees to pay it back later The amount of money that the company borrows. Both the buyer and seller agree to exchange the stock at that price. What is the value of a share of stock in a specific company? In one sense it is the price the stock trades at. This is like interest. Think about it.079. Market Interest This changes everyday.58 The Present Value of a Bond = $ 399. pretty soon every single person in the world is their customer and then they can't grow at that rate anymore. Usually it is $1. 4.000 Maturity Date is in 5 years Annual Coupon Payments of $100.27 The Present Value of the Par Value (time value of money) =$680. yes. But that's pretty darn easy. Date when the company pays the par value back to the bondholder.
05) D1 = $1. There are three numbers commonly used to measure the annual rate of return you are getting on your investment: 44 . Example • • • Last years dividend = $ 1.G ) Po = $1. D1 = D0 (1 + G) Ks = Rate of Return G = Growth Rate What is all this D1 and D0 stuff ? • • D1 is the next dividend D0 is the last dividend Well we are assuming that the company has constant growth. Constant Growth Formula Po = D 1 / ( Ks . multiply it by the growth rate and we can get the next dividend.5%) Po = $1.00 Bond Yield-to-Maturity Imagine you are interested in buying a bond. • • • • Po = D 1 / ( Ks . So we take the last divided.BUT.05) D1 = $1.00 Growth Rate = 5% Rate of Return = 10% First figure out D1. if we go ahead and assume that a company has a constant growth rate. at a market price that's different from the bond's par value.05 / 5% Po = $21. • • • • D1 = D0 (1 + G) D1 = $1.G ) • • • • Po = Price D1 = The next dividend.00 ( 1 + .00 (1. we can use the following formula to get its value.05 / (10% .05 Next us the formula. right.
If you want. and each one ending at the moment that the payout it corresponds to takes place. so the equation to satisfy is 2. + c(1 + r)-n + B(1 + r)-n = P 45 . not a percent) n = number of years to maturity B = par value P = purchase price You should try to form a mental picture of what this equation is saying. it matures in 4 years. . which in turn is greater than the coupon rate.) The yield-to-maturity is the best measure of the return rate. where c = annual coupon payment (in dollars. In an equation. just to make sure it checks out. And if you add up the present values of all these curves (that's the left side of the equation). all starting out now. we need to satisfy the same condition as with all composite payouts: Whatever r is. This will always be true for a bond selling at a discount. and has a coupon rate of 7%. since it includes all aspects of your investment. so people have been able to create programmable calculators and computer programs (and even tables back in the old days) to help you find r.53%. The very last curve will be a lot taller.Coupon Rate: Current Yield: Yield-toMaturity: Annual payout as a percentage of the bond's par value Annual payout as a percentage of the current market price you'll actually pay Composite rate of return off all payouts. equation 1 can't be solved exactly. and end up at the par value B. the sum will exactly equal the purchase price of the bond (that's the right side). coupon and capital gain (or loss) (The capital gain or loss is the difference between par value and the price you actually pay.37%). so you just use the popup calculator instead. One thing to notice is that the YTM is greater than the current yield. you can plug this number back into equation 2. the sum will equal your initial investment. and find that r is 8. if you use it to calculate the present values of all payouts and then add up these present values. the coupon payment. in general. To calculate it. As with most composite payout problems. 1. and the par value is $1000. The left side represents n+1 different compound interest curves. because they only grow to a value of c. Example: Suppose your bond is selling for $950. The nice part is that all yield-to-maturity problems have basically the same form. In fact. . 70(1 + r)-1 + 70(1 + r)-2 + 70(1 + r)-3 + 70(1 + r)-4 + 1000(1 + r)-4 = 950 Of course you aren't really going to solve this. Most of these curves will lie pretty low to the axis. What is the YTM? The coupon payment is $70 (that's 7% of $1000). you will always have this: Bond Selling Satisfies This Condition c(1 + r)-1 + c(1 + r)-2 + . (Current yield is $70/$950 = 7.
At . how large must each of the 4 payments be? c). Your Bank compounds interest at an 8 percent rate annually. how large would your payments have to be for you to obtain the same ending balance you calculated in part a? ST-3 Assume that it is now January 1. your father offers to give you $400 on January 1. If all of this money is deposited in a bank which pays 8 percent. If you have only $750 on July 1.000 on January 1. On January 1. a). 1990.000 on January 1. but they sometimes mean that the yield to maturity was down because the asking price was up (a good day for bond holders). If you buy such a bond the yield to maturity you'll get on your investment naturally increases if you can buy it at a lower price: as they say. If somebody says "10 year treasuries were down today". suppose you deposited the $1. What interest rate. If your father were to offer either to make the payments calculated in part b ($221. all of its future payouts are determined.29 each January 1 from 1990 through 1993. based on 8 percent annual compounding? d). If the bank compounds interest annually. That can be confusing since people aren't always consistent in the way they talk about bond performance.000 on January 1. 1992. 1990. what interest rate. If you want to make equal payments on each January 1 from 1990 through 1993 to accumulate the $1. suppose you can deposit only $186. how much will you have in your account on January 1.000 on January 1. with annual compounding.000 into savings account paying an 8 percent interest rate. 1993? e). which would you choose? d). 1991. How much must you deposit on January 1. and 1993. and the only thing that varies is its asking price. 1993. a). 1991. 1990. to have a balance of $1. and 1993. Discount Premium Par Value Coupon Rate < Current Yield < YTM Coupon Rate > Current Yield > YTM Coupon Rate = Current Yield = YTM Bond Yields and Prices Once a bond has been issued and it's trading in the bond market. compounded annually. compounded semiannually. 1992. 1990.000. they probably mean that the asking price was down (so it was a bad day for bond holders).92) or give you a lump sum of $750 on January 1. You will get a part-time job and make 6 additional payments of equal amounts each 6 months thereafter. 1993. how large must your payments be? 46 . 1990. . what would your January 1. 1993. QUESTIONS AND ANSWERS ST-2 Assume that is now January 1. but you still need $1.000 in 4 payments of $250 each on January 1 of 1990. Assuming an 8 percent interest rate. 1993? b). 1989. must you seek out to achieve your goal? f). to help you reach your $1. 1993. 1993? b). How much would you have in your account on January 1. balance be if the bank used quarterly compounding rather than annual compounding? c). bond prices and yields "move" in opposite directions. 1989 and you will need $1. Suppose you deposited 4 equal payments in your account on January 1 of 1990. . you will deposit $1.000 goal. would you have to earn to have necessary $1.
20.71: FV = PV (1+k) n = $1.0 4 = (1.000(1.000(FVIF 2% 12 periods) = $1.24.08)³ =$1.000(1+0. 3 X 4 =12 Periods FV =$1.1/1/89 1/1/90 1/1/91 1/1/93 $1.268. you may solve this problem by finding the future value of an annuity of $250 for 4 years at 8 percent: 47 . Is there a reinvestments rate risk implied in the preceding analysis? If so.0=0.000(1. Rounding errors also occur between calculator and tabular solutions.02)4 – 1.000 is being compounded for 3 years. c. rounding errors occur.268.0824=8. The effective annual rate for 8 percent. compounded quarterly. or stated. is $1.g). Alternatively. so your balance on January 1993.259.000(1.10. What nominal. but interest is to be compounded on a monthly basis. on its money market account.000 1/1/92 $1. keep in mind that tables assume that payments are made at the end of each period.08)4 – 1. What is the effective annual rate being paid by the bank in part f? Reinvestment rate risk was defined in chapter 3 as being the risk that maturing securities (and coupon payments on bonds) will have to be reinvested at a lower rate of interest that they were previously earning. rate must Bank B set? SOLUTIONS TO SELF-TEST PROBLEMS ST-a.24% Therefore.268.2681) = $1. how might this risk be eliminated? ST-4 Bank A pays 8 percent interest.259. (Calculator solution = $1. 1/1/89 1/1/90 1/1/93 $250 1/1/91 $250 $250 1/1/92 $250 As you work this problem. is effective Annual = (1 +0. The managers of Bank B want its money market account to equal Bank A’s effective annual rate.71. Therefore.0824)3= $1.2682) = $1. use FVIF for 2%.) Note that since the interest factors are carried to only four decimal places. compounded quarterly. FV = $1.
FV (PVIF8%. Perhaps The simplest is to ask this question. 4 years) = FV PMT (4.71 on January 1.71 PMT = $1.259.5061 = $221. and that your deposit will grow for 3 years at 8 percent.78.71/4.PMT (FVIFA k.08) (1.56 each to have a balance of $1. you would have to make 4 payments of $279. and whose future value must equal $1. is the PV.08) (1. ST-3 a.000(0.83) Here we are dealing with a 4-year annuinity whose first payment occurs one year from today. 3 years) = PV PV = $1. This problem can be approached in several ways. 1993. k =8%. the fact that it is now January 1. Therefore.5061 = $279.56.5061) = $1.80 = Initial deposit to accumulate $1. what would I have required $1.000 on 1/1/93?’’ The answer is no: $750(1. and the $1.000: n= 3. Set up a time like those in the preceding problem. You should set up a time to help visualize the situation. 48 .259. PMT (FVIFA 8%4 years ) = FV FV (FVIFA 8%4 years) PMT = = $1. FV = $1.000.259.53.000.126.92 = payment necessary to accumulate$1. Here is the solution: FV = $1. Here is the solution: FV = $1. on 1/1/90.7938) = $793. is irrelevant.000 (Calculator solution = $793.71:k = 8%: n= 4 PMT (FVIFA 8%.259. the deposit on January 1.n ) = $250(45061) = $1. 1990.000.08) = $944. ‘’If I received $750 on 1/1/90 and deposited it to earn 8 percent.000 4. n = 4: k = 8%. 1989.000 = FV.
1992. PV = $750. 1990. this would be a mistake. to December 31.3333. 4 years k. at an 8 percent interest rate.000 goal.02 by 1.92(3. k =? PMT (FVIFA $186. Therefore.02 PV of the annuity you were finding the value of the annuity today.000 = 5. 1989. 4 years = $1. PMT (PVIFA 8%4 years) = PV $221. 1990. you would require an interest rate of approximately 10 percent to achieve your $1.02 today with the lump sum of $750 one year from now. and the future value would be only The problem is that when you found the $735.0642 percent. Look across the period 3 row of the table until you come to 1. of course.92: k = 8% n = 4. 1993. from January 1. This is less than the $750 lump sum offer. $750 Use the future value of $1 table (Table A-3 at the end of the book) for 3 periods to find the interest rate corresponding to an FVIF of 1.3121) = $735.82.08 to get $793. in the 10 percent column.29. if you were to deposit the $750 on January 1. is 10. 4 years ) = FV ) = $1. to be withdrawn in January 1.000.3333. on January 1.02 = present value of the required payments. found with a financial calculator.This indicates that you should let your father make the payments rather than accept the lump sum of $750. multiply $735. FV = $1.3686.000. You could also compare the $750 with the PV of payments: PMT = $221. so your initial reaction might be to accept the lump sum of $750. What you should have done was take the $735.82 with the lump sum of $750. 1990.3333. The exact rate required. As we saw before. PMT = $186.02. This is.29(FVIFA FVIFA k. interest would be compounded for only 3 years. 49 . recognize that this is the PV of an annuity as of January 1. However. You would then take your father’s offer to make the payments rather than take the lump sum on January 1. invalid. n = 3: k =? PV (FVIFk3 years) = FV FVIF k3 years) = FV PV = $1. n = 4.3310.000 k. The closest value is 1. and compare $793. You were comparing $725.000 =1. 1989. FV = $1.
3680 corresponds to a 20 percent interest rate. This will be accumulated by making 6 equal payments which earn 8 percent compounded semi annually.000. k = 4% PMTV (FVIFA4%.9997%) f. You might be able to find a borrower willing to offer you a 20 percent interest rate.6330 50 .12 = $493. or 4 percent each 6 months.12. 6) = FV PMT = FV (FVIFA4% 6) = $493.$506.* Using Table A-4 at the end of the book. n = 6. you need an additional sum of $493. This means that on January 1.000! (Calculator solution = 19.88: $1. 1993.88 = $74.00 .46 6. FV = $493. 1/1/89 1/1/90 $400 ? ? ? ? ? 1/1/91 1/1/92 1/1/93 ? Find the future value of the original $400 deposit: FV = PV (FVIF4%.88. but there would be some risk involved – he or she might not actually pay you your $1. we find that 5. 6) = $400(1.88.2653) = $506.
QUESTION ONE Lancaster Engineering. It’s minimum rate of return required on investment on investment. 5. Cost of capital is useful in designing a firm’s dividend policy. Knowledge of cost of capital is useful to management when deciding on method of financing at a given time. Cost of capital is significant in designing the firms capital structure – A firms target capital structure should aim at minimizing cost of capital and maximizing the market value of the firms. Cheaper sources of funds would be employed by the company to finance it’s operation. Inc. Historical costs refer to costs incurred on funds raised to finance firm’s current project. CLASSIFICATION OF COST OF CAPITAL 1. 4.in decision making the relevant cost are future costs not historical costs. Which it considers to be optimal: Debt 25% 51 . Cost of capital can be used to evaluate financing performance of top management. dividend policy is mainly concerned with how to give to shareholders. Firms cost of capital is the discount rate used in evaluating the desirability of investment projects.COST OF CAPITAL Cost of capital is minimum rate of return required by investors. (LEI) has the following capital structure. Future cost on the otherhand refers to the cost that the firms would incur when raising funds to finance its future projects. Significance of cost of capital 1. 2. Such evaluation will involve comparison of actual profitability of project undertaken with projected overall cost of capital and an appraisal of actual cost incurred in raising required funds. FUTURE AND HISTORICAL COSTS.CHAPTER FIVE . It cut off or target or hundle rate. It’s minimum rate of return which maintain market value per share at its current. 3.
