BBFH209

Bachelor of Commerce in
Accounting (Honours)
Banking and Finance
(Honours)
Internal Auditing (Honours)
Business Finance II
Module BBFH 209

Authors: I. Kwesu
MSc Economics (UZ)
BSc Economics (UZ)
S. Zhanje
MSc Economics (UZ)
BSc Economics (UZ)
Content Reviewer: O. Chiwira

MSc Economics (UZ)
BSc Econonomics (UZ)
Editor: Constance Kadada

MEd (Indira Gandhi National Open University)
BA (UZ)
Grad CE (UZ)
Revised by: Kernell Madzirerusa

MSc Finance and Investment (NUST)
B Com Banking (Honours) (NUST)
IOBZ Diploma
Editor: Cuthbert Muza

Master of Commerce in Accounting (MSU)
Bachelor of Business Administration in Accounting
(Solusi University)
Certified Public Accountant (CPA(Z)) (ICPAZ)
Certified Professional Forensic Accountant
(CPFAcct) (ICFA-Canada)
Public Accountants and Auditors Board (PAAB)
Registration Certificate
Intermediate Certificate (ICSAZ)
Published by: Zimbabwe Open University
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The Zimbabwe Open University is a distance teaching and open

learning institution.
Year: August 2013
Reprinted: November 2013
Cover design: T. Ndhlovu
Layout : S. Mapfumo
I.S.B.N: 978-1-77938-726-4
Printers : ZOU Press
Typeset in Times New Roman, 12 point on auto leading
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The Six Hour Tutorial Session At
The Zimbabwe Open University
A s you embark on your studies with the Zimbabwe
Open University (ZOU) by open and distance
learning, we need to advise you so that you can make
This is where the six hour tutorial comes in. For it
to work, you need to know that:
· There is insufficient time for the tutor to
the best use of the learning materials, your time and
the tutors who are based at your regional office. lecture you
· Any ideas that you discuss in the tutorial,
The most important point that you need to note is originate from your experience as you
that in distance education and open learning, there work on the materials. All the issues
are no lectures like those found in conventional raised above are a good source of topics
universities. Instead, you have learning packages that (as they pertain to your learning) for
may comprise written modules, tapes, CDs, DVDs discussion during the tutorial
and other referral materials for extra reading. All these
· The answers come from you while the
including radio, television, telephone, fax and email
can be used to deliver learning to you. As such, at tutor’s task is to confirm, spur further
the ZOU, we do not expect the tutor to lecture you discussion, clarify, explain, give
when you meet him/her. We believe that that task is additional information, guide the
accomplished by the learning package that you receive discussion and help you put together full
at registration. What then is the purpose of the six answers for each question that you bring
hour tutorial for each course on offer? · You must prepare for the tutorial by
bringing all the questions and answers
At the ZOU, as at any other distance and open that you have found out on the topics to
learning university, you the student are at the centre the discussion
of learning. After you receive the learning package, · For the tutor to help you effectively, give
you study the tutorial letter and other guiding him/her the topics beforehand so that in
documents before using the learning materials. During cases where information has to be
the study, it is obvious that you will come across gathered, there is sufficient time to do
concepts/ideas that may not be that easy to understand so. If the questions can get to the tutor
or that are not so clearly explained. You may also at least two weeks before the tutorial,
come across issues that you do not agree with, that that will create enough time for thorough
actually conflict with the practice that you are familiar preparation.
with. In your discussion groups, your friends can bring
ideas that are totally different from yours and In the tutorial, you are expected and required to
arguments may begin. You may also find that an idea take part all the time through contributing in every
is not clearly explained and you remain with more way possible. You can give your views, even if
questions than answers. You need someone to help they are wrong, (many students may hold the same
you in such matters. wrong views and the discussion will help correct
The Six Hour Tutorial Session At The Zimbabwe Open University
the errors), they still help you learn the correct thing as the tutor may dwell on matters irrelevant to the
as much as the correct ideas. You also need to be ZOU course.
open-minded, frank, inquisitive and should leave no
stone unturned as you analyze ideas and seek
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those who take part in tutorials actively, do better in and student separate. By introducing the six hour
assignments and examinations because their ideas are tutorial, ZOU hopes to help you come in touch with
streamlined. Taking part properly means that you the physical being, who marks your assignments,
prepare for the tutorial beforehand by putting together assesses them, guides you on preparing for writing
relevant questions and their possible answers and examinations and assignments and who runs your
those areas that cause you confusion. general academic affairs. This helps you to settle
down in your course having been advised on how
Only in cases where the information being discussed to go about your learning. Personal human contact
is not found in the learning package can the tutor is, therefore, upheld by the ZOU.
provide extra learning materials, but this should not
be the dominant feature of the six hour tutorial. As
stated, it should be rare because the information
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together with the sources to which you are referred.
Fully-fledged lectures can, therefore, be misleading
The six hour tutorials should be so structured that the

tasks for each session are very clear. Work for each
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Session I (Two Hours)

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The Six Hour Tutorial Session At The Zimbabwe Open University
Session II (Two Hours)

This session comes in the middle of the semester to respond to the
challenges, queries, experiences, uncertainties, and ideas that you are
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Your tutor gives you feedback on the assignments so that you can use
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You are the most important part of the solutions to your
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Conclusion for this course, but also to prepare yourself to