Debt: up to $ 5.60 per share last year.191.500 of preferred.000 project IRR 12. floatation costs of $ 5 per share will be incurred for up to $ 7. Preferred: new preferred stock with a dividend of $ 11 can be sold to the public at a price of $ 100 per share.000 of new stock and new stock and 20 percent for all common over $12. 52 .42 2.000 of debt can be sold at an interest rate of 12 percent: debt in the range of $ 5. and as its stock currently sells at a price of $ 60 per share.789. LEI paid a dividend of $ 3.72: its established dividend payout ratio is 30 percent: its federal –plus –state tax rate is 40 percent and investors expect earnings and dividends to grow at a constant rate of 9 percent in the future.84 5 8 10 6 (a) Find the break points in the MCC schedule.500.427.000 10.2 13. on all preferred over $ 7.000 will have an interest rate of 16 percent.154.000 must carry an interest rate of 14 percent: and all debt over $ 10. However.4 14. LEI can obtain new capital in the following ways.48 5.000 20.000.000 10. or 10 percent.7 16 • • Cash Flow life $ 2.Preferred stock Common 15 60 100 LEI’s expected net income this year is $ 34. (b) Determine the cost of each capital structure component.0% 17. • Common: New common stock has a floatation cost of 10 percent for up to $12.18 3. LEI has the following investment opportunities: Cost Annual Net Project at: = 0 A B C D E $ 10.170.000 20.001 to $ 10.285.20 7 years 3. rising to $ 10 per share.
after first noting that LEI has $ 24. We establish the break points as follows.7) = $ 24.000 0. A break point will occur each time a low-cost type of capital is used up.000 Break point = Total amount of low-cost capital of a given type Fraction of this type of capital in the capital structure Break Capital used up Number Retained earnings 2 Break Point Calculation BPRE = $ 24.15 12% debt BP12%D = $5.000 53 .0-payout) = $ 34.000 of retained earnings: Retained earnings = (Total earnings) (1.000 1 = $ 50.000 0.(c) Calculate the weighted average cost of capital in the interval between each break in the MCC schedule.000 4 0.25 = $ 20. (d)Calculate the IRR for project E.72 (0.60 10% floatation commonBP10%E= $ 24.000+ $ 12.60 5% floatation preferred BP5%P = $7.285. (f) Which projects should LEI accept? SOLUTIONS a.500 0.000 = $ 60. (e) Construct a graph showing the MCC and schedules.000 3 = $ 40.
9) 54 .54 Common with F = 10% ($40.000. The first break point occurs at $ 20. respectively. therefore.0654 + 0. determined after all the break points were calculated.000): Ks = D1 +g = D0 (1+g) +g Po Po 3. There are two preferred costs and hence one preferred break.000 and $ 60. two equity–induced breaks in the MCC.60(1.000. are used up.09 60 = 0. and. $ 40.0-F) + g = $ 3.000 +$5.09 = 15.000 = $ 40.27% $60(0. 0001 to $ 60. The MCC curve also rises at $ 50.000. as preferred stock with a 5 percent floatation cost and common stock with a 10 percent floatation cost. when the 12 percent debt is used up.000): Ke = D1 P0 (1. There are three common equity costs and hence two changes. 2.09) + 0.2 Summary of Break Points 1. The second break point. The numbers in the third column of the table designate the sequential order of the breaks.000 0. results from using up both retained earnings and the 14 percent debt. There are three debt costs and hence two debt breaks. Component costs within indicated total capital interval are as follows: Retained earnings (used in interval $0 to $ 40. Note that the second debt and the break for retained earnings 3.14% debt 2 BP14%D = $5. b.924 + 9% = 16.
40% Debt at Kd = 16% (OVER $40.6) = 7.86% 2. preferred = 11.90%.000): K p = $11 $100(0.58%.20% Debt at K d = 14% ($20.58%) + 0.54%) = 13.6%.27%): WACC3=0.924 + 9% $60(0.22% (1-T) = 12% (0.15(11.95) Preferred with F = 10% ( Over $50. and RE = 15.54%) = 12.Preferred with F = 20% (over $60.6%) + 0.000): K d (1-T) = 16 %( 0.4%) + 0. $40. WACC calculations within indicated total capital intervals: 1.2%)+0.58% $100(0.001 to $50.6(16.000): Kd (1-T) = 14 %( 0.60(15.000(debt=9.58%.4%.6) = 9.60(15.25(8.54%): WACC1 = WdKd (1-T) + WpKp +WsKs = 0.6) = 8.001 to $40.8) = 17.25(9.000): Ke = $ 3. $20.000): Kp = preferred dividend = Pn $ 11 = 11.000(debt=8.58%. preferred =11.000): K d = 12.18% Preferred with F = 5% ($ 0 to $ 50.58%) + 0.58%)+0. preferred = 11. $0 to $20. and retained earnings (RE) = 15.25(7.15(11.9) Debt at K1 = 12% ($0 to 20.2%.000 (debt = 7.60% c.27%) = 13.16% 3.54%): WACC2 = 0. and equity = 16.001 to $40. 55 .15(11.
5 17.60(17.9% E=16.00% 5.6%.0% 80 New Capital (Thousands of Dollars) WACC = 12. Inc.25(9.84 56 .5 14.00% MICC and IOS Schedules for Lancaster Engineering.22%) +0.18%)= 14.5 13.15(12.60(16. $50.15(12.86% C = 14.86% 13. Percent 17.5 12.6847 $5.000 (debt = 9.0 WACC12.427.18%): WACC5 = 0.0 15.0 12.27%) = 14.000 (debt = 9.0 0 20 40 60 A= 12.22%)+0.2% WACC3 = 13.5 15.25(9.6%)+0.0% B = 17.27%): WACC4 = 0.4.0 14. preferred = 12.6%) + 0.60(16.22) + 0.5 16.27%)=14.0 16.4% WACC4 = 0.6%) +0. Over $60.15(12.22% and equity =16.54% b) IRR calculation for project E: PVIFAK.6%.22% and equity = 17.000 = 3.25(9. preferred = 12.6 = $20.001 to $60.
This is the factor for 16 percent, so IRRE = 16% c) See the graph of the MCC and IOS schedules for LEI at the top of the page.
LEI should accept Projects B, E, AND C. It should reject A and D, because their IRRs do not exceed the marginal costs of funds needed to finance them. The firm’s capital budget would total $ 40,000. QUESTION TWO Sasini Company has the following capital structure, which it considers to be optimal Debt Preferred stock Common stock Total capital 25% 15 60 100%
Sasini’s net income expected this year is $ 17,142.86, its established dividend payout ratio is 30%: its tax rate is 30%: and investors expect earnings and dividends to grow at a constant rate of 9% in the future. Sasini paid a dividend of $ 3.60 per share, last year and its stock currently sells at a price of $ 60 per share. Treasury bonds yield 11% an average stock has a 14% expected rate of return: and Sasini’s beta is 1.51. These terms will apply to new security offerings. Common: New common stock would have a flotation cost of 10% Preferred: New preferred stock could be sold in the public at a price of $ 100 per share, with a dividend of $11. Floatation costs of $5 per share would be incurred. Debt: debt could be sold at an interest rate of 12%. REQUIRED: (i) Calculate the component costs of debt, preferred stock, retained earnings, and new common stock. (ii) How much new capital can be raised before Sasini must sell new equity? (iii) What is the WAC when Sasini meets its equity requirement with retained earnings? With new common stock?
Construct a graph showing Sasini’s MCC schedule
SOLUTION TO QUESTION TWO SASINI 1. a) Effective cost of debt /after tax of debt kd = 12% (1-tax) = 12% (1-0.3)= 8.4% a) Cost of preferred stock (kp) Kp = annual dividends (Po - F) = 11 = 0.1158
(Always translate to %) = 11.6% b) Retained earnings
Ks = DO (1+g) Po
3.6(1+0.09) +0.09 60
= 0.1554 x 100
Ks = 15.54% D) New common stock ke = Do(1+g) +g
(Po-F) or Po (1-f) =3.6(1+0.09) + 0.09 60(1- 0.1) = 16.27% (ii) Break point of fund
BPE = available equity Weight of 11 Available equity Profit after tax Less Dividends (30% x 17,142.86) Available retained earnings Weight of equity = common stock BPE = 12,000 0.6 = $ 20,000 NB: Break point same as jumps iii) WACC with Sasini’s retained earnings ii) Specific cost of capital Ke = 15.54 Kd = 3.4 Kp = 11.6% iii) Weights W e = 0.6 W d = 0.25 W p = 0.15 WACC = 15.54 (0.6) + 8.4 (0.25) + 11.6 (0.15) =13.164 WACC = kewe + kdwd + kpwp Ke = 16.3% Kd=8.4% Kp = 11.6% (3) weight we = 0.6 wd = 0.25 Wp = 0.15 = 13.60 5,142.86 12,000.00 17,142.86
WACC = 16.3 (0.6) + 8.4 (0.25) + 11.6(0.15) SASINI’S MCC SCHEDULE
1 20.Range of financing A-B up to 20.3 13.6 13.000 Range of financing 40.6% 60 .4 13.5 jump/break 13.16% 13.000 C-D Above 20.2 13.16% SASINI’S GRAPH 13.00 Sources of capital E D P E D P Specific cost of capital Weights of capital WACC 13.7 13.000 13.8 13.
or should it sell them to new shareholders instead? i) If a company sells the new shares to existing shareholders in proportion to their existing shareholding in the company. we have a rights issue.1 SOURCES OF FUNDS A company might raise new funds from the following sources: The capital markets: i) new share issues. The market value of a quoted company's shares bears no relationship to their nominal value. for example. a company with 200. if the firm is seeking to grow. A new issue of shares might be made in a variety of different circumstances: a) The company might want to raise more cash. although this method may not provide enough funds. Simply retaining profits. Ordinary shareholders put funds into their company: a) by paying for a new issue of shares b) through retained profits.000 shares would be issued as a one-in-four rights issue.000 ordinary shares in issue decides to issue 50. ii) If the number of new shares being issued is small compared to the number of shares already in issue. If it issues ordinary shares for cash. the issue price must be equal to or be more than the nominal value of the shares. for example. typically of $1 or 50 cents. In the example above. which are entitled to a dividend only after a certain date or if profits rise above a certain amount. Ordinary (equity) shares Ordinary shares are issued to the owners of a company. since ownership of the company would only be minimally affected. it might be decided instead to sell them to new shareholders. Voting rights might also differ from those attached to other ordinary shares.SOURCES OF FINANCE 6. by companies acquiring a stock market listing for the first time ii) rights issues Loan stock Retained earnings Bank borrowing Government sources Business expansion scheme funds Venture capital Franchising. 61 . simple low-cost source of finance. should the shares be issued pro rata to existing shareholders. but more importantly to float' its shares on a stick exchange. b) The company might want to issue shares partly to raise cash. so that control or ownership of the company is not affected? If. the 50. by offering shareholders one new share for every four shares they currently hold.CHAPTER 6 . should it offer the new shares to existing shareholders. They have a nominal or 'face' value. offers an important.000 new shares to raise cash. Deferred ordinary shares are a form of ordinary shares. for example. instead of paying them out in the form of dividends. except that when ordinary shares are issued for cash.
who are being asked to provide extra funds. The arrears of dividend on cumulative preference shares must be paid before any dividend is paid to the ordinary shareholders. in order to take it over. and giving existing shareholders the chance to cash in some or all of their investment in their company. As with ordinary shares a preference dividend can only be paid if sufficient distributable profits are available. although with 'cumulative' preference shares the right to an unpaid dividend is carried forward to later years. All the shares in the company. The methods by which an unquoted company can obtain a quotation on the stock market are: a) an offer for sale b) a prospectus issue c) a placing d) an introduction. When this occurs. would then become marketable. b) Shareholders in an unquoted company may sell some of their existing shares to the general public. at a price of 280c per new share. but without obtaining a Stock Exchange quotation c) a company which is already listed on the Stock Exchange wishing to issue additional new shares. 62 . A company making a rights issue must set a price which is low enough to secure the acceptance of shareholders. For example.c) The company might issue new shares to the shareholders of another company. a 'large' issue will probably take the form of an offer for sale.2 PREFERENCE SHARES Preference shares have a fixed percentage dividend before any dividend is paid to the ordinary shareholders. New shares issues A company seeking to obtain additional equity funds may be: a) an unquoted company wishing to obtain a Stock Exchange quotation b) an unquoted company wishing to issue new shares. to raise cash for the company. Offers for sale: An offer for sale is a means of selling the shares of a company to the public. but just providing a wider market for its existing shares (all of which would become marketable). not just the new ones. 6. A smaller issue is more likely to be a placing. When companies 'go public' for the first time. a rights issue on a one-for-four basis at 280c per share would mean that a company is inviting its existing shareholders to subscribe for one new share for every four shares they hold. so as to avoid excessive dilution of the earnings per share. but not too low. inviting them to subscribe cash for new shares in proportion to their existing holdings. Rights issues A rights issue provides a way of raising new share capital by means of an offer to existing shareholders. since the amount to be raised can be obtained more cheaply if the issuing house or other sponsoring firm approaches selected institutional investors privately. and then sell them on the Stock Exchange. a) An unquoted company may issue shares. the company is not raising any new funds.
From the company's point of view, preference shares are advantageous in that: Dividends do not have to be paid in a year in which profits are poor, while this is not the case with interest payments on long term debt (loans or debentures). Since they do not carry voting rights, preference shares avoid diluting the control of existing shareholders while an issue of equity shares would not. Unless they are redeemable, issuing preference shares will lower the company's gearing. Redeemable preference shares are normally treated as debt when gearing is calculated. The issue of preference shares does not restrict the company's borrowing power, at least in the sense that preference share capital is not secured against assets in the business. The non-payment of dividend does not give the preference shareholders the right to appoint a receiver, a right which is normally given to debenture holders. However, dividend payments on preference shares are not tax deductible in the way that interest payments on debt are. Furthermore, for preference shares to be attractive to investors, the level of payment needs to be higher than for interest on debt to compensate for the additional risks. For the investor, preference shares are less attractive than loan stock because: they cannot be secured on the company's assets the dividend yield traditionally offered on preference dividends has been much too low to provide an attractive investment compared with the interest yields on loan stock in view of the additional risk involved. Loan stock Loan stock is long-term debt capital raised by a company for which interest is paid, usually half yearly and at a fixed rate. Holders of loan stock are therefore long-term creditors of the company. Loan stock has a nominal value, which is the debt owed by the company, and interest is paid at a stated "coupon yield" on this amount. For example, if a company issues 10% loan stocky the coupon yield will be 10% of the nominal value of the stock, so that $100 of stock will receive $10 interest each year. The rate quoted is the gross rate, before tax. Debentures are a form of loan stock, legally defined as the written acknowledgement of a debt incurred by a company, normally containing provisions about the payment of interest and the eventual repayment of capital. Debentures with a floating rate of interest These are debentures for which the coupon rate of interest can be changed by the issuer, in accordance with changes in market rates of interest. They may be attractive to both lenders and borrowers when interest rates are volatile. Security Loan stock and debentures will often be secured. Security may take the form of either a fixed charge or a floating charge. a) Fixed charge; Security would be related to a specific asset or group of assets, typically land and buildings. The company would be unable to dispose of the asset without providing a substitute asset for security, or without the lender's consent. b) Floating charge; With a floating charge on certain assets of the company (for example, stocks and debtors), the lender's security in the event of a default payment is whatever assets of the appropriate class the company then owns (provided that another lender does not have a
prior charge on the assets). The company would be able, however, to dispose of its assets as it chose until a default took place. In the event of a default, the lender would probably appoint a receiver to run the company rather than lay claim to a particular asset. The redemption of loan stock Loan stock and debentures are usually redeemable. They are issued for a term of ten years or more, and perhaps 25 to 30 years. At the end of this period, they will "mature" and become redeemable (at par or possibly at a value above par). Most redeemable stocks have an earliest and latest redemption date. For example, 18% Debenture Stock 2007/09 is redeemable, at any time between the earliest specified date (in 2007) and the latest date (in 2009). The issuing company can choose the date. The decision by a company when to redeem a debt will depend on: a) how much cash is available to the company to repay the debt b) the nominal rate of interest on the debt. If the debentures pay 18% nominal interest and the current rate of interest is lower, say 10%, the company may try to raise a new loan at 10% to redeem the debt which costs 18%. On the other hand, if current interest rates are 20%, the company is unlikely to redeem the debt until the latest date possible, because the debentures would be a cheap source of funds. There is no guarantee that a company will be able to raise a new loan to pay off a maturing debt, and one item to look for in a company's balance sheet is the redemption date of current loans, to establish how much new finance is likely to be needed by the company, and when. Mortgages are a specific type of secured loan. Companies place the title deeds of freehold or long leasehold property as security with an insurance company or mortgage broker and receive cash on loan, usually repayable over a specified period. Most organisations owning property which is unencumbered by any charge should be able to obtain a mortgage up to two thirds of the value of the property. As far as companies are concerned, debt capital is a potentially attractive source of finance because interest charges reduce the profits chargeable to corporation tax. Retained earnings For any company, the amount of earnings retained within the business has a direct impact on the amount of dividends. Profit re-invested as retained earnings is profit that could have been paid as a dividend. The major reasons for using retained earnings to finance new investments, rather than to pay higher dividends and then raise new equity for the new investments, are as follows: a) The management of many companies believes that retained earnings are funds which do not cost anything, although this is not true. However, it is true that the use of retained earnings as a source of funds does not lead to a payment of cash. b) The dividend policy of the company is in practice determined by the directors. From their standpoint, retained earnings are an attractive source of finance because investment projects can be undertaken without involving either the shareholders or any outsiders. c) The use of retained earnings as opposed to new shares or debentures avoids issue costs. d) The use of retained earnings avoids the possibility of a change in control resulting from an issue of new shares. Another factor that may be of importance is the financial and taxation position of the company's shareholders. If, for example, because of taxation considerations, they would rather make a capital profit (which will only be taxed when shares are sold) than receive current income, then finance through retained earnings would be preferred to other methods.
A company must restrict its self-financing through retained profits because shareholders should be paid a reasonable dividend, in line with realistic expectations, even if the directors would rather keep the funds for re-investing. At the same time, a company that is looking for extra funds will not be expected by investors (such as banks) to pay generous dividends, nor overgenerous salaries to owner-directors. Bank lending Borrowings from banks are an important source of finance to companies. Bank lending is still mainly short term, although medium-term lending is quite common these days. Short term lending may be in the form of: a) an overdraft, which a company should keep within a limit set by the bank. Interest is charged (at a variable rate) on the amount by which the company is overdrawn from day to day; b) a short-term loan, for up to three years. Medium-term loans are loans for a period of from three to ten years. The rate of interest charged on medium-term bank lending to large companies will be a set margin, with the size of the margin depending on the credit standing and riskiness of the borrower. A loan may have a fixed rate of interest or a variable interest rate, so that the rate of interest charged will be adjusted every three, six, nine or twelve months in line with recent movements in the Base Lending Rate. Lending to smaller companies will be at a margin above the bank's base rate and at either a variable or fixed rate of interest. Lending on overdraft is always at a variable rate. A loan at a variable rate of interest is sometimes referred to as a floating rate loan. Longer-term bank loans will sometimes be available, usually for the purchase of property, where the loan takes the form of a mortgage. When a banker is asked by a business customer for a loan or overdraft facility, he will consider several factors, known commonly by the mnemonic PARTS. Purpose Amount Repayment Term Security PThe purpose of the loan A loan request will be refused if the purpose of the loan is not acceptable to the bank. AThe amount of the loan. The customer must state exactly how much he wants to borrow. The banker must verify, as far as he is able to do so, that the amount required to make the proposed investment has been estimated correctly. RHow will the loan be repaid? Will the customer be able to obtain sufficient income to make the necessary repayments? TWhat would be the duration of the loan? Traditionally, banks have offered short-term loans and overdrafts, although medium-term loans are now quite common. SDoes the loan require security? If so, is the proposed security adequate? Leasing A lease is an agreement between two parties, the "lessor" and the "lessee". The lessor owns a capital asset, but allows the lessee to use it. The lessee makes payments under the terms of the lease to the lessor, for a specified period of time.
a form of rental. Operating leases Operating leases are rental agreements between the lessor and the lessee whereby: a) the lessor supplies the equipment to the lessee b) the lessor is responsible for servicing and maintaining the leased equipment c) the period of the lease is fairly short. cars and commercial vehicles. less than the economic life of the asset. of the asset's expected useful life. The company will take possession of the car from the car dealer. and so will purchase the car from the dealer and lease it to the company. the supplier has no further financial concern about the asset. ensure that the lease payments during the primary period pay for the full cost of the asset as well as providing the lessor with a suitable return on his investment. Other important characteristics of a finance lease: a) The lessee is responsible for the upkeep. and apart from obligations under guarantees or warranties. which covers all or most of the economic life of the asset. The lessor is not involved in this at all. c) It is usual at the end of the primary lease period to allow the lessee to continue to lease the asset for an indefinite secondary period. quarterly. so that at the end of the lease agreement. but might also be computers and office equipment. The lessor must. the lessor can make good profits. the lessor would not be able to lease the asset to someone else. the lessee and the lessor are as follows: The supplier of the equipment is paid in full at the beginning. servicing and maintenance of the asset. as the asset would be worn out. Leasing might be attractive to the lessee: 66 . A finance house will agree to act as lessor in a finance leasing arrangement. and obtain a good rent for it. or all. At the end of the lease. There are two basic forms of lease: "operating leases" and "finance leases". six monthly or annually) to the finance house under the terms of the lease. A car dealer will supply the car. in return for a very low nominal rent. the lessee might be allowed to sell the asset on the lessor's behalf (since the lessor is the owner) and to keep most of the sale proceeds. therefore. Why might leasing be popular The attractions of leases to the supplier of the equipment. The lessor invests finance by purchasing assets from suppliers and makes a return out of the lease payments from the lessee. or ii) sell the equipment secondhand. therefore. Leased assets have usually been plant and machinery. Provided that a lessor can find lessees willing to pay the amounts he wants to make his return. Finance leases Finance leases are lease agreements between the user of the leased asset (the lessee) and a provider of finance (the lessor) for most. Alternatively. paying only a small percentage (perhaps 10%) to the lessor. Suppose that a company decides to obtain a company car and finance the acquisition by means of a finance lease. and make regular payments (monthly. The equipment is sold to the lessor. b) The lease has a primary period. the lessor can either i) lease the equipment to someone else. He will also get capital allowances on his purchase of the equipment.Leasing is.
the lessee does not have to keep on using it. if the equipment becomes out-of-date before the end of its expected life. whereas a lessee never becomes the owner of the goods.i) if the lessee does not have enough cash to pay for the asset. and it is the lessor who must bear the risk of having to sell obsolete equipment secondhand. the term 'venture capital' is more specifically associated with putting money. a business customer obtains hire purchase finance from a finance house in order to purchase the fixed asset. Venture capital Venture capital is money put into an enterprise which may all be lost if the enterprise fails. Hire purchase agreements usually involve a finance house. A venture capitalist will require a high expected rate of return on investments. A businessman starting up a new business will invest venture capital of his own. An industrial or commercial business can use hire purchase as a source of finance. Operating leases have further advantages: The leased equipment does not need to be shown in the lessee's published balance sheet. Government assistance The government provides finance to companies in cash grants and other forms of direct assistance. with the exception that ownership of the goods passes to the hire purchase customer on payment of the final credit instalment. There is a serious risk of losing the entire investment. The cost of payments under a loan might exceed the cost of a lease. However. iii) The hire purchase arrangement exists between the finance house and the customer. or ii) if finance leasing is cheaper than a bank loan. and it might take a long time before any profits and returns materialise. The equipment is leased for a shorter period than its expected useful life. i) The supplier sells the goods to the finance house. and so has to rent it in one way or another if he is to have the use of it at all. ii) The supplier delivers the goods to the customer who will eventually purchase them. especially in high technology industries and in areas of high unemployment. Hire purchase is similar to leasing. The size of the deposit will depend on the finance company's policy and its assessment of the hirer. where the lessee might not be required to make any large initial payment. as part of its policy of helping to develop the national economy. office equipment and farming machinery. The institution that puts in the money recognises the gamble inherent in the funding. But there is also the prospect of very high profits and a substantial return on the investment. For example. 67 . and would have difficulty obtaining a bank loan to buy it. usually in return for an equity stake. plant and machinery. Goods bought by businesses on hire purchase include company vehicles. This is in contrast to a finance lease. but he will probably need extra funding from a source other than his own pocket. Hire purchase Hire purchase is a form of instalment credit. the Indigenous Business Development Corporation of Zimbabwe (IBDC) was set up by the government to assist small indigenous businesses in that country. The finance house will always insist that the hirer should pay a deposit towards the purchase price. The lessee will be able to deduct the lease payments in computing his taxable profits. and so the lessee's balance sheet shows no increase in its gearing ratio. to compensate for the high risk. In the case of hightechnology equipment. With industrial hire purchase. a management buy-out or a major expansion scheme. into a new business.
Under a franchising arrangement. that is. The franchisor must bear certain costs (possibly for architect's work. 68 . a franchisee pays a franchisor for the right to operate a local business. A high percentage of requests for venture capital are rejected on an initial screening. The directors of the company must then contact venture capital organisations. to look after its interests. legal costs. Franchisors include Budget Rent-a-Car. establishment costs. The franchisor may well help the franchisee to obtain loan capital to provide his-share of the investment cost. Examples of venture capital organisations are: Merchant Bank of Central Africa Ltd and Anglo American Corporation Services Ltd. The advantages of franchises to the franchisor are as follows: The capital outlay needed to expand the business is reduced substantially. Wimpy. and when it considers putting money into a business venture. a cash flow forecast and a profit forecast d) details of the management team. A venture capital organisation will only give funds to a company that it believes can succeed. Franchising Franchising is a method of expanding business on less capital than would otherwise be needed.A venture capital organisation will not want to retain its investment in a business indefinitely. The image of the business is improved because the franchisees will be motivated to achieve good results and will have the authority to take whatever action they think fit to improve the results. Although the franchisor will probably pay a large part of the initial investment cost of a franchisee's outlet. to try and find one or more which would be willing to offer finance. under the franchisor's trade name. how it will be able to pull out of the business eventually (after five to seven years. it will want from the company management: a) a business plan b) details of how much finance is needed and how it will be used c) the most recent trading figures of the company. For suitable businesses. marketing costs and the cost of other support services) and will charge the franchisee an initial franchise fee to cover set-up costs. and only a small percentage of all requests survive both this screening and further investigation and result in actual investments. a balance sheet. with evidence of a wide range of management skills e) details of major shareholders f) details of the company's current banking arrangements and any other sources of finance g) any sales literature or publicity material that the company has issued. relying on the subsequent regular payments by the franchisee for an operating profit. they must recognise that: the institution will want an equity stake in the company it will need convincing that the company can be successful it may want to have a representative appointed to the company's board. it is an alternative to raising extra capital for growth. These regular payments will usually be a percentage of the franchisee's turnover. When a company's directors look for help from a venture capital institution. and before it will make any definite offer. Nando's Chicken and Chicken Inn. the franchisee will be expected to contribute a share of the investment himself. it will also consider its "exit". say) and realise its profits.