contribute in the best way possible so that you
In conclusion, we should be very clear that six can maximally benefit from it. We also urge you
hours is too little for lectures and it is not to avoid forcing the tutor to lecture you.
necessary, in view of the provision of fully self-
contained learning materials in the package, to BEST WISHES IN YOUR STUDIES.
turn the little time into lectures. We, therefore,
urge you not only to attend the six hour tutorials ZOU
CONTENTS
Module Overview...........................................................................................................................................................8
Unit 1 .................................................................................................................................................................................. 9
Project Cash Flow Determination .................................................................................................................................... 9
1.0 Introduction ...................................................................................................................................................... 9
1.1 Objectives ......................................................................................................................................................... 9
1.2 Major Cash Flow Components ........................................................................................................................ 9
1.2.1 Initial investment .................................................................................................................................... 10
1.2.2 Operating cash inflows ........................................................................................................................... 10
1.2.3 Terminal cash flow ................................................................................................................................. 10
1.3 Expansion versus Replacement Decisions .................................................................................................... 10
1.4 Sunk Costs and Opportunity Costs ................................................................................................................ 11
Activity 1.1 ........................................................................................................................................................... 11
1.5 Estimating Project Cash Flows ...................................................................................................................... 12
1.6 The Nature of Project Cash Flows................................................................................................................. 12
1.6.1 Wear and tear allowance ......................................................................................................................... 12
1.6.2 Special initial allowance ......................................................................................................................... 12
1.6.3 Scrapping allowance ............................................................................................................................... 13
1.6.4 Recoupment ............................................................................................................................................ 13
1.7 Beginning of Project Cash Flow in General.................................................................................................. 13
1.7.1 Beginning of project cash flows for new investments ............................................................................. 13
Activity 1.2 ........................................................................................................................................................... 14
1.7.2 Beginning of project cash flows for replacement investment ................................................................... 14
Activity 1.3 ........................................................................................................................................................... 15
1.8 Annual Cash Flows ........................................................................................................................................ 15
1.8.1 Annual cash flows of new investment and special initial allowance..................................................... 15
Activity 1.4 ............................................................................................................................................................ 17
1.8.2 Annual cash flows of new investment and wear and tear allowance .................................................... 17
Activity 1.5 ............................................................................................................................................................ 18
1.8.3 Annual cash flows of replacement investment.............................................................................................. 18
1.9 Terminal Cash Flows ..................................................................................................................................... 21
Activity 1.6 ........................................................................................................................................................... 22
1.10 Summary ...................................................................................................................................................... 22
References ............................................................................................................................................................ 23
Unit 2 ................................................................................................................................................................................. 24
Capital Budgeting ........................................................................................................................................................... ..24
2.0 Introduction .................................................................................................................................................... 24
2.1 Objectives ....................................................................................................................................................... 24
2.2 Motives for Capital Expenditure ................................................................................................................... 24
2.3 The Nature of Capital Budgeting Decisions.................................................................................................. 24
2.3.1 Independent projects ................................................................................................................................. 25
2.3.2 Mutually exclusive projects .................................................................................................................... 25
2.3.3 Complementary projects ......................................................................................................................... 25
2.3.4 Pre-requisites or contingent projects ...................................................................................................... 25
2.3.5 Unlimited funds versus capital rationing................................................................................................ 25
2.3.6 Accept-reject versus ranking approaches ............................................................................................... 25
2.4 Stages in the Capital Budgeting Process ....................................................................................................... 25
2.4.1 Investment screening and selection ........................................................................................................... 25
2.4.2 The capital budget proposal ...................................................................................................................... 26
2.4.3 Budgeting approval and authorisation ....................................................................................................... 26
2.4.4 Project tracking ......................................................................................................................................... 26
2.4.5 Post-completion audit ............................................................................................................................... 26
Activity 2.1 ............................................................................................................................................................ 26
2.5 Investment Appraisal Techniques ................................................................................................................. 26
2.5.1 Payback period ........................................................................................................................................ 27
Activity 2.2 ........................................................................................................................................................... 29
2.5.2 Discounted payback period .................................................................................................................... 30
3
2.5.3 Net present value..................................................................................................................................... 31
Activity 2.3 ........................................................................................................................................................... 35
2.5.4 Profitability index ................................................................................................................................... 35
2.5.5 Internal rate of return .............................................................................................................................. 37
2.6 Comparing Techniques .................................................................................................................................. 42
2.6.1 Which approach is better? ...................................................................................................................... 42
Activity 2.4 ........................................................................................................................................................... 43
2.7 Summary ........................................................................................................................................................ 44
References ............................................................................................................................................................ 45
Unit 3 ................................................................................................................................................................................. 46
Advanced Capital Budgeting ........................................................................................................................................... 46
3.0 Introduction .................................................................................................................................................... 46
3.1 Objectives ....................................................................................................................................................... 46
3.2 Different Life Projects ................................................................................................................................... 46
3.2.1 Replacement chains .................................................................................................................................. 46
3.2.2 The Uniform Annual Series (UAS) ........................................................................................................ 48
Activity 3.1 ........................................................................................................................................................... 49
3.3 Inflation and Capital Budgeting .................................................................................................................... 49
3.3.1 Change nominal cash flows into real cash flows ................................................................................... 49
3.3.2 Converting real cash flows into nominal cash flows ............................................................................. 50
3.3.3 Changing real discount rate into nominal discount rate ........................................................................... 51
3.4 Inflation, Tax Shields and Capital Budgeting ............................................................................................... 51
Activity 3.2 ........................................................................................................................................................... 52
3.5 Risk and Capital Budgeting ........................................................................................................................... 52
3.5.1 Sensitivity analysis................................................................................................................................... 52
3.5.2 Decision trees .......................................................................................................................................... 53
3.5.3 Certainty equivalents .............................................................................................................................. 54
3.5.4 Adjusted discount rate ............................................................................................................................ 55
3.5.5 Payback period: accounting for money at risk ........................................................................................... 55
3.6 Capital Rationing ........................................................................................................................................... 55
3.7 Summary ........................................................................................................................................................ 57
References ............................................................................................................................................................ 58
Unit 4 ................................................................................................................................................................................. 59
Theory of Capital Structure ............................................................................................................................................. 59
4.0 Introduction .................................................................................................................................................... 59
4.1 Objectives ....................................................................................................................................................... 59
4.2 Corporate Valuation and Capital Structure ................................................................................................... 59
4.2.1 Debt increases the cost of stock,............................................................................................................ 60
4.2.2 Debt reduces the taxes a company pays ................................................................................................. 60
4.2.3 The risk of bankruptcy increases the cost of debt, rd ........................................................................... 60
4.2.4 The net effect on the weighted average cost of capital .......................................................................... 60
4.2.5 Bankruptcy risk reduces free cash flow ................................................................................................. 60
4.2.6 Bankruptcy risk affects agency costs ..................................................................................................... 61
4.2.7 Issuing equity conveys a signal to the marketplace ............................................................................... 61
4.2.8 Business risk and financial risk .............................................................................................................. 61
Activity 4.1 ........................................................................................................................................................... 62
4.3 Traditional and Modern Theory of Capital Structure ................................................................................... 62
4.4 Initial Assumptions of the Modigliani-Miller Model ................................................................................... 63
4.4.1 Modigliani and Miller without (corporate or personal) taxes .................................................................. 63
4.4.2 Proposition 2 ........................................................................................................................................... 64
4.5 Modigliani and Miller with Corporate Taxes ................................................................................................ 66
4.5.1 Proposition 1 ........................................................................................................................................... 66
4.5.2 Proposition 2 ........................................................................................................................................... 67
4.6 Miller with Corporate and Personal Taxes .................................................................................................... 68
4.7 Implications of the MM Theory .................................................................................................................... 69
Activity 4.2 ........................................................................................................................................................... 70
4.8 Summary ........................................................................................................................................................ 71
References ............................................................................................................................................................ 72
4
Unit 5 ................................................................................................................................................................................. 73
Dividend Policy and Theory ............................................................................................................................................ 73
5.0 Introduction .................................................................................................................................................... 73
5.1 Objectives ....................................................................................................................................................... 73
5.2 Definitions ...................................................................................................................................................... 73
5.3 Dividend Payment Procedures....................................................................................................................... 74
5.3.1 Declaration date ..................................................................................................................................74
5.3.2 Record date..........................................................................................................................................74
5.3.3 Ex-dividend date .................................................................................................................................74
5.3.4 Payment date .......................................................................................................................................74
5.4 Share Repurchase Procedures ........................................................................................................................ 75
5.5 Forms of Dividend ......................................................................................................................................... 75
5.5.1 Cash dividend .....................................................................................................................................75
5.5.2 Scrip dividend......................................................................................................................................75
5.2.3 Dividend in specie................................................................................................................................75
5.2.4 Bonus issue...........................................................................................................................................75
5.5.5 Dividend in kind ..................................................................................................................................75
Activity 5.1 ........................................................................................................................................................... 76
5.6 Dividend Policy Theories .............................................................................................................................. 76
5.6.1 Residual Theory Dividends .................................................................................................................... 76
5.6.2 The Dividend Irrelevance Theory .......................................................................................................... 77
5.6.3 Dividend Relevance Theory ................................................................................................................... 77
5.6.4 Tax-based Theories ................................................................................................................................. 78
5.6.5 Signal Hypothesis ................................................................................................................................... 78
5.6.6 Clientele Effect ....................................................................................................................................... 78
5.6.7 Agency Cost Theory ............................................................................................................................... 78
Activity 5.2 ........................................................................................................................................................... 78
5.7 Factors Affecting Dividend Policy ................................................................................................................ 79