The advantage of a franchise to a franchisee is that he obtains ownership of a business for an agreed number of years (including stock and premises. although premises might be leased from the franchisor) together with the backing of a large organisation's marketing effort and experience. The franchisee is able to avoid some of the mistakes of many small businesses. 69 . because the franchisor has already learned from its own past mistakes and developed a scheme that works.
000 at the end of 8 years. MMC expects to be able to sell the equipment for $5.000 outlay will be charged off as an expense by the firm this year (year 0). Assume that the entire $50. The price of the product on January 1 will be $400 per unit. ii) The new equipment would not affect revenues. The $50. vi) The appropriate discount rate is 12%.e. how high the price must be for the equipment to have a zero NPV. Revenues are received and costs paid at year-end. iv) The new equipment will be depreciated to zero using straight-line depreciation over five years. These savings in costs would occur at year-end. and it is expected to have no resale value at the end of those eight years. in the form of greater productivity and a reduction in employee turnover are estimated as follows (on an after-tax basis): Years 1 – 10 $5.CLASS ASSIGNMENT DFI 501: FINANCIAL MANAGEMENT ASSIGNMENT ONE: QUESTION ONE: a) A company is planning to invest $50. The company has estimated its cost of capital to be 15%.00 (before tax) in a personnel training program. The proceeds from this sale would be subject to taxes at a rate of 30%. iii) The old equipment is now 5 years old.000. v) MMC has profitable ongoing operations.000 per year. MMC wants to know the maximum price that it should be willing to pay for the equipment i. REQUIRED: Should the firm undertake the training program? b) Majestic Mining Company (MMC) is negotiating for the purchase of a new piece of equipment for their current operations. c) Sony International has an investment opportunity to produce a new stereo Colour TV. in units 100. Labour costs will be $15 per hour on January 1. You are given the following facts i) The new equipment would replace existing equipment that has a current market value of $20. they will increase at 2% per year in real terms. The firm will depreciate the investment to zero using the straight-line method.000 200. Year 1 Year 2 Year 3 Year 4 Physical production. It was purchased for $40.000 per year for eight years.000 per year Years 11 – 20 $15. The returns from the program. but before-tax operating costs would be reduced by $10. It is expected to last for another eight years.000 200.000 is paid at time 0. The inflation rate is 5%. The required investment on January 1 2005 is $32 million. The firm is in the 30% tax bracket. The marginal tax rate for the firm is 30%.000 70 .000 150.000 and is being depreciated to zero on a straight-line basis over 10 years. That price will stay constant in real terms.
000 200. All inflows of cash occur at year-end.000 The risk less nominal discount rate is 4%.000 in 25 years.000. The note is certain to pay $2. what rate of interest will you receive? 71 .25 a share was paid yesterday and maintained its historic 7% annual rate of growth. If the market discount rate is 16%.000 200. how much can you afford to invest per acre? DFI 501: FINANCIAL MANAGEMENT ASSIGNMENT TWO: a) The Bozo basketball company (BBC) earned $10 a share last year and paid a dividend of $6 a share. The real discount rate for costs and REQUIRED: Calculate the NPV of this project.2 million. d) An acre planted with trees is estimated to be worth $4. If you want to realize a 12% return on your investment. Assume that you expect to be to be able to sell the stock for $132 a year from now.000 at the end of each of the next 10 years.Labour input.800. If you buy the note. As a result of competition.000 2.000 Energy input.000.000. how much would you be willing to pay for it? b) Gentry Company’s latest annual dividend of $1. If you required 14% on this stock.000 200.000 revenues is 8%. You plan to purchase the stock today because you feel that the dividend growth rate will increase to 8% for the next three years and the selling price of the stock will be $40 per share at the end of that time. Their newest program will cost $5 million to develop first year profits will be $1. profits will fall by 4% each year. 2.000 Term to Maturity: 20 years Coupon Rate: 8% Semi-annual payments Calculate the price of the bond if the market interest rate is: i) 8% ii) 10% iii) 6% d) Locust software is one of a myriad of companies selling word processor programs.000 2. physical units 200. REQUIRED: i) How much should you be willing to pay for the Gentry company stock if you require a 14% return? ii) What is the maximum price you should be willing to pay for the Gentry company stock if you feel that the 8% growth rate can be maintained indefinitely and you require a 14% return? c) A bond with the following characteristics is available: Principal: $1. what is the value of the company? e) You are offered the opportunity to buy a note for $12. in hours 2. Next year you expect BBC to earn $11 and continue its pay-out ration.000.
000 (20.701.000 Les tax savings (30% of 50.000 five years from now Which one should you choose if the discount rate is (i) 10% or (ii) 20%? What rate makes the options equally attractive to you? ASSIGNMENT THREE: Discuss the various short-term and long-term sources of funds available to companies and businesses.000) Initial cash outlay $ 35.000 Present value of the cash inflows will be as follows: 5.10 = 25. highlighting their advantages and disadvantages.0188) + 15.5 To get the Net Present Value of cash inflows – Initial Investment Therefore NPV = 43.000) x 6-8 2.000 one year from now Alternative 2: $20.(PVIFA) = 5.50 = $ 43.000) $ (15. b) Initial Cash Outlay: $ New equipment Market value of old equipment Book value of new equipment Gain/loss 0 Tax consequences Net cash outlay Incremental Depreciation: Year 1-5 New machine 0.000 (PVIFA) .000 = $ 8.000 (6.f) You need $25.607.000 (PVIFA) + 15.701.094 + 18.701.500) $ x 72 .2 x – 2500 20.000 five years from now. You budget to make equal payments at the end of every year into an account that pays a stated annual interest rate of 7%.500 0.701.2 x Old machine 2.50 NPV = $ 8.2593 – 5.5 – 35. SOLUTION ASSIGNEMENT ONE Question One: a) Cost of the training program $ 50.50. What are your annual payments? g) You have won a lottery and the officials offer you the choice of the following alternative payouts: Alternative 1: $10. 701.000 (5.50 Decision: undertake the training program since the NPV is greater than zero (positive) or $ 8.500 (2.0188) 15.
970 13.723 8.000 8.700.06x 6.970 21.000.419.000 (1.727.000.500 2.370.90 28.967 1 $ Sales 40.259.000 1.808.071. Tax consequences @ 30% Terminal cash flows $ 5.000 31.000 Adjustments 40.000 35.000 10.000.630.000.600.461.309.000.500) Annual cash flows 6.000 Less: Incremental depreciation 0.000 30.9676 – 3.000 40.000 39.000 Cash inflows 8. 5YRS) + 3500 (PVIFA12%.000.130 5.000 Tax 30% 300.928.250 (4.6048) + 3.500 Tax @ 30% 0.060.6048 + 6.Increamental depreciation (0.000 3 $ 80.000.000.2x) 8.000.599.900 8.000 31.4039) =x = 32.092.74 C Year SONY INTERNATIONAL 2 $ 80.250 + 0.000 8.750 Add.100 19.000 8.2x) 3.000 40.2163x = x The price of new machine shall be $ 41. 8YRS – PVIFA12%.000 1. 8YRS) =X = (6.240 1.417.250 + 0.10 38.0 6x) 3.071.3 (12.250 + 0.727 8.000 Inflation 9.000 27.918.000 Add depreciation 8.000 36.349.500 Savings before tax 12.836.000.500) (2.030.500 Discounting the cash flows:(6.000 Depreciation 8.250 (PVIFA12%.033 12.06x) PVIFA 12%.418.15 + 0.500 (0.950 37.000 After tax profit 700.111.2x 12.000 39.000 Profit tax 1. 721.500-0.000 Labour 30.212.000.209.7 (12.250 Terminal cash flows: Market value of new machine Less.000 11.500 – 0.2x – 2. 5YRS + 6.900 4 $ 60.272.259.500) $ 3.000.2x – 2.000.750 Savings after tax 0.000.000. 349.000.000 39.723.26 Inflation adjustments are given by 1+R = (1+r) (1+i) Where R = nominal rate r = real rate I = inflation rate 73 .500 – 0.808.50 22.135.000 Energy 1.Cash flows $ $ Year 1-5 6-8 Savings 10.
599.08) = $ 22.6047 PV 8.368 Price = $ 30.8772 1.000.50 22.14-0.4% Year 1 2 3 4 cash flows 9.25 (1+0.36 Present value after super normal growth = 40 (pvif14%.37 ii) P = d1 = 1.2 $ 44.748.6750 1.2 The price per acre will be ASSIGNMENT II $ 235.781.418.0 (1+g) = 0.000 38.997.14 – 0.997.R = [1+0. 3years) = 40(0.604.071.6750) = 27 Price per share = 27 + 3.417.08) (1+0.25 (1+0.686.350.44 76.05)] – 1 R = 13.26 PVIF 13.1 or 10% 10 Therefore Dividends next year D1 = EPS1 x payout ratio = 11x6% = $ 6.0588 = $ 235.6 = $ 165 0.950 37.4% 0.25 (1+0.27 13.32 25.08)3 = 1.209.8818 0.243 29.1842 1.458 0.1219 1.03 A.1 Shall be willing to pay $ 165 per share B. 000 PVIF = 4.7695 1.000 NPV = D.135.599.0625 3. 4.574 0.599. Previous year earnings per share (EP0) = $ 10 Previous year dividends per share d0 = $ 6 Earnings per share next year EPS1 = $ 11 Dividends per share next year d1 = ? Cost of capital (Ks) = 14% Pay out ratio = 6 = 60% and g = 6. i) price = present value of all supernormal growth + present value of price After supernormal period Thus Period 1 2 3 Dividends PVif14% PV 1.6857 0.6 = 6.555.000 X 0.25 (1+0.08) = 1.08 74 .03 Initial cost 32.055.6 Price of share p1 = d1/ Ks-g = 6.7776 0.08)2= 1.5 Ks-g 0.36 = $ 30.921.
000 (PVIF10. coupon rate = 8%.200. n) V = I (PVIFA3.19 D) Value of firm (V) = x1 Ks-g = 1.7928) + 1000 (Doesn’t change since the market rate is equal to the coupon rate) ii) If the market rate is 10% Then value of the bond (V) = I (PVIFAi.000 at 10% received after a year = 10.04 E) 12.36 iii) If the market rate is 6% Then V = I (PVIFAi.27 G i) Alternative 1: To receive $ 10.331. 10 = PVIFAr. 10 = 6. n) + M (PVIFi. 10 = 12.231.7507 x X = 25. n) + 1000 (PVIFi. 1) = 10.1148) + 1000(0.4 2000 PVIFAr.6209 = $ 12418 75 .36 Value of the bond (V) = $ 828. Present value of 10.5 c) Calculation of the price of a bond if the market rate is (i) 8% Value of the bond (V) = I (PVifAin) + M (PVIfi.1420) = 828. Therefore periodic interest payments = 4% x 1000 = $40 V= 40 (PVIFA) + 1000 (PVIF) = 40 (19.4 From the tables r = 9% F) Amount required in 5 years = $ 25. n) = 40 (PVIFA5. 40) = 40 (23. then the price of the share will be $ 22.7507 The amount of yearly instalments to be paid = $ 4.347. 5Years 25. n) Bonds per value = $ 1000.1591) + 1000(0.16+0. years to maturity = 20 years with semi annual interest payments.000 x 0.9091 = $ 9091 Present value of 2.000 five years from now Evaluation of the alternatives at discount rate of 10%. 40) + 1000(PVIF5. 40years) = 40 (17.3066) V = $ 1.500 = x PVIFA7%.800 = 6.800 = 2000 PVIFA r.000 a year from now Alternative 2: To receive $ 2.000(1-0.000 = $ 4.04) 0.000 received after five yeas at 10% discount rate = 20.000 = 5.347.000 x 0. 5) = 20. 40) + 1000 (PVIF3.19 Thus at 6% the value of the bond = $1.000 Instalments to be paid to an account charging 7% interest payment 2.000 (PVIF10.27 5.Thus if the cost of capital is 14% and growth is 8%.
the company increases its financial capability. advantages and disadvantages. materials.000 = (1+r) 4 10.333).Choice: choose 20. 5) = 20.000 x 0.000 (PVIF20. thus it can avoid cash out flow associated with ordinary shares Demerits of Equity 76 .333 Present value of $ 20.9% At 18. Equity Financing Shares or common stock provide ownership rights to investors.1892 r = 18. 1) = 1.419 = $ 8038 Choice: take 10.000 be received after one year because the present value of 20% is higher ($ 8.8333 = $ 8. These sources of funds can be classified both in the short term and long term. Lenders generally lend in proportion to the company’s equity capital.000 received after one year = 10. Thus it can avoid cash flow associated with ordinary shares. Merits of Equity Since ordinary shares are not redeemable the company has no liability for cash associated with its redemption.000 is higher ($ 12. It is permanent capital and is available for use as long as the company trades.000 (1+r) 20.000 (1+r) (1+r) 5 10. This paper examines these sources of funds within the framework of their nature. The discount rate that makes the two options attractive:10. • A company is not legally obliged to pay dividends it times of financial difficulties. A firm therefore seeks several sources of finance to meet their investment objectives.000 = 20.000 x 0.9% the two options shall be both attractive (the same) INTRODUCTION Firms make decisions on investment both in the short term as well as in the long term.000 received after five years 20. It can reduce or suspend payment of dividends.1 (1. These decisions are require firms to commit resources in terms of people. • A company is not legally to pay dividends it times of financial difficulties.000 to be received in five years because the present value of 20. money and time. ii) At discount rate 20% Present value of $ 10.000 received after one year whose present value is $ 9019. LONG TERM SOURCES OF FINANCE A.000 2 = (1+r) 4 r = 4√2. • Equity capital increases the company’s financial base and thus its borrowing limit.418) compared to $ 10.000(PVIF20.000 (1+r) 5 = 20.333) compared to that of $ 20. Ordinary share are a source of permanent capital since they do nod have a maturity date for the capital by shareholders by purchasing shares they are entitled for dividends.000 received after five years ($ 8.1892-1) = 0. By issuing ordinary shares. Holders of common shares are called shareholders or stockholders and are the legal of the company.
though fixed decline in real terms. Preference Shares Preference shares can be considered a hybrid security since they have features of both the ordinary shares and the debentures. • Dividends are not deductible for tax purposes. debenture issue benefits the company. • They usually do not have voting rights. While shareholders have a pre-emptive right to retain their proportionate ownership. Advantages 1. The obligation of paying interest and principal. • Preference shares do not voting except when the dividends have been accumulated for several years. The purchasers of debentures are called debenture holders. Demerits 1. They are similar to debentures in that:• Preference shares do not participate in residual income. Therefore. they may not have funds to invest in additional shares. 1. MERITS It involves less cost to the firm than equity financing because. • Preference shareholders have claims on income prior to ordinary shares. Investors consider debentures as a relatively less risky investment alternative and therefore require a lower rate of return. B. 4. Debentures indenture may contain restrictive covenants. Thus payments are limited to interest paid. • It is a perpetual security therefore it does not have a maturity date. The non payment of these dividends does not force the company into insolvency. The issuance of ordinary shares can change ownership. which is advantageous since preference dividend is a fixed obligation. Debenture holders do not participate in extraordinary earnings of the company. which may limit the company’s operating flexibility in future. The issuance of new ordinary shares dilutes the existing shareholder’s earnings per share if the profits do not increase immediately in proportion to the increase in the number of ordinary shares. • Has no fixed maturity date. During high periods of inflation. Ordinary shares are riskier from the investor’s point of view as their uncertainty regarding dividends and capital gains. Preference shares provide a financial leverage. The firm promises to pay interest and principal as stipulated. It increases the firm’s financial leverage of paying interest. if not paid. Debentures may result in legal obligation of p [paying interest and principal. which may be particularly disadvantageous to those firms with fluctuating sales and earnings. 2. Debentures must be paid on maturity and therefore at some point it involves substantial cash flows. Interest payments are deductible. 4. 3. Debentures: A debenture is a long-term instrument or promissory note for raising loan capital. It increases holders do not have voting rights therefore debenture issue does not cause dilution of ownership. • Dividend rate is fixed whether the business makes profit or not. 2. 3. they require high rate of return. which. • The preference shareholders have claims on income and assets prior to that of common shareholders. They are similar to common shares in that:• The non payment of dividends does not force the company into insolvency. can force a company into liquidation. 77 .• • • Shares have a higher cost for two reasons: dividends are not tax deductible as are interest payments and floatation costs on ordinary shares are higher than those on debts. C.
Interest paid on mortgage is tax deductible/allowable expense thus it reduces a companies tax liability. It is easier to set up and does not involve tedious formalities thus very flexible. which avail finance for long –term use. the firm therefore reaps profits from an investment it has not incurred i. The firm continues to use the asset mortgaged in its financing endeavours and at the same time having received a lump sum of funds to finance its operations. These avail finance in large 2. Preference shares do not participate in excess profits. the interest expense and insurance of the security respectively. The periodic rental charges may outweigh the cost of the same as. DEMERITS 1. MERITS 1. They do not have voting rights except in the case of dividends in arrears.g. DEMERITS 1. It entails implicit costs such as repairs and maintenance of the leased asset. Does not affect the company’ gearing level and financial risk. MERITS 1. INSTITUTIONAL INVESTORS These are corporate companies.e. It is an arrangement where the mortage agrees to give a specific sum of money on the mortgagor on the strength of land or building acting as the security for this finance. insurance companies. 3. no capital expenditure on its part. Does not call for securities. the lessee enjoys the benefits of wear and tear which also reduces tax liability 3. 2. Mortage finance increases the company’s gearing level thus increasing financial risks same time agrees to lease the same asset back at an agreed rental charge. 2. Therefore the preference dividend is restricted to a stated amount. Lease charges are tax deductible expenses thus will reduce the company’s tax liability 2.e. in situation of economic recession e. with inflationary effects the firms leasing the asset stands to gain in that the rental charges will be lower then due to effects of inflation which reduce the real value of money. G. 4. Leasing Leasing is available through the granting of an asset to a company. DEMERITS 1. Preference shares provides sane financial flexibility to the company since it can post pone payment of dividend. 3. Later payments of mortgage loan due to the impact of inflation. Disadvantages 1. E. There is no immediate cash outlay. 3. Lease finance entails implicit costs like maintenance and insurance. Preference dividend is not tax deductible. MERITS 1. At the end of the lease period (usually 99 years in Kenya) the owner may repossess the asset or the lessee may get the option to purchase the asset or review the lease contract. 4.2. which obtains full use of an asset for a specific period of time in return for payment of regular charge. It is expensive because it carries both explicit and implicit costs i. pension organizations. 2. a do ordinary shares. 3. they have a cumulative attribute thus an obligation upon the company to pay D. 2. 3. 78 . They include trustee companies. MORTAGE FINANCE This is a source of finance that is available to companies with freehold properties such as land and buildings. Financing through leasehold is only limited to financing fixed assets and does not have any provision for working capital. Interest and principal repayments are legally binding to pay failure to which may lead the borrower to receivership in the extreme.
DEMERITS 1. Trade credit is very flexible especially since it grows with growth of the firm’s revenue figures. Availability of financing depends on the reputation of the debtor which might in some cases be pegged to the size of the firm. Investors can rescue the firm if it is facing financial problems beyond the control of itself. It is relatively easy to obtain except in cases of financially unsound firms. It is an informal spontaneous source of funds.e.quantities and usually do this to earn a return on the same finance or to acquire ownership in those companies to safeguard their interest. Investors with a majority shareholding use their voting rights in an advantageous way which may lead to takeovers and acquisitions as they might support proponents of takeover bids in particular if these are competitors. They may disrupt the company’s running through the various they would want the company to implement which may not be interest of the interest of the shareholders. However there is an opportunity cost which is the discount foregone. MERITS They are cheaper to access this sort of finance because it will be available in large sums and from a few companies e. 3. Trade credit refers to credit that a customer receives from suppliers of goods in the normal course of business. It is normally restricted to working capital items and as such may not be available to finance other activities like acquisition of fixed assets which affect long-term profitability. 2. MERITS 1. Trade credit is partly cost free i. 3. 5. The company that offers commercial paper must have a high reputation on credit worthiness. Trade credit is mostly an informal arrangement made or granted on an open account basis. 2. these institutions using their financial experience offer advisory services to the companies in investment issue so as to utilise such finance more profitably DEMERITS 1.g. 9. It does not affect the gearing level of the company. 7. 2. The firm does not need to give security to acquire trade credit thus an advantage for smaller firms which do not have assets to pledge. Its easy availability is particularly important to small firms which generally face difficulties accessing other sources of finance from the capital markets. These securities can be easily sold in the money market. 1. It may also take the form of bills payable. B. The maturity of the paper is usually several months. In practice the buying firm does not have to pay cash immediately for purchases made. It is automatic and does not require negotiations. For most lending economies bank lending rates are higher than rates of discount offered on trade credit. 2. 4. This source of finance is not reliable because in the event of default on buyer’s side the seller might cut future credit by limiting the buyer from obtaining credit. 3. They influence the firm’s dividend policy and as such this may be to the detriment of smaller shareholders. the supplier does not charge any interest if the firm pays within the credit window. insurance companies. Source of SHORT-TERM FUNDS Short-term sources of finance are arranged in advance from bank and other suppliers recording it as debt. 79 . A bill is a formal acknowledgement of an obligation to repay a specific sum of stated standing amount. COMMERCIAL PAPER Commercial paper consists of promissory notes of large companies. They are normally restricted to large commercial firms. 3. 6. smaller firms may be restricted from obtaining credit. or treasury bills written by the government. which are sold to other businesses. pension funds or even individuals. 8. floatation costs will be low.
Negotiability and thus liquidity as investment will depend upon the good will depend upon the goodwill of the drawer which might lack in some cases.t. The compensating balance requirements are associated with issuance of the CP trough the firm is generally required to maintain a commercial bank relationship of approved credit equal to the amount of the CP outstanding. DEMERITS 1. They therefore constitute interest free sources of funds. A firm can obtain discount debtors with a bank and obtain immediate finance. No security is normally required in lines of credit. The discount rates are normally lower than bank rates on loans. 3. They involve costs i.e. There is a possibility of the negotiable instrument to be dishonoured by the drawer and thus the drawer may have to offset or settle any liability incurred thereon. it is also buying some degree of loyalty and commitment that is unavailable in the CP market.g. insurance premium. 2. Some interest is charged on the overdrawn amount. DEMERITS 1. 2. MERITS 1. A firm may pay a higher rate of bank loan. SHORT TERM LOANS FROM COMMERCIAL BANKS Commercial banks may offer or supply short-term funds in the form of overdrafts and Notes payable. Cash credit: this is interest on the credit granted. Line of credit: this is a formal/informal that will be made available by the bank within a specified period of time. 3. They are accrues salaries & wages. 2. They are highly negotiable instruments which can be easily liquidated at any time. interest payable e. The growing popularity of commercial paper can be attributed to the rapid growth of the money market. CPs limited to only large firms that are proven to be credit worthy. 3. D. ACCRUDE EXPENSES AND DEFERRED INCOME.g. 80 . Though funds offered through issuance of CP are cheaper. TRADE DEBTORS. 4. stamp duty. they are very unpredictable. 2. bills of exchange and promissory notes held by the company. Overdrafts: an overdraft is an arrangement made available to allow a company to overdraw funds from its bank account in excess of the minimum balance. Accrued expenses represent shortterm liability that a firm acquires for services already utilised. Debtors can also be used a security for loans in particular overdraft facilities. mutual funds. 4. C. discounts which may be substantially high depending on conditions prevailing e. 1. Commercial paper is normally sold at a discount rate. Banks require that a regular borrower maintain an average account balance equal to a certain percentage of the outstanding loan.c Deferred income represents funds received for goods and services that a firm has agreed to deliver at some future date. They are interest free. Notes payable: this involves discounting of commercial papers. Firms enjoy the prestige associated with being able to float a CP at a lower rate than that charged against short-term loans by commercial banks. 3. 3. These receipts increase the firm’s liquidity and therefore constitute a source of finance e. They are cheaper to obtain and finance.MERITS 1. 2. MERITS 1. insurances and the need to find securities for short term investment. accrued income taxes.
Do not require any form of collateral. DEMERITS They are short-term sources hence they might not contribute to the company’s profitability. as they cannot be used to acquire fixed assets. 81 .2.
b.EXAMINATION QUESTIONS AND ANSWERS UNIVERSITY OF NAIROBI DEPARTMENT OF ACCOUNTING DFI 501: FINANCIAL MANAGEMENT TEST II 07/11/04 TIME: 2. REQUIRED: (i) Compute the value of each firm (ii) Compute the cost of equity for each firm (3 marks) (3 marks) (2 marks) (iii) What is the market value of equity for each firm? (iv) Calculate the WACC for each firm (3 marks) a) Assume that all the facts hold as in (b) above. Show all the necessary workings and computations. QUESTION ONE: (31 Marks) a.00 – 3. Attempt ALL questions. c. Both firms have book assets of shs. 20 milion. Discuss the Trade-off theory of capital structure b. The cost of equity to Gay Company is estimated to be 10%. (3 marks) REQUIRED: i) ii) iii) Compute the value of each firm Compute the cost of equity for each firm What is the market value of equity for each firm? (4 marks) (3 marks) (2 marks) 82 .30 PM INSTRUCTIONS: a. Assume that there are no corporate or personal income taxes and that all of the MM assumptions apply. except that Kay Company has Shs 10 million of 5% bonds outstanding. Marks are allocated as shown at the end of each question. while Gay Company does not use debt financing. except that both firms are subject to a 30% tax rate.and they both expect to earn a 10% return on those assets before interest and taxes. Kay and Gay Companies are identical in every respect.
The Company tax rate is 30% and its cost of capital is 15%.200. The Company is offered a replacement machine which has a cost of Sh 1. A and B.500. Baggy Company is analyzing two proposed investment projects.000 salvage value. QUESTION TWO: (5 marks) (26 marks) a.500 per year. The projects’ expected net cash flows are as follows: YEAR EXPECTED NET PROJECT A 1 2 3 4 REQUIRED: (i) Calculate each project’s Regular payback period. Net present value (NPV).000 and the firm’s cost of capital is 12%. Each project has a cost of Sh 1. the new machine’s much greater efficiency would still cause operating expenses to decline by Sh 22. and it can be sold for Sh 450.000 (ii) Which project (s) should be accepted if they are independent? Mutually exclusive? (2 marks) b) Kentucky Company currently uses an injection moulding machine that was purchased two years ago. even so.000 450. so sales would rise by Sh 150.000.000 525. and it has 6 years of remaining useful life. (16 marks) Sh 975.000 CASH FLOWS PROJECT B Sh 525.000 150. an estimated useful life of 6 years and a zero salvage value. The replacement machine would permit an output expansion.iv) Calculate the WACC for each firm (4 marks) b) Explain how MM used the arbitrage process to prove the validity of proposition 1 when the company does not pay taxes.000 525.000. REQUIRED: Should the old machine be replaced? (8 marks) 83 . The company uses straight – line method of depreciation on the new machine. This machine is being depreciated on a straight – line basis towards a Sh 75.000 per yea.000 525. internal Rate (IRR) and Modified Internal rate of Return (MIRR).000 at time. its current book value is Sh 390. discounted payback period.000 450.