5.7.1 Legal requirements ................................................................................................................................. 79
5.7.2 The information content of dividends .................................................................................................... 79
5.7.3 Contractual obligations ........................................................................................................................... 79
5.7.4 Internal constraints .................................................................................................................................. 79
5.7.5 The nature of shareholders...................................................................................................................... 79
5.7.6 Market considerations ............................................................................................................................. 80
5.7.7 Owners' investment opportunity ............................................................................................................. 80
5.7.8 Growth prospects .................................................................................................................................... 80
5.8 Types of Dividend Policies ............................................................................................................................ 80
5.8.1 Constant payout-ratio dividend policy ................................................................................................... 80
5.8.2 Regular dividend policy .......................................................................................................................... 80
5.8.3 Low-regular-and-extra dividend policy ..................................................................................................... 81
Activity 5.3 ........................................................................................................................................................... 81
5.9 Summary ........................................................................................................................................................ 81
References ............................................................................................................................................................ 83
Unit 6 ................................................................................................................................................................................. 84
Working Capital Management ................................................................................................................................... 84
6.0 Introduction .................................................................................................................................................... 84
6.1 Objectives ....................................................................................................................................................... 84
6.2 Importance of Working Capital Management across Disciplines ................................................................ 84
6.3 Definition of Terms........................................................................................................................................ 84
6.4 Financing Needs of an Enterprise.................................................................................................................. 85
6.4.1 Aggressive financing strategy ................................................................................................................ 85
6.4.2 Risk considerations in the aggressive financing strategy ......................................................................... 85
6.4.3 Conservative financing strategy ............................................................................................................. 86
6.4.4 Risk factor in the conservative financing strategy ................................................................................. 86
6.4.5 Aggressive strategy versus conservative strategy .................................................................................. 86
6.5 Cash Management Model .............................................................................................................................. 86
6.5.1 Rationale for holding cash ...................................................................................................................... 86
6.5.2 Sources of cash ....................................................................................................................................... 87
6.5.3 Cash operating cycle (COC) ................................................................................................................... 87
5
Activity 6.1 ........................................................................................................................................................... 89
6.6 Banking Policy ............................................................................................................................................... 89
6.6.1 Management of cash receipts and disbursements ................................................................................... 89
6.6.2 Float management ................................................................................................................................... 90
Activity 6.2 ........................................................................................................................................................... 91
6.7 Cash Management Models............................................................................................................................. 91
6.7.1 The Baumol Model ................................................................................................................................. 91
Activity 6.3 ........................................................................................................................................................... 94
6.7.2 The Miller Orr Model ............................................................................................................................. 94
Activity 6.4 ........................................................................................................................................................... 96
6.8 Planning and Controlling Debtors ................................................................................................................. 96
6.8.1 Credit standards ...................................................................................................................................... 96
6.8.2 Credit terms ............................................................................................................................................. 98
6.8.3 Collection procedures ............................................................................................................................. 98
6.8.4 Control procedures .................................................................................................................................. 99
6.9 Inventory Management .................................................................................................................................. 99
6.9.1 Basic functions of inventory ................................................................................................................. 100
6.9.2 Economic order quantity....................................................................................................................... 102
Activity 6.5 ......................................................................................................................................................... 103
6.9.3 Just-in-time (JIT) production ................................................................................................................ 103
6.10 Managing Creditors ................................................................................................................................... 103
Activity 6.6 ......................................................................................................................................................... 104
6.11 Summary .................................................................................................................................................... 104
References .......................................................................................................................................................... 105
Unit 7 ...............................................................................................................................................................................106
Short-Term Financing ....................................................................................................................................................106
7.0 Introduction .................................................................................................................................................. 106
7.1 Objectives ..................................................................................................................................................... 106
7.2 Goals of Short-term Financing .................................................................................................................... 106
7.3 Short-term Financing Sources ..................................................................................................................... 106
7.3.1 Short-term bank borrowing................................................................................................................... 106
7.3.2 Trade credit (Accounts payable) .......................................................................................................... 107
7.3.3 Accruals................................................................................................................................................. 109
7.3.4 Factoring ............................................................................................................................................... 110
Activity 7.2 ......................................................................................................................................................... 111
7.4 Summary ...................................................................................................................................................... 111
Unit 8 ..............................................................................................................................................................................113
The Medium-term Financing .......................................................................................................................................113
8.0 Introduction .................................................................................................................................................. 113
8.1 Objectives ..................................................................................................................................................... 113
8.2 Hire Purchase ............................................................................................................................................... 113
8.3 Leasing ......................................................................................................................................................... 113
8.3.2 Why leasing is popular ......................................................................................................................... 115
Activity 8.1 ......................................................................................................................................................... 116
8.3.3 Lease-versus-purchase decision ........................................................................................................... 116
Activity 8.2.……………………………………………………………………………………………….......118
Activity 8.3 ..................................................................................................................................................... 121
8.3.4 Advantages and disadvantages of leasing ............................................................................................ 121
Activity 8.4 ......................................................................................................................................................... 122
8.4 Summary ...................................................................................................................................................... 122
Unit 9 ...............................................................................................................................................................................124
Merger Fundamentals.....................................................................................................................................................124
9.0 Introduction .................................................................................................................................................. 124
9.2 Basic Merger Terminology .......................................................................................................................... 124
9.2.1 Mergers ................................................................................................................................................. 124
9.2.2 Consolidation ........................................................................................................................................ 124
9.2.3 Holding company .................................................................................................................................. 124
6
9.2.4 Divestiture ............................................................................................................................................. 125
9.2.5 Leveraged buyout.................................................................................................................................. 125
9.2.6 Joint venture .......................................................................................................................................... 125
9.2.7 Acquiring versus target companies ...................................................................................................... 125
9.2.8 Friendly merger versus hostile takeovers ............................................................................................. 125
9.3 Rationale for Mergers .................................................................................................................................. 126
9.3.1Growth.................................................................................................................................................... 126
9.3.2 Diversification....................................................................................................................................... 126
9.3.3 Synergy ................................................................................................................................................. 126
9.3.4 Tax considerations ................................................................................................................................ 127
9.3.5 Fund raising........................................................................................................................................... 127
9.3.6 Increased managerial or technology ..................................................................................................... 127
9.3.7 Increased ownership liquidity ............................................................................................................... 127
9.3.8 Breakup value ....................................................................................................................................... 127
9.3.9 Defence against takeover ...................................................................................................................... 128
9.4 Types of Mergers ......................................................................................................................................... 128
9.4.1 Horizontal merger ................................................................................................................................. 128
9.4.2 Vertical merger ..................................................................................................................................... 128
9.4.3 Congeneric merger ................................................................................................................................ 128
9.4.4 Conglomerate merger ........................................................................................................................... 128
Activity 9.1 ......................................................................................................................................................... 129
9.5 Valuation of Mergers ................................................................................................................................... 129
9.5.1 Corporate valuation model ................................................................................................................... 129
Activity 9.2 ......................................................................................................................................................... 131
9.5.2 The Adjusted Present Value (APV) Approach .................................................................................... 131
Activity 9.3 ......................................................................................................................................................... 133
9.5.3 The Free Cash Flow to Equity Approach (Equity Residual Model) ................................................... 133
Activity 9.4 ......................................................................................................................................................... 134
9.6 Reasons Why Mergers and Acquisitions Fail ............................................................................................. 136
Activity 9.5 ......................................................................................................................................................... 137
9.7 Summary ...................................................................................................................................................... 137
References .......................................................................................................................................................... 138
7
BLANK PAGE
Module Overview
The primary purpose of this course is to introduce the student to the world of finance. It is
intended to be a true survey of the field with material selected from the three principal areas of
finance: financial institutions and markets, investments, and business finance. The study of
financial institutions and markets is concerned with the institutional aspects and it
encompasses the creation of financial assets, the markets for trading securities, and the
regulation of financial markets. Investments focus on the analysis of individual assets and the
construction of optimal portfolios. Lastly, business finance relates to the financial manager's
role in raising and administering capital in an efficient and profitable manner. This module is
constructed with the assumption that the student has covered Business Finance I (BBFH202).
The synopsis of the broad areas covered by this course is given below:
• In Unit One we identify the major components of project cash flows and how each of
them is determined.
• In Unit Two we look at the basic capital budgeting process. This entails evaluating and
selecting projects using various investment appraisal techniques.
• In Unit Three we look at the advanced capital budgeting process. This entails
appraising projects with different life periods, inflation, risk, tax shields, and capital
rationing situations.
• Unit Four is about the theory of capital structure. Here we identify the different types
of capital structure for firms and determine the value of firms.
• In Unit Five we look at the dividend policy and theory, explaining the implications of
dividend payouts on share prices, investment and financing decisions.
• In Unit Six we describe the working capital management practices of firms and how
shareholders’ wealth can be maximized in the face of liquidity risk.
• In Unit Seven we look at the short-term financing activities of firms. We identify and
evaluate the various sources of short-term financing.
• In Unit Eight we discuss the various sources of medium-term financing which can be
used by firms.
• Lastly in Unit Nine we discuss the various types of mergers, motives for merger
activities, and the various models used in merger evaluation.
8
BLANK PAGE
Unit 1
Project Cash Flow Determination
1.0 Introduction
In this unit we discuss that to evaluate investment opportunities, financial managers must
determine the relevant cash flows associated with the project. These are the incremental
cash outflows (investment) and inflows (return). The incremental cash flows represent the
additional cash flows, that is, outflows or inflows, expected to result from a proposed capital
expenditure. Cash flows rather than accounting figures are used because cash flows directly
affect the firm’s ability to pay bills and purchase assets. In capital budgeting, only cash
flows are relevant. A firm's cash flow differs from accounting income that is based on
accounting conventions; hence the use of cash flows is more objective than accounting
income. The estimation of future cash flows is probably the most relevant and difficult task
in evaluating an investment project.
1.1 Objectives
By the end of this unit, you should be able to:
• discuss the three major cash flow components
• discuss relevant cash flows, expansion versus replacement decisions, sunk costs and
opportunity costs, and international capital budgeting
• differentiate annual cash flows from accounting income
• explain the nature of annual cash flows
• compute the initial investment, annual cash flows and terminal cash flows
• examine critically the effect of Special Initial Allowance and Wear and Tear Allowance
on cash flows
• calculate net after tax annual cash flows of a new investment and a replacement
investment
• determine the value of scrapping allowance and recoupment
1.2 Major Cash Flow Components

Gitman and Zutter (2012) state that the cash flows of any project may include three basic
components: (1) an initial investment, (2) operating cash inflows, and (3) terminal cash flow. All
projects — whether for expansion, replacement or renewal, or some other purpose — have the
first two components. Some, however, lack the final component, terminal cash flow. Figure 1.1
depicts on a time lime the cash flows for a project.
9
Terminal Cash Flow {$25 000
Operating Cash Inflows
$5 000 $7 000 $8 000 $8 000 $10 000
$4 000 $6 000 $7 000 $8 000 $9 000
1 2 3 4 5 6 7 8 9 10
$50 000} Initial Investment
Figure 1.1: Time Line for Major Cash Flow Components

Source: Gitman and Zutter (2012)
1.2.1 Initial investment
Initial investment is the relevant cash outflow for a proposed project at time zero. The initial
investment for the proposed project in Figure 1.1 is $50 000.
1.2.2 Operating cash inflows
These are incremental after-tax cash inflows resulting from implementation of a project
during its life. The operating cash inflows, which are the incremental after-tax cash inflows
resulting from implementation of the project during its life, gradually increase from $4 000
in its first year to $10 000 in its tenth and final year.
1.2.3 Terminal cash flow
This represents after-tax non-operating cash flow occurring in the final year of a project. It
is usually attributable to liquidation of the project. In this case it is $25 000, received at the
end of the project’s 10-year life. Note that the terminal cash flow does not include the $10
000 operating cash inflow for year 10.
1.3 Expansion versus Replacement Decisions