K=levered G = un – levered firm K-Debt of 10 million. I = 5% Book assets = 20m EBIT = 10 x 20m = 2 m 100 Cost of equity to Gay K K ev ev = 10% = 10% i) Value of each firm Let value of Gay be Vn = value of intervered VG = E = EBIT VG = 2.i) (1-T) D/E In this case both value of VL = VU.SOLUTIONS FOR TEST II 07/11/04 a) Trade-off theory of capital structure is when a firm considers the benefits of using debt and companies to the costs/risks associated with debt financing of bankruptly and agency costs as well as financing distress.1 Value of Gay = VG = 20 M Vk = value of k = Debt + Ek Ek = EBIT K K et = eL K eu + (K en .000. = VL = VK = 20 M i) Value of book firms’ = 20 M 84 .000 = 20 M 0.
1 85 .000 Both WACC = 10% c) i) with taxes 30% rate ii) Value of each firm a) value of Gay VG = EBIT (1-T) Keu V unlevers = VGay = 2 m (1-0.000 = 0.5 Vk = Debt +Ek VK = 20 M = 10 M + EK Value of equity.000. Ek = 10m v) WACC = EBIT V WACCk and WACCG = 2.ii) Cost of equity K K K Also K K Ev eu= eg =K eL K eg = 0.1 = 10% eg = 10% eu eL =K + (K e u -i) D/E = 10% + (10-5)10 M/10M = 15% K Ev = 15% iii) Market value of equity a) E E Gay = EBIT/ E Keg = 20 M Financing on equity only.000.1 20.000 – 0. kay = EBIT – iD = 2.000.000.000 K Ev 1.5 x 10.3) 0.
0323 17 m = 8. Under preposition 1.3 x 10 m = 17 m ii) Cost of equity K eg = 10% = cost of equity Gay = 10% K ek =K eg + (K eg .7) x 10/7 = 15% iii) Equity Values: Equity Gay = 14 m Equity Kay = 7 m iv) WACC = EBIT (1-T) V WACC of Gay = 10% WACC Kay = 2m (1-0.i) (1-T) D/E = 10% + (10-5) (0.500.000 86 . MM explains that through arbitrage process the value to the value of the unlevered firms.23% c) Arbitrage process is the process whereby investors will continue to sell the shares of the higher valued firm as they buy the shares of the less valued firm until an equilibrium is reached at when the two firms will be equally valued. ii) Regular pay back: Initial investments = 1.VG = 14 M b) Value of levered Vk = VG = + TD = 14m + 0.3) = 0.
000 450.000 450.7972 0.772.7118 0. 857 years ii) Discounted payback PVIF 0.000 = 2.000 525.6355 A 975.000 358.000 525.000 525.8929 0.685 333.000 450.5 525.000 x 12 months 450.845 years B = 3 years + 239.Project A Project B 525.530 373.5 94.000 PV Project B PV 468.000 Pay Back A = 2 years + 95.000 150.000 975.310 95.952 Project A = 2years + 270.71 years 333.637.325 525.000 = 2.000 525.000 Discount payable 144.683 = 2. 04.000 450.16 years B = 2 years + 450.71 years NPV for A = 144.5 418.000 525.740 320.634 870.5 = 3.577.000 525.634 87 .637 = 3.952 NPV for B = 94.000 150.
000(1.857 IRR = 15% IRR for B = 15% MIRR n r. d) Salvage = 75.IRR :B 525.L = 1.000 Σ C of = nΣ CIF (1+K)Nn-t = (1+k) (1+e)n t For A 975.137 = 13.000 + 150.725 – 1 = 0.000 (1.000 88 .72552 MIRR = 4√1.12)0 1.000 (1) MIRR = 0.000 = 2588284 (1+ MIRR) 4 (1+MIRR)4 = 1.500.000 PVIA PVIFAR.000(1.000.369.7% ii) Accept project If independent accept Both A and B ii) If mutually exclusive: accept project A It has a higher NPV and higher MIRR than the other project.1461 = 14.000 (1.000(1.500.12)2 + 450.8 + 564.000(1+0.L = 2.804.7% Project B MIRR = 13.12)3 + 450.000 (1+ MIRR)4 1.12)1 + 150.61% Project B 525.12)3 +525.480 + 504.12) + 525.000 = 1.
000 Less Earned after tax 262.000 EBIT 375.3 x 44.000 Benefit reduced costs Sh 225. 768.750 = 306.000 (432.250 306.200. = 0. Tax in gain 30% 18.000 6 = 52.160.000 Benefits 375.7845 X 306.000 Add.000 89 .000 375.000 – 75.000 Disposal of old M/C 450.000 Add dep.000 Cost outlay= Initial on of new 1.2 M – 0 = 200.000 6 Sales incremental Sh 150.000 MP = 450.000 6 years life zero salvage Depreciate old M/C = 390.750 PVIFA15% 6 + 0 = 3.500 Dep of new M/C = 1.Bv = 390.750 = 1.000) Investment = Benefits = 375.200.000 New M/C cost = 1.895 Sh.
c) Marks are allocated as shown at the end of each question.895 Hence Replace old machine as NPV > UNIVERSITY OF NAIROBI MODULE II DEGREE PROGRAMME 2003/2004 EXAMINATIONS FOR THE DEGREE OF MASTER OF BUSINESS ADMINISTRATION DFI 501: FINANCIAL MANAGEMENT DATE: 3RD DECEMBER.(3 marks) (iii) Capital gains yield and Dividend yield (3 marks) c Explain the two propositions advanced by Modigliani and Miller (MM) to explain the relationship between capital structure and the value of a firm as well as cost of capital when there are corporate taxes. (6 marks) d Discuss the relationship between corporate ethics and shareholder wealth maximization. (3 marks) (ii) Systematic and unsystematic risks.00 PM – INSTRUCTIONS: a) Attempt ALL questions. b) Show all the necessary workings and computations.160. 2004 8.NPV = 1.00 PM TIME: 6.000 NPV = 392. QUESTION ONE: a Explain how the goal of stock price maximization is beneficial to society (6 marks) b Distinguish between: (i) Business and financial risks.898 – 768. (4 marks) 90 .
00 13.85 3. The current market price of its stock is Sh30 per share.60 2. which it considers to be optimal under present and forecasted conditions.50 25. (4 marks) ii) Compute the WACC in each of the intervals between the breaks (10 marks) QUESTION THREE: 91 .000 Sh900.05 1. Debt Preferred stock Equity 30% 20 50 For the coming year. its last dividend was Sh3 per share. Present commitments from its banker will allow Raymond to borrow according to the following schedule: LOAN AMOUNT INTEREST RATE 10% 12% 14% Sh0 to Sh500.25 9. The company’s tax rate is 30%. Raymond’s pas dividend policy of paying out 60% of earnings will continue.00 18.QUESTION TWO: a Stocks A and B have the following historical dividend and price data: YEAR PRICE 1998 1999 2000 2001 2002 2003 STOCK A DIVIDEND YEAR-END PRICE Sh 1.15 1.40 2.25 Assume that an investor holds a portfolio consisting of 40% A and 60% B.75 11.00 1. REQUIRED: i) Calculate the actual (realized) rate of return for each stock and for the portfolio in each year from 1999 through 2003.25 15.50 24. Floatation costs of 5% will be incurred.000 Sh500.05 3.5 million.30 1.00 Sh2. (8 marks) ii) Compute the Mean (average) return for each stock and the portfolio.001 to Sh900.50 STOCK B DIVIDEND YEAR-END Sh22. management expects after-tax earnings of Sh2.001 and above New preferred stock with a dividend of Sh11 can be sold to the public at a price of Sh100 per share. REQUIRED: i) Determine the breaks in the MCC schedule.50 Sh 12.50 19.75 13.25 22. External equity can be sold at a floatation cost of 15%. (3 marks) b Raymond enterprises has the following capital structure. and the expected growth rate is 5%.
000 204. The company’s marginal tax rate is 30%. an annual savings of Sh510. Jane estimates that tightening the credit terms to 30 days of sales. 000. However.a) Explain why capital budgeting decisions are important to the success of a firm. The old machine has a book value of Sh1. and the savings on investment in them should more than overcome any loss in profit. The firm does not expect to realize any return for scrapping the old machine in 5 years but it can sell it now to another firm in the industry for Sh530. b) Jane has been employed as the new credit manager for KINGORI Company and is alarmed to find that the company sells on credit terms of net 90 days while industry wide credit terms have recently been lowered to net 30 days.6 and 7 after which the dividends should grow at a constant rate of 8% per year.000 and a remaining useful life of 5 years.000) 216.000 432. (8 marks) The new machine has a purchase price of Sh2. The Company’s variable cost ration is 85% and the interest rate on funds invested in receivables is 18%. It’s expected to economize on electric power usage. REQUIRED: Compute the value of the stock. The old machine is being depreciated towards a zero salvage value.000 204. In total.000 432. (5 marks) b) The BigBee bottling Company is contemplating the replacement of one of its bottling machines with a newer and more efficient one. The dividend should grow rapidly at a rate of 40% per year during years 4. The required return on the stock is 15%. The projects’ expected net cash flows are as follows: YEAR 0 1 2 3 4 5 REQUIRED: EXPECTED NET CASH FLOWS PROJECT A PROJECT B Sh (468.000) 92 . REQUIRED: Should the Company change its credit terms? (7 marks) c) Micro-tech Company is expanding rapidly. investors expect Micro-tech to begin paying dividends.000) Sh (636.200.000 (288. with the first dividend of Sh3 coming three years from today.000 (204.000 432.000 an estimated useful life of 5 years. labour and repair costs. and it has a 20% cost of capital. hence it does not pay any dividends. and it currently needs to retain all of its earnings.000) 204. the company currently averages 95 days’ sales in accounts receivable.5 million. as well as to reduce the number of defective bottles. and an estimated salvage value of Sh290.000 will be realized if the new machine is installed.000 204. On annual credit sales of Sh2. The company uses straight-line depreciation. 350.000. REQUIRED: Should the firm purchase the new machine? (8 marks) c) KAJEMBE Company is considering two mutually exclusive investments.5.
when construction in the area slows. (12 marks) QUESTION FOUR: a) KONGONI Company is considering changing its credit terms from 2/15. net 30. (Assume a 360 day year) What is the expected average accounts receivable level? (5 marks) If the bank loans cost is 12%. The terms of sale are ‘’net 30’’. half of the customers who do not take the discount are expected to pay on time. However.2 million per year. 50% to pay on the 40th day. discount customers are expected to rise to 70%. and then fall of again in the summer. 60% of KONGONI’S customers take the 2% discount. therefore bad debt losses are not expected to rise above their present 2% level. the more generous cash discount terms are expected to increase sales from Sh1 million to Sh1. The variable cost ration is 70%. rise during the spring. to 3/10 net 30. Question One: (35 marks) 13/7/03 (10 marks) Jane a recent MBA graduate is planning to go into the wholesale building supply business with her sister Winnie. IRR and MIRR. because Winnie. Sales would be slow during the cold months. in order to speed collections. while the remainder will pay 10 days late.Compute each project’s NPV. knows which contractors are having financial problems. who majored in building construction. At present. Under the new terms. what is the annual cost of carrying the receivables? marks) (3 93 . the building construction expert. Regardless of the credit terms. The change does not involve a relaxation of credit standards. Required: Assume that on coverage. the sisters expect 30% of the customers to pay on the 10th day following the sale. and it would start operating next January. the interest rate of funds invested in accounts receivable is 12%. the sisters expect annual sales of 18. but because of special incentives. No bad debt losses are expected. and the remaining 20% to pay on the 70th day. The firm would sell primarily to general contractors. REQUIRED: Should the Company change its credit terms? UNIVERSITY OF NAIROBI DEPARTMENT OF ACCOUNTING DFI 504: FINANCE MANAGEMENT TEST THREE: INSTRUCTIONS: Attempt ALL questions Show all the necessary workings and complaints. assuming a required rate of return of 14%.000 items at an average price of sh 100 per item and a variable cost ratio of 75%.
on day 40. (8 marks) Under the current credit policy.000 per year. what is the firm’s Days sales outstanding (DSO)? What would the expected DSO be if the credit policy change were made? What would be the firm’s expected cost granting discounts under the new policy? What is the firm increased change in the level of investment on receivables? What is the incremental before tax profit associated with the change in credit terms? Should the company make the change? (8 marks) QUESTION TWO: (15 marks) The ABC Company purchased a machine 5 years ago at a cost of sh.000. Sales are not expected to change. At the end of its useful life. It had an expected life of 10 years at the time of purchase salvage value of sh.Assume that now it is several years later. The old machine can be sold to day for sh.000.000. for 30% to pay full amount on day 20. The firm’s tax is 30%. briefly the trade-off theory of capital structure.100. The net expected result is for sales to increase to 1. Assume straight-line depression for the new machine as well. 650. 100. and for bad debt losses to fall from 2% to 1% of gross sales.500. employing stricter credit standards before granting credit.000.000. The firm’s variable cost ratio will remain unchanged at 75% and the cost of carrying receivables will remain unchanged at 12%. 1. for 60% of the paying customers to take the discount and pay on the 10th day. SOLUTIONS (15 marks) (10 marks) (5 marks) (5 marks) FOR TEST THREE: 13/7/03 D SOo = 80% (30) + 20% (40) = 32 days 94 . Gross sales are now running at sh 1. 2% of the firm’s gross sales end up as bad debt losses. 100.000 a year and 80% of the firm’s paying customers generally pay full amount on day 30. which are now ‘’net 30’’. net 20’’.000 at the end of 10 years.000. The sisters are now considering a change in the firm’s credit policy. It is being depreciated by the straight –line method towards a salvage value of sh. The appropriate discount rate is 15%.000 including installations costs. Required: Describe the four variables that make up a firm’s credit policy and explain how each of them affects sales and collections. for 10% to pay late on day 30. and enforcing collections with greater vigour than in the past. The change would entail changing the credit terms to ‘’2/10. A new machine can be purchased for sh. the machine is estimated to be worthless. on average. while the other 20% pay. REQUIRED: Should the firm replace the old machine? QUESTION THREE: What are the primary implications of portfolio theory? Explain. The sisters are concerned about the firm’s current credit terms. Over its 5 year life it will reduce cash operating expenses by sh 500. 1.