According to Gitman and Zutter (2012), developing relevant cash-flow estimates is
straightforward in the case of expansion decisions. In this case, the initial investment,
operating cash inflows, and terminal cash flow are merely the after-tax cash outflow and
inflows associated with the proposed capital expenditure.
Gitman and Zutter further argue that identifying relevant cash flows for replacement
decisions is more complicated, because the firm must identify the incremental cash outflow
and inflows that would result from the proposed replacement. The initial investment in the
case of replacement is the difference between the initial investment needed to acquire the
new asset and any after-tax cash inflows expected from liquidation of the old asset. The
operating cash inflows are the difference between the operating cash inflows from the new
10
asset and those from the old asset. The terminal cash flow is the difference between the
after-tax cash flows expected upon termination of the new and the old assets. These
relationships are shown in Figure 1.2. Actually, all capital budgeting decisions can be
viewed as replacement decisions. Expansion decisions are merely replacement decisions in
which all cash flows from the old asset are zero. In light of this fact, this unit focuses
primarily on replacement decisions.
Initial investment Initial investment need to After tax cash inflows

acquire new asset - from liquidation of old
=
asset
Operating cash Operating cash inflows Operating cash inflows

inflows = from new asset - from old asset
Terminal cash flow After-tax cash flows from - After-tax cash flows from
= termination of new asset termination of old asset
Figure 1.2: Relevant Cash Flows for Replacement Decisions: Calculation

of the three components of relevant cash flows for a replacement
decision: Source: Gitman and Zutter (2012)
1.4 Sunk Costs and Opportunity Costs

When estimating the relevant cash flows associated with a proposed capital expenditure, the
firm must recognise any sunk costs and opportunity costs. These costs are easy to mishandle
or ignore, particularly when determining a project’s incremental cash flows. Sunk costs are
cash outlays that have already been made (past outlays) and therefore have no effect on the
cash flows relevant to the current decision. As a result, sunk costs should not be included in
a project’s incremental cash flows.
Opportunity costs are cash flows that could be realised from the best alternative use of an
owned asset. They, therefore, represent cash flows that will not be realised as a result of
employing that asset in the proposed project. Because of this, any opportunity costs should
be included as cash outflows when one is determining a project’s incremental cash flows.
Activity 1.1
1. Discuss the importance of evaluating capital budgeting projects on the basis of
incremental cash flows.
2. Describe the three components of cash flow that exist for any project.
3. Explain how expansion decisions can be treated as replacement decisions.
4. Discuss the effects of sunk costs and opportunity costs on a project’s incremental
cash flows.
11
1.5 Estimating Project Cash Flows
In the evaluation of a project, an estimate must be made of its cash flow. The present value of any
asset is a function of the expected cash flow, which can be obtained from the asset. Should the
cash inflow exceed the cash outflow, the net cash flow is positive. Should the cash outflow exceed
the cash inflow, the net cash flow is negative, and should the cash inflow equal the cash outflow, the
net cash flow is zero.
1.6 The Nature of Project Cash Flows

The project cash flows must be:
• incremental
• after tax
• include opportunity costs
• exclude sunk costs
• exclude interest payments
A project's cash flow may be classified under the following categories:
• initial investment or beginning of project cash flows
• annual operating cash flows
• end of project cash flows or terminal cash flows
Wear and Tear allowance and Special Initial Allowance that are discussed below influence
project cash flows and the two will result in either a recoupment (profit) or scrapping allowance
(loss).
1.6.1 Wear and tear allowance
Wear and tear allowance is available for assets that diminish in value with use which are:
• machinery
• equipment and any articles used by the taxpayer in trade
• commercial and industrial buildings, farm improvements, railway lines and staff
housing
The percentage allowed on cost differs between different classes of assets, depending on
whether the firm is dealing with immovable or movables. For immovables, (for example,
buildings) the straight-line technique is used to calculate the wear and tear allowance,
whereas for the movables (such as furniture, motor vehicles) the diminishing method is
used.
1.6.2 Special initial allowance
The government grants special initial allowance in order to encourage investment in needy
areas. This gives the firm the opportunity to claim a much higher amount than wear and tear
allowance. Special initial allowance is only granted to capital expenditures incurred in respect
of the following:
• purchase of articles, implements machinery whether new or second hand
12
• construction, additions, alterations of farm improvements, industrial buildings, rail lines,
staff housing
It should be noted that special initial allowance is not available for commercial buildings
and assets acquired through donations or inheritance and is only granted if the taxpayer
elects to claim it. For any asset for which special initial allowance is claimed, the taxpayer is
not allowed to claim wear and tear allowance. The firm is allowed to claim 50% of the cost
of the asset in the first year, 25% in the second year and another 25% in the third year.
1.6.3 Scrapping allowance
The firm will take advantage of a scrapping allowance provided that, when the asset is
scrapped it has not fully availed of the special initial allowance or the wear and tear
allowance. Scrapping allowance computation is similar to that of loss on disposal, which has
a negative impact on the firm's profits. In the same vein, tax is not paid on the scrapping
allowance figure indicating a tax shield. The scrapping allowance is calculated as follows:
Scrapping allowance (+ve) = cost of the asset – capital allowance – sale proceeds
If the amount is positive, then the firm has scrapping allowance, which can be deducted
from taxable income.
1.6.4 Recoupment
Recoupment arises when an expenditure (loss) is claimed for tax purposes but is later
recovered; recoupment has a positive impact on taxable income since it is included as gross
income and also calculation of recoupment is similar to that of profit on disposal.
Recoupment is computed as follows:
Recoupment (-ve) = cost of the asset - capital allowance - sale proceeds
If the amount is negative, there is recoupment and tax has to be paid on recoupment.
1.7 Beginning of Project Cash Flow in General

The initial investment may result in the following cash flows:
• cost of acquisition
• installation costs
• transportation cost and tariffs/customs charges of the acquired assets
• proceeds from sale of existing assets
• tax effects
• change in working capital requirements
Installation costs, increase in working capital and tax on recoupment are recorded as cash
outflows in our analysis whilst proceeds from sale of existing assets and tax on scrapping
allowance are recorded as cash inflows.
1.7.1 Beginning of project cash flows for new investments
The initial investment may result in the following cash flows:
• cost of acquisition/cost of the fixed asset
13
• change in working capital

Example 1.1
A project is expected to cost $1 000 000 and requires $150 000 in installation costs.
Implementation of the project will result in the need for $100 000 additional working capital.
What is the initial investment of the project?
The initial investment is computed as follows:
$
Cost of acquisition 1 000 000
Installation costs 150 000
Additional working capital 100 000
Basic cost 1 250 000
Activity 1.2
A project will cost $3 million and requires $200 000 to install. Implementation of the project
will result in the need for $500 000 additional working capital. Determine the initial
investment of the project.
1.7.2 Beginning of project cash flows for replacement investment

When a fixed asset is acquired to replace an old asset, the initial investment is composed of:
• cost of the new fixed asset
• changes in working capital
• proceeds from the sale of existing assets
• scrapping tax on allowance or recoupment
Example 1.2
A project requires the purchase of a machine that costs $1 million and will cost $500 000 to
install. Additional working capital of $210 000 will also be required when the project is
commissioned. The machine will replace an old one that was purchased a year ago at a cost
of $800 000 and can now only be disposed for $300 000. The firm has claimed SIA using
new rates of 50%, 25% and 25%, over the last year on the old machine. The tax rate is 40%.
Calculate the initial investment to be used in appraisal of the project.
The Special Initial Allowance (SIA) claimed for the old machinery in the first year is:
14
50
× 800,000 × 1 year = $400,000
100
But scrapping allowance = cost – capital allowance claimed – sale proceeds
Therefore scrapping allowance = 800 000 – 400 000 – 300 000 = 100 000 [similar to loss on
disposal]
Tax on scrapping allowance = 100 000 x 0.40 = $40 000
The initial investment of the project is computed below:
$
Cost of the new asset 1 000 000
Installation cost 500 000
Additional working capital 210 000
Proceeds from sale of old machinery 300 000
Tax on scrapping allowance 40 000
Initial investment 1 370 000
Activity 1.3
A project requires the purchase of a machine that costs $4 million and will cost $600 000 to
install. Additional working capital of $300 000 will also be required when the project is
commissioned. The machine will replace an old one that was purchased two years ago at a
cost of $1 million and can now only be disposed for $400 000. The firm has claimed SIA
using new rates of 50%, 25% and 25%, over the last two years on the old machine. The tax
rate is 40%. Compute the initial investment of the project.
1.8 Annual Cash Flows

Annual cash flows are cash flows to be generated by the project after it has been
implemented. They are after tax incremental revenue minus incremental expenses, which are
assumed to occur at the end of the year. Once the project is implemented, it will generate
cash flows every year while at the same time costs will be incurred. Annual cash flows must
be adjusted for any opportunity cost or benefits. It however ignores sunk cost (already
committed but irrelevant costs such as engineering, pilot or consultation costs) and interest
payments (because it is catered for by the discount rate or cost of capital, otherwise there
will be double discounting). It should be however noted that capital allowances could only
be claimed if the company has adequate taxable income and that allowances can be carried
forward to future period.
1.8.1 Annual cash flows of new investment and special initial allowance
Annual cash flows of the new investment are calculated using either of the two techniques:
15
Method A
Net Difference or
incremental cash flow
Net incremental before tax revenues X
Add reduction in costs X
Less increase in costs X
XXX
Less tax X
XXX
Add capital allowance tax benefit/shield X
After tax annual cash flows XXX
Method B
Net incremental before tax revenue X
Add reduction in costs X
Less increase in costs X
XXX
Less annual capital allowance X
Taxable income XXX
Less tax X
XXX
Add annual capital allowance X
After tax annual cash flows XXX
Example 1.3
Equipment that costs $1,5 million including installation costs will last for three years and
result in an increase in net incremental before tax revenues of $3,5 million per annum and
reduction in costs of $0.5 million per annum. The tax rate is 40% and the current rates of
SIA are available for the investment. What are the annual cash flows for the investment?
Using Method A, annual cash flows are determined as follows:
Method A
Year 1 Year 2 Year 3
Net incremental before tax revenues 3 500 000 3 500 000 3 500 000
Add reduction in costs 500 000 500 000 500 000
4 000 000 4 000 000 4 000 000
Less tax @ 40% 1 600 000 1 600 000 1 600 000
2 400 000 2 400 000 2 400 000

Add SIA tax benefit 300 000 150 000 150 000
After tax annual cash flows 2 700 000 2 550 000 2 550 000
Calculations:
SIA (Year 1) = 1 500 000 x = 750 000
SIA tax benefit (Year 1) = 750 000 x 0.40 = 300 000
SIA (Year 2 & 3) = 1 500 000 x = 375 000
SIA tax benefit (Year 2 & 3) = 375 000 x 0.40 = 150 000
16
Using the alternative technique B we have:
Method B
Net incremental before tax revenues 3 500 000 3 500 000 3 500 000
Add reduction in costs 500 000 500 000 500 000
4 000 000 4 000 000 4 000 000
Less SIA 750 000 375 000 375 000
Taxable income 3 250 000 3 625 000 3 625 000
Less tax @ 40% 1 300 000 1 450 000 I 450 000
1 950 000 2 175 000 2 175 000
Add SIA 750 000 375 000 375 000
After tax annual cash flows 2 700 000 2 550 000 2 550 000
Activity 1.4
A machinery that costs $2 million including installation costs will last for three years and result
in an increase in net incremental before tax revenues of $4 million per annum and reduction in
costs of $0.7 million per annum. The tax rate is 35% and the current rates of SIA are
available for the investment. Determine the annual cash flows for the investment.
1.8.2 Annual cash flows of new investment and wear and tear allowance
If the investment does not qualify for Special Initial Allowance or the firm elects not to
claim SIA then Wear and Tear Allowance can be claimed. Wear and Tear Allowance for
immovables and movables are calculated using the straight-line method and diminishing
balance technique respectively.
Example 1.4: Wear and Tear Allowance on Immovables
XYZ Ltd has elected to claim wear and tear allowance at 5% per annum on buildings that
cost $1 250 000. The building will generate before tax cash flows of $375 000 per annum
for 10 years after which it will have zero scrap value. The tax rate is 40% and the investment
is expected to last for 10 years. Calculate the after tax cash flows.
Annual Wear and Tear Allowance is computed as follows:
Annual Wear and Tear Allowance = 5% x $1 250 000 = $625 000
Using Method A and B annual cash flows are determined as follows:
Method A
Before tax cash flows $375 000
Less tax @ 40% $150 000
$225 000
Add wear and tear tax shield (625 000 x 0.40) $ 25 000
After tax annual cash flows $250 000
17
Method B
Before tax cash flows $375 000
Less wear and tear allowance $ 62 500
Taxable income $312 500
Less tax @ 40% $125 000
$187 500
Add wear and tax allowance $ 62 500
After tax annual cash flows $250 000
Activity 1.5
Z Ltd has elected to claim wear and tear allowance at 5% per annum on buildings that cost $2
million. The building will generate before tax cash flows of $0.7 million per annum for 15 years
after which it will have zero scrap value. The tax rate is 35% and the investment is expected to last
for 15 years. Compute the after tax cash flows.
Example 1.5: Wear and Tear Allowance on Movables