and the dividend payout ratio is expected to be 30%. The company has a marginal tax of 30% External sources of funds: Debt: up to $150 million can be raised at an 11% interest rate without issue costs.000.000+ 0.POSODO)-kd(Di) = (1. then floatation costs increase to 6% 95 .000x 2%-0) = 13068 Di = (DSON. Floatation costs are 4% on the first $150 million. No other projects are under consideration.DSO O SOO/360 + V(DSON) SN-SO 360 = (15-32) 1. which is estimated to require $180 million of financing and to yield a 16% return.64 incremental profit COST OF CAPITAL Total Oil is planning a large expansion program during the coming year. Cost granting discounts under new policy.PODOSO) = (60% x 99% x 1.DSO N = 60% (10) + 30% (20) + 10% (30) = 15 days exp.000.44. Above that amount. = (PNSN.100. 000-0) – 12% (.000) 360 360 = 44.233. 100.097 No discount DP = (SN-SO) (1-VC)-BNSN –BOSO) – (PNSNDN.000 – 1. the interest rate will be 14% Preferred: Up TO $150 million can be sold at par value of $60 to yield the investor 12%. Total Oil wants to raise the funds in accordance with its target capital structure shown hereunder: Market values Debt 30% Preferred 20 Common 50 amount of retained Total Oil expects net earnings available to common shareholders this year of 280 million.100.75) – (1%x1.75 (15) (100.000) (1 – 0.097:2) = 26.
The last dividend was $1. The floatation costs are 8%.Common: Current market price is $18 per share. Required: What is the break point in the MCC schedule due to retained earnings being used up? What is the component cost of retained earnings? marks) (7 What is the component cost for less than $150 million of preferred stock? What is the component cost of preferred stock above this amount? What is the break point due to low-cost preferred stock being used up? (6 marks) What is the component cost of up to $120 million of debt? What is the cost above this point? What is the break point due to low-cost debt being used up? (6 marks) What is the component cost of new equity? (7 marks) What is the marginal cost of $180 million of capital? Should the expansion program be undertaken? (8 marks) (Total: 34 marks) SOLUTIONS FOR TOTAL OIL Break point in the Mcc = Available capital Weight of the capital Hence Break point of retained earnings = available RE Weight of RE To get retained earnings After tax profit Less preferred dividends Profits available to Ordinary shareholder xx 80 96 xx (xx) .50 and the expected growth rate is 12%.
4 97 .5 = 112m or 56 = 112m 0.77% 56.12 x 60 = 60 9(1-0.3% (b) (i) kp 18(1-0.12) + 0.03% = annual dividends Po .2 60 (1-04) 57.2 = 7.5 kg = DO (1+g) + g P-* P(1+F) = 1.5 ((1+ 0.2) +* (ii) kr = DO (1+g) +g PO = 1.6 = 12.2 = 12.06) Break point Bpp = Available preferred stock Weight of preferred stock = 150 = 750m 7.F or Po (1-F) Annual dividends – par x dividend Value rate = 12% x 60= Hence Kp = 7.12 18 = 21.Less ordn dividends (dividend) payment ratio RE available (a) P Br (xx) (30% of 30) 24 xx 56 Net earnings = 80 (1-30 0.5% (ii) Above & 150 kp = annual dividends po (1-F) = 0.3) 0.2193 = 22.06) = 0.5 (1+0.
12) + 0.3 = 400m competent cost of new equity kg = DO (1+g) +g po (1 –F) = 1.56 = 22.5 (1 +0.8% (iii) Bpd = available debt Weight of debt = 120 0.2 (c) (i) up to 120m effective cost of debt/after tax Kd = kd (1 – tax) = 11 (1-03) = 7.12 10.12 18 (1-0.0.3) = 9.08) = 2.7% above 120m after tax cost debt or effective cost debt: kd = 14 (1.0.1% If the RRR is 16% is greater than the cost of capital then accept the perfect as * 98 .62 + 0.
60% take the discount and pay on day 10.000 per year. e) Marks are allocated as shown at the end of each question. However. with variable costs amounting to 60% of sales. net 60’ and she estimates that this charge would increase sales to $ 100. However. It is expected that 75% of the paying customers would take the discount under the new terms. What is the effect on the firm’s pre-tax profits? (7 marks) d) Refer back to the original terms. paying on day 20. bad debt losses at the new sales level would be 30%.000.M INSTRUCTIONS: c) Attempt ALL questions.30 P.UNIVERSITY OF NAIROBI DEPARTMENT OF ACCOUNTING DFI 501: FINANCIAL MANAGEMENT MAKE – UP TEST DATE 23/03/03 TIME 2. Suppose that the firm’s credit manager decides to shorten the collection period by tightening the credit terms to ‘2/10. with bad debt losses running at 2% of gross sale. QUESTION ONE: (30 Marks) Mumias industries currently sells on terms of 2/10. The firm’s gross sales are currently $ 1. Of the 98% of the customers who pay. a) b) REQUIRED: What are the old and new Days sales outstanding? (4 marks) Should the change in credit terms be made? (11 marks) c) Assume that the firm’s competitors immediately react to the change in credit terms by easing their terms. this tightening of credit terms is expected to 99 .00 – 3. while 40% pay on day 40. This causes Mumias to gain no new customers. The firm finances receivables with a 10% line of credit and there are sufficient fixed assets to support a doubling in sales. of the existing buyers who pay (2% continue as bad debt losses). while 25 % pay on day 60. collection experience and level of sales. net 40”.000. net 30’. Bad debt losses would remain at 2% of gross sales and collection percentages are expected to remain at 60% and 40%. 75% now take the discount and pay on day 20. however. while 25% would now pay on day 60. d) Show all the necessary workings and computations. The firm‘s credit manager has proposed that credit terms be changed to ‘2/20.
000 -2%X1. Would this decision be desirable? (8 marks) MUMIAS INDUSTRIES c) Days sales outstanding ∆0 = 60% (10) + 40% (40) = 22 days ∆sn = 75(20) +25% (60) = 30 days d) Look at impact of profits ∆ Profit = (SN-SO)(1-rc) – (BN SN-B0 S0)= (PN SN ∆N – P0 S0 0∆) – kd (∆ I) ∆I = (∆ S ON -∆ S0 O) ( SN -360) + V(S00) (∆SN -S0)/ 360) If sales are to decrease) ∆1 = (∆ S ON -∆ S0 O) ( SN -360) + V (∆S00) (SN -S0)/ 360) ∆1 = (30-22) 1.100.000.000.162.reduce gross sales to $ 900.778 ∆S0N = 75 (20)-25% (60) = 30 DAYS ∆I = (30-22) (1.000 360 = 27.000 + 0.000-1. because it will result in incremental profit of 20.778 Should change credit terms.02) = -5.000-1.032.032. 360 ) incremental debtors ∆P = (1.000.22 + 0.000)(1-0.100.222.222.000.000) + 0.000) – (75% X 97% X 1.000.222.000) 100 d) .222.22 New Debtors ∆P = (1m-1m) (1-0.6) – 2% x 1m – 2% x 1m) (2% x 1m x 60% x 98%) – 10% (22.000.000.6 (30) (100.162.000 X 2%) – 10% (27.22 use decreased sales ∆I = (∆ S ON -∆ S O0 SN / 360 + V (-∆ S00 ) S N -S0 / 360 = (18-22) 900.6(30) (1M-1M) 360 360 = 22.22) = 20.000 X 2% .60% X 98% X 1.22 Change should not be made because pre-tax profit goes down by 5.100.6 (22) (900.000.6)-(3% X 1.000-1.
000.667 Change in profit ∆P = (900.22 Use decreased sales ∆i= (∆SoN .778 ∆S0N = 75 (20)-25 %(60)=30 Days ∆I = (30-22) (1.6). Because it will result in incremental profit of Ksh 20.6(22) (900.000.000) -10% (27222.6(30)(1M-1M) 360 = 22.000-1.10.666.000.22 New debtors ∆P =(1M-1M) (1-0.000.4 360 360 .162.000.6)-(2%X900.000.02) = -5.000)(98% X60% X2% X 900.000)+0.22 Change should not be made because pre-tax profit goes down by 5.000 -366.000.222.(2% X 900.000)(1-0.000 – 98% X 75% X 2% X 1.162.22) = 20032.000-1.666 = -13.10.000-2%X1.032.222.667 Change in profit ∆P = (900.000)-10% 101 .000-2% X 1.775 Should change credit terms.000.000) (1-0.000-98%X76%X2%X1.000 – 3.∆Soo) SN/360 +V(∆Soo) SN-SO 360 = (18-22) 900.6)-2% X 1M -2%X1M) – (2% X 98%X1Millionx75%2%x1Mx60%x98%)-10%(22.000 + 0.000-1.06 = -13.000)(98%X60%X2%X900.000) 4 360 360 360 .
REQUIRED: Advice the directors of ABC Ltd whether it should produce X-2 QUESTION TWO The owner of Makanga Ltd wishes to replace an old garage equipment with a more efficient modern one. Annual inflation rates for production costs are expected to be as follows: Variable 4% Variable labour 10 Variable overheads 4 Fixed costs 5 The company’s weighted average cost of capital in nominal terms is expected to be 15%. 102 .DFI 501: FINANCIAL MANAGEMENT ASSIGNMENT THREE QUESTION ONE ABC Limited has just developed a new product to be called X-2 and is now considering whether to put it into production. The new equipment costs $66 million. Production costs of X-2 (at year 1 prices) are estimated as follows: Variable materials $80 per unit Variable labour 120 per unit Variable overheads 120 per unit Fixed cost (including depreciation) $8 million per year. The machinery has a production life of 4 years and a production capacity of 30. Assume straight-line depreciation. will have an estimated economic life of 5 years and an estimated salvage value of $12 million.000 units per annum for the next four years. Demand is Expected to be 25. Annual cost savings amount to $30 million before tax and depreciation. The selling price of X-2 will be $800 per unit (at year 1 prices). The following information is available: Production of X-2 will require the purchase of new machinery at a cost of $24 million payable immediately. The machinery is specific to the production of x-2 and will be obsolete and valueless when that production ceases. Its current market value is $18 million and it has a zero salvage value after 5 years.000 units per year. The retail price index is expected to increase at 5% per annum for the next four years and the selling price of X-2 is expected to increase at the same rate. The company’s marginal tax rate is 30% and its cost of capital is 20%. The company’s tax rate is 30%. The book value of the old equipment is $30 million it has a remaining economic life of 5 years.
6 m 44.8 Life = 5 years 5 Salvage = 12M Annual salvage before tax and depr = 30m Tax rate= 30% cos of capital = 20% Cash outflows Year 0 (66m) * proceed 18 48m 48m 3.64 2 17.8 4.6 15.56 7.64 17.64 17. should the old equipment be replaced? QUESTION THREE: Discuss the various long-term and short-term sources of funds.56 7.64 17.8330 0.56 7.2 25.69440 0.8 4.64 4.2 25.8 Loss of 1.56 7.8 4.2 Cash flow 7.5 12 10.4m savings before tax Tax Saving after 108 6 4.2 25.56 20% Savings after tax Tax 17.64 3.44 22.44 22.5787 0.8 22. 17. 1 2 3 4 5 30 30 30 30 30 4.8 4.4823 103 .2m Tax shield 30%x12 Cash inflow Year Savings change Depr.64 17.64 4.8 PV 1 17.REQUIRED: Using the NPV criterion.8 4. QUESTION TWO Book value & 30 million Remaining life = 5 years – salvage Market value = 18m DEP old = 6m New equipment Depr New = 66 – 12 = 10.2 25.44 22.8 4.8 Add ds 25.8 4.64 Xxx 18.44 0. indicating their advantages and disadvantages. 17.
M 0 89 832 80.1019 9. and the current interest rate on marketable securities is about 5% REQUIRED: Use the Baumol model to calculate the optimal transfer amount between cash and marketable securities (3 marks) What is the company’s average cash balance? (2 marks) How many transfers would be required in a year? (2 marks) What is the total cost associated with the average cash balance? (3 marks) 104 .525 Decision criteria The equipment should be replaced because it has a position not go present value Therefore accept.925 27.000 per year.000.6 Advice The directors should put the new product into production.8 22. It costs about sh 5 per transaction to transfer funds between the cash account and the marketable securities account.44 67.L V.99 S.64 12m (0 4019) 4.5.P 0 * 840 832 920 V.98 134.000) VC = VM +V.L – Variable * V.3 = 1800* Revenue = spx quotation (25 000) Variable cost = v.O – Variable ove * V.82 71 925 0.O TVC 0 0 0 120 20 320 * 12.m – variable * V. QUESTION ONE Depreciation 24 = 6m 4 Year 0 1 2 3 4 S. 17.53 89.10 4.2 129.L +0.48 360 145.c quantity (25.V cash inflow – cash out flaw 71.02 * NPV =∑ P.98 38* DT = 6m x 0.P – selling price V. a) MOGOTHO Company’s annual cash requirements average about Sh 1.72 36*52 159.