MN Ltd would like to acquire a motor vehicle to be used in transporting goods. The motor vehicle
is expected to cost $945 000 and MN Ltd expects to derive $225 000 in before-tax cash flows each
year from the motor vehicle. The motor vehicle is expected to last 5 years and MN Ltd will claim
wear and tear allowance at the rate of 20% per annum. The motor vehicle will be disposed of at a
value of $300 000 after the 5 year period. Given a tax rate of 35%, calculate the annual cash flows
for the motor vehicle.
1 2 3 4 5 6
Year Balance Wear & tear Before tax Taxable Tax Annual cash
Allowance cash flows income flows
0.35 x (4)
(1) x 20% (3)-(2) (3)-(5)
1 9 450 000 189 000 225 000 36 000 12 600 212 400
2 756 000 151 200 225 000 73 800 25 830 199 170
3 604 800 120 960 225 000 104 040 36 414 188 586
4 483 840 96 768 225 000 128 232 44 881.2 180 118.8
5 387 072 77 414.4 225 000 147 585.6 54 654.96 173 345.04
1.8.3 Annual cash flows of replacement investment

When an asset is replaced, the existing production is maintained. The new asset may result in cost
18
savings that is brought about by increased efficiencies. When a firm is producing an established
product line, cost savings are usually relatively certain.
Example 1.6
Equipment acquired for $1.5 million replaces an old machine that was purchased a year ago for
$800 000 for which SIA is being claimed (50%, 25% and 25%). Both the old and the new
machines can last for another 4 years and the old machine’s salvage value is zero whilst the new
machine’s salvage is $500 000 on terminal date. The acquisition of the new machine will result in
an increase in annual profit of $3 million. The profit figure includes depreciation for both machines
on a straight-line basis for 5 years on the new machine. Capital allowances have been excluded in
the computation of profit. Determine the annual cash flows of the investment given a tax rate
of 40%.
Solution
There is need to remove the non-cash item (depreciation) in order to determine the before-
tax cash flow, but prior to that, the profit before tax should be computed.
Profit after tax = profit before tax (1 – tax rate)
profit.after.tax
Profit before tax =
1 − tax.rate
3000000
= 1 − 0.4
= $5 000 000
Depreciation for both old and new machine is calculated as follows:
Cost − residual.value
Depreciation [old machinery] =
Life. exp ec tan cy
800000 − 0
= =160 000
5
Cost − scrapping.value
Depreciation [new machinery] =
Life. exp ec tan cy
1500000 − 500000
=
4
=$250 000
Special Initial Allowance for the two machines is calculated below:

New Machine
SIA (Year 1) = 1 500 000 × 0.50 = 750 000
SIA (years 2&3) = 1 500 000 × 0.25 = 375 000
Old Machine
SIA (years 1 & 2) = 800 000 × 0.25 = 200 000
Annual cash flows are now determined on incremental basis as follows:
19
Annual Cash Flows for Year 1
With new Without new Net difference or
investment investment change in cash flows
Incremental before tax profit 5 000 000
Add Depreciation 250 000 160 000 90 000
Incremental before tax cash flow 5 090 000
Less SIA 750 000 200 000 550 000
Taxable income 4 540 000
Less tax @ 40% 1 816 000
2 724 000
Add SIA 750 000 200 000 550 000
After tax annual cash flow 3 274 000
Annual Cash Flow for Year 2

Less SIA 375 000 160 000 215 000
Less tax @ 40% 1 950 000
2 925 000
Add SIA 375 000 200 000 175 000

Less SIA 375 000 - 375 000
Less tax @ 40% 1 816 000
2 829 000
Add SIA 375 000 - 375 000

Less SIA 375 000 - -
Less tax @ 40% 2 036 000
3 054 000
Add SIA 375 000 - -
20
1.9 Terminal Cash Flows
Terminal cash flows is the net after tax amount received by the firm when a project is
terminated and the terminal cash flow may include:
• the estimate salvage value of the asset

• change in net working capital
• tax on scrapping allowance or recoupment
Residual value forms part of the investment project's cash flows at the end of the asset's economic
life, and should be taken into account in the financial evaluation process. The asset may still be
useful in its present form, and therefore presents a saving on the purchase price of a new, similar
asset. Alternatively, the firm could sell the asset, therefore generating a positive cash inflow, or
there may be a negative cash flow owing to the cost of wear and tear. The residual value of both
fixed and current assets (working capital recovery) must be considered. Apart from the above
factors, the tax concession on write-off has an important influence, especially with regard to the
time value of money. A higher residual value means a smaller annual write-off for tax purposes,
and even if the sale of the asset were to result in a loss, this tax benefit would only be received
at the end of the period.
Example 1.7
A machine which costs $1.5 million with a salvage value of $500 000 has fully availed SIA at
current rates per annum. Working capital of $210 000 was introduced on commissioning of
the project. Determine the terminal cash flow, when tax rate is 40%.
Initially there is a need to determine whether the new machine has scrapping allowance or
recoupment. Since the machine has fully availed of SIA, there is recoupment which is
computed as follows:
Recoupment = cost of asset – capital allowance claimed – sale proceeds
= 1 500 000 – 1 500 000 – 500 000
= -500 000
Therefore:
Tax on recoupment = 500 000 × 0.40 = 200 000
Hence terminal cash flows for the project are computed below:
Salvage value of the asset 500 000

Recovery of working capital 210 000
Tax on recoupment (200 000)
Terminal cash flow 510 000
21
Activity 1.6
A firm is considering the replacement of its machine and the marketing department has
envisaged that the replacement of this machine will result in an increase in sales of $300
000. Labour and raw material savings are expected to be $250 000 by the production
department. The acquiring cost and the installation cost are $700 000 and $50 000
respectively. The new machine is expected to last for 5 years with a terminal value of $150
000. Working capital of $20 000 is required on commencement. The old machine is 1 year
old and can last another 5 years when it will yield a residual value of zero. The old machine
was purchased for $500 000 but has a current market value of $200 000. The firm has a tax
rate of 40% and the cost of capital is 20%, whilst the firm is taking advantage of the current
SIA on both the new and the old machinery.
Compute:
(a) The initial investment
(b) The annual cash flows
(c) The terminal cash flows
1.10 Summary
In this unit we discussed that cash flow estimation is the most critical aspect and benchmark
of capital budgeting analysis. Incremental cash flows should be considered when
determining project cash flows, and in the process a financial analyst should be able to deal with
sunk costs, opportunity costs, externalities and inflation.
22
References
Block, S.B. and Hirt, G.A. (1994). Foundations of Financial Management. (6th Edition). Boston:
Irwin.
Ehrhardt, M.C. and Brigham, E.F. (2011). Financial Management, Theory and Practice.
(13th Edition). Mason: South-Western Cengage Learning.
Gitman, L. and Zutter, C.J. (2012). Principles of Managerial Finance. (13th Edition). Boston: Pearson
Education, Inc.
Kwesu, I., and Chikwava, M.. (2002). Business Management. Harare: ZOU.
Kwesu, I., Nyatanga, E. and Zhanje, S. (2002). Business Statistics. Harare: ZOU.
Levy, H. and Sarnat, M.. (1991). Capital Investments and Financial Decisions. (4th Edition). Prentice
Hall.
McLaney, E.J. (2000). Business Finance; Theory and Practice. New York: Prentice Hall.
23
BLANK PAGE
Unit 2
Capital Budgeting
2.0 Introduction
Long-term investments represent sizable outlays of funds that commit a firm to some course of
action. Consequently, the firm needs procedures to analyse and select its long-term
investments. Capital budgeting is the process of evaluating and selecting long-term investments
that are consistent with the firm’s goal of maximising owners’ wealth. Capital budgeting
decisions continue for many years and therefore have long-term consequences. Firms
typically make a variety of long-term investments, but the most common is in fixed assets,
which include property (land), plant, and equipment. These assets, often referred to as earning
assets, generally provide the basis for the firm’s earning power and value. The knowledge of
the computation of initial investment, annual cash flows and terminal cash flows is critical in
business finance since this involves the estimation of project cash flows. In this unit we
examine issues concerning the identification of the relevant cash flows, cash flows in
replacement and new investment which enable the financial manager to make good capital
budgeting decisions.
2.1 Objectives
• define capital budgeting
• examine the capital budgeting process
• differentiate cash flows from income
• explain the nature of project cash flows
• compute cash flows for a new and replacement investment
• differentiate discounted from non-discounted cash flow techniques
• apply techniques of investment appraisal
• evaluate projects using investment appraisal techniques
• select projects that maximise shareholders' wealth
2.2 Motives for Capital Expenditure

Companies make capital expenditures for many reasons. The basic motives for capital
expenditures are to expand operations, to replace or renew fixed assets, or to obtain some other,
less tangible benefit over a long period.
2.3 The Nature of Capital Budgeting Decisions

Capital budgeting decisions can be referred to as either replacement decisions or expansion
decisions. Replacement decisions involve investigating capital projects to be acquired in
order to replace the existing assets and in the process maintain existing operations. Expansion
decisions involve determining whether to acquire capital projects and add to the existing
assets to increase existing operations. It should also be noted that capital budgeting decisions
24
are made on independent projects, mutually exclusive projects, complementary projects and
prerequisite or contingent projects.
2.3.1 Independent projects
The construction of a capital budget must take into account the inter-relationships among
proposed projects. If the acceptance or rejection of one project does not affect the cash flows of
another project, the two projects are said to be independent.
2.3.2 Mutually exclusive projects
If the acceptance of one project precludes the acceptance of another project, the two are
mutually exclusive and are regarded as alternatives.
2.3.3 Complementary projects
If the acceptance of one project enhances the cash flows of another project, the two are said to
be complementary.
2.3.4 Pre-requisites or contingent projects
If the acceptance of one project depends upon the prior acceptance of another project, the
acceptance of the former is a prerequisite to the acceptance of the latter.
2.3.5 Unlimited funds versus capital rationing
Gitman and Zutter (2012) argue that the availability of funds for capital expenditures affects
the firm’s decisions. If a firm has unlimited funds for investment (or if it can raise as much
money as it needs by borrowing or issuing stock), making capital budgeting decisions is quite
simple: All independent projects that will provide an acceptable return can be accepted.
Typically, though, firms operate under capital rationing instead. This means that they have
only a fixed number of dollars available for capital expenditures and that numerous projects
will compete for these dollars.
2.3.6 Accept-reject versus ranking approaches
Two basic approaches to capital budgeting decisions are available. The accept–reject
approach involves evaluating capital expenditure proposals to determine whether they meet
the firm’s minimum acceptance criterion. This approach can be used when the firm has
unlimited funds, as a preliminary step when evaluating mutually exclusive projects, or in a
situation in which capital must be rationed. In these cases, only acceptable projects should be
considered. The second method, the ranking approach, involves ranking projects on the basis
of some predetermined measure, such as the rate of return. The project with the highest return
is ranked first, and the project with the lowest return is ranked last. Only acceptable projects
should be ranked. Ranking is useful in selecting the “best” of a group of mutually exclusive
projects and in evaluating projects with a view of capital rationing.
2.4 Stages in the Capital Budgeting Process

The capital budgeting process consists of five distinct but interrelated steps:
2.4.1 Investment screening and selection
Projects consistent with the corporate strategy are identified. But projects do not simply walk into
25
corporate headquarters. The firm must have some system for seeking or generating investment
opportunities. Identifying investment opportunities is not necessarily the task of the financial
manager. This task typically lies with the production, marketing, and research and development
management of the firm.
2.4.2 The capital budget proposal
A capital budget is proposed for the projects surviving the screening and selection process. The
budget lists the recommended projects and the dollar amount of investment needed for each. This
proposal may start as an estimate of expected