00 PM (b) (c) 105 . QUESTION ONE: (a) What is the difference between stock price maximization and profit maximization? TIME: 6. 2000 INSTRUCTIONS (a) Attempt All questions.142 ii) AV.778 sh 2778 iii) Transfer = Sh 1000 000 =71 14142 Costs = (71x5) + (5% x14142) = sh 708 14.071 2 UNIVERSITY OF NAIROBI MODULE II DEGREE PROGRAMME 2004/2005 EXAMINATIONS FOR THE DEGREE OF MASTER OF BUSINESS ADMINISTRATION DFI 501: FINANCIAL MANAGEMENT DATE: 3RD APRIL. Cash balance = sh 1000000 360 = sh 2. Marks are allocated as shown at the end of each question.00 PM – 8.What is the total cost associated with the average cash balance? (3 marks) Are economies of scale in cash management implicit in the Baumol model? (2 marks) What assumptions underlie the Baumol model? (2 marks) SOLUTIONS Annual cost requirements = sh 1000 000 Transfer costs sh 5/ transactions Interest is 5% optimal size and transfer = √2 x 1000 000 x 5 5% = sh 14. Show all the necessary workings and computations.142 = 4.
(b) REQUIRED: i. © Discuss the trade-off theory of capital structure. REQUIRED: IComputer the RPS and price per share for Makala Company. Total sales for the year are sh912. (d) Explain the FOUR credit policy variables. QUESTION TWO: (a) Makala Company. on average. while the other 60% of the customers pay on the 10th day and take the discounts.000.000 Book value per share Ksh10 Interest rate on debt Ksh10% Cost of equity Ksh15% (Tax rate) Ksh30% Since Makala Company’s product market is stable and the company expects no growth.000. (5 Marks) ii. EBIT Ksh8.000 to Sh12. (5 Marks) iii Makala Company can increase its debt by Ksh8. Should the Company change its capital structure? Dowell Industries sell on terms of 3/10. all earnings are paid out as dividends. What is the average amount of receivables? (2 Marks) (3Marks) 106 . Computer Makala’s WACC. a product of generators is in the situation described below. Net 30.500.000. while the other 60% pay.000 Share of common stock outstanding Ksh1. Computer the Day’s Sale Outstanding.000.000. ii. 40 days after their purchases. Its cost of equity will rise to 18%. EBIT will remain constant.000 using the new debt to buy back and retire some of its shares at the current price. The debt consists of perpetual bonds. 40% of the customers pay on the 10th day and take discounts.000 Debit outstanding Ksh4. Its interest rate on debt will be 15% (it will have to call and retire old).Under what condition might profit maximization and Not lead to stock price? (b) Describe THREE ways by which funds cam be transferred between savers and borrows.
30 per share and new preferred stock could be sold at a price to net the company Sh 30 per share.000 60.000. The market risk premium is %5.000. (b) (13 Marks) Komoro Company paid a dividend of Sh3 last year.iii. The preferred stock pays a dividend of Sh3.000 35. REQUIRED 107 . The firm can issue additional long-term debt at an interest rate of 12% and it is marginal tax is 30%.000. What would happen to average receivables if Dowell toughened up on its collection policy with the result that all non-discount customers paid on the 30th day? (3Marks QUSTION THREE The condensed Balance Sheet for Kitui Company is given below: 2004 Ksh 25.10.000 ======== Current assets Net fixed assets Total assets Current Liabilities Long-term debit Preferred Stock Common stock Retained earnings Total liabilities and equity The company’s EPS last year we Sh3.000 14.000. and last year’s dividend was Sh2.500. A floatation cost of 15% would be required to issue new common stock. the risk-free rate is 6% and the company’s beta1.000 15.5.000 16. REQUIRED Computer the firm’s WACC. The earnings and dividends are expected to grow at a rate of 8% indefinitely.000 60.000 ======== 10.000.500.000.000. the stock sells for Sh55. The company ha a beta coefficient of 1. Security analysts are projecting that the common dividend will grow at a rate of 9% per year.12. the yield on Treasury bonds is 8% and the average rate of return on the market is 12%.20.000 4.
Heymann’s cost of capital is 10%.6209 – 100.i.000 30.000 30. Net cash inflows are expected to be Sh123 Million.2 Sh (100.000 20.000 Pulf a y 18.6 Sh (100. then to return to its long-run constant growth rate 8%.000 20.000) 40.000 * Line 5 contains the estimated salvage values.000 Pulf – 100. What is the next stocks value under these conditions? (6 Marks) QUESTION FOUR The staff Heymann manufacturing has estimated the following net cash flow and probabilities for a new manufacturing process. iii.000 x 3.000 20.000 30.000) 20. YEAR P=0. payable at the end of year 2.000 30. Compute the firm’s stock price. the land must be returned to its natural state at a cost of Sh 12 Million.000) 30.000 40.2 (b) Kentucky mining Company is deciding whether or not to open a strip mine. (8Marks) 108 .000 0 NET CASH FLOWS P=0.900.000 p=0. (2 Marks) Assume that Komoro Company is expected to experience super-normal growth of 30% for the four years.000 10% 5 years 10 5 years =30.00 =24. REQUIRED Compute the project’s expected NVP QUSTION FOUR: NPV =30.000 40. all coming at the end of year 1. the net cost of which is Sh2 million.000 40. ii.7908 + 18000 x 0.2 0 1 2 3 4 5* Sh (100. (4 Marks) Compute the expected dividend yield the capital yield and the total return during the first year.000 20.
199986 109 .000.9168m T. The bonds have a face value of Sh10.5001m 500.V 2 +1 3 (12m) Profcost = 2m + 12(0.V =13(1. Should the project be accepted if k = 10%? If K = 20% (5Marks) What is the project’s MIRR at K=10% At K=20%? Does the MIRR lead to the same accept/reject decision as the NPV method? (8Marks) © Task Company’s bonds will mature in 10 years. The price of the bond is sh11.V (1 +m1rr0 11.54% ====== Profcosts = T. What is the yield to maturity (YTM)? i.6944) =0.000 and an 8% coupon rate paid semi-annually.0943] m1rr =9.300.000 (1+m1RR) (1+m1Rn)=1. (2) + 13 pulf – 12m pulf 10% 1 yrs 10 2 yrs -2 + 13 (0.3 1+1m1nR =1.8264) =-0.500) (2) + 13 pulf – 12m pulf 20% 1yr 20% 2yrs -2 + 13 (0.8264) =11.100 ====== (ii) 0 (2m) 1 13 Profcot = T.REQUIRED: i. ii.1) =14.800=14.8333)-12 (0.916.0985m (98.9091)-12 (0.
For each alternative being considered. Any discounts given for early payment. Credit standards refer to the minimum financial strength of acceptable credit customers and the amount of credit available to different customers. Higher cashflows are associated with higher share price-while higher risk results in lower share prices. Profit is therefore measured in terms of earnings per share (EPS) . 2000 Q1(c) (C) Trade Off Theory Of Capital Structure The optimal capital structure is found by balancing the tax shield benefits of leverage against the financial distress and agency costs of leverage. where risk is involved stockholders expect higher rates of return on investments. which is Measured by the price of the stock prices are based on the timing of cash flows or returns. Risk.SOLUTIONS FOR 3RD APRIL. 110 - - - - . the financial manager would select the one that is expected to result in the highest monetary return. Q1 To achieve profit maximization. including the discount amount and the period.profit maximization disregard risk and a trade off exists between return and risk.) • • • • Credit Policy Variable Credit period is the length of time that buyers are given to pay for their purchases. This is a trade off between marginal costs and benefits of debt financing and the result is an optimal capital structure that falls between 0 and 100% debt. Under what conditions may profit maximization not lead to share price maximization? Cash flows –maximum profits do not necessarily result in cashflows available to stockholders and firms may experience high earnings that do not translate into high stock prices. their magnitude and their risk financial managers in maximizing stock process accept only those actions that increase share prices because share price represents the owners wealth in the firm. measured by dividing the total earnings by the number of common shares outstanding. 1 (d. the financial manger takes only those actions that are expected to contribute to the firms overall profits. Collection policy is measured by the toughness or laxity in following up slow paying accounts. Stock price maximization aims at maximizing the wealth of stocks holders.
7908 + 18. Because of their large size.1)1 = 14.100.000 = 24.6209 . QUESTION FOUR: a).9091) – 12 (0. ii) 0 .000 Pvif A + 18. • Through financial intermediaries.000 Pvif .500) (2) + 13 pvif – 12m Pvif 20%1yr 20%2yrs -2+13(0. Banks and mutual funds are intermediaries that obtain funds from savers. Firm sells stocks and bonds to investments bank which in trun sell these securities to savers.3 111 .66944) = 0.000 10%5yr 10%5yr = 30.13 2-(12) Pv of cost = t.8264)= -0.5001m =500.000 x 3. insurance companies and saccos.(2m) 1.8333) –12 (0. Npv =38.v 1-MIRR Pv of cost = 2m +12 (0. issue them with their own securities and then use the money to purchase other securities.9168m T. they can pool risks and help savers diversify.v =13 (1.0985m (98.900.100. Firms deliver securities to saver who in turn give the firm the money it needs • Investments bank – serves as a middleman facilitating issuance of securities.8264) = 11.1 (b) ways in which funds are transferred between savers and borrowers:• Direct transfers of money and securities where a business sells its securities directly to saves.100.2 b) (2) + 13Pvif – 12m P v i f 10%1yr 10%2yr -2+13(0.000 x 0. Intermediaries include commercial banks investment banks.
6944)=10.2)1 = 15.87% C).Pv of cost = T.800 = 14.000 – 11.09543 MIRR = 9.000 (1+MIRR)N Q4 1+mirr = 1.000 20 10.Pv of costs = 2m +12 (0.033 =6.916.000 + 11.300.600.3328 TV = 13(1.000 (1+1MIRR) 2 2 (1+MIRR) = 1.Y T M = Interest + Per value-market No of yr’s Per value + market 2 = 400 + 10.2287 MRR = 22.500 112 .332.V (1+MIRR)N 11.000 2 = 0.880 = 15.6 10.5097 1+ MIRR = 1.7% 350 10.54% For 20% .
15 ii.320.000 2. BT TAX 30% 8.00 EPS = 5.QUESTION TWO E.111 +12.111.3) Ke = 35.600.) E= (EBIT – IB) (1-T) Ke = (8m – 0.280.000.667 WACC = EBIT (1-T) = 8M (1 – 0.320.000 = SH.189% iii.15 x 12m) (1-0. Q2 V = 24.46 per share 0.000 7.667 WACC = 14.466.667 Price per share =35.3) = 7% ke = 15% V = D+E =35.000 5.111.3) 0.000.) EXIT INTEREST E.000 1.1 X 4M) (1-0.3) V 39.000 =36. 5.6220.127.116.116.111.000 400.111 113 .000.18 = 24.32 per share E = (EBIT – ID) (1-T) = ( 8m .) Kd = 10% (1 – 0.
08 = 3.06 = 3. total return =(3.14 – 0.24 = 54 p 0.Do not charge the capital.24 Price = 3.14 = 3 (1. structure value of the firm has decreased.63 = 12.5 = 14% market =12% r = D (1+g) + g P 0.24 + 4.32.24 p = 3.08 = 58.24 (1.32) PVIF 14% = 6.32. b (i) Do = 3% So= 912.28% 54 Dividend PV 114 .03 ) + 0. capital gain = 4.5 field =8% Cost or required rate of return r= 8 + (12 –8) 1.500 Dso = 40%x10%+60%x40% 28days (ii ) D1 =(DSon – DS00) 30 + VD SON (SN – S00) 300 300 (28 – 0) 0 + 0 (28) 300 =0 iii) DSON = 40% X 10 + 60% x 30 = 22 D=3 g=8 beta 1.08) 0.06 Price = sh 54 (ii) Dividend field D 1 = 3 x 1.08 p 0.63 Total return = 6.
30 =11% 30 115 .25 g = 9% Kd = 12% Tax 30% mrk (1) = 5% R f = 6 % k Beta 1.14 – 0.9 5.16% 55 cost of common stock ks = D (1+g) +g p-f = 2.12 Cost of retained earnings = D ( 1+gd) + g.2294 QUESTION 3 Eps =3.3 = 3 X (1.08 per of price add PV of dividend stock value =91.3) 2 = 3.8772 0.2 Price = 55 D 2.421 3.08) 0.449 5.90% cost of preference stock D P = 3.1 (1.583 (1.15 x 55 = 8.6750 0.5921 3.7695 20.1 (1-09) 55 –8.25 + 0.07 0. P = 2.896 3 X (1X3) 3 = 6.126 16.3) 4 = 8. = 8.1 F= 0.09 = 13.09) = 13.319 =16.896 = 108.D1 D2 D3 D4 3 X 1.5683 Price after yr F.901 4.215 = 154.591 3(1.
500.6 ) + (0.000 15.09 X 11 ) +(.28 X 11.12 (11.7656% = 12.000 .032 X 13.31 X 13.16 ) WACC = 12.Cost of debt after tax Kd = rf+b (Mr-Rf) =6% + 1.000 31% WACC = (0.000 .000 16.0 –6) WACC Debt Preferred Common = = 12.6% proportion 14.000 4.400.9 )+(0.77% 116 .000.000 28% 9% 32% Retained 50.
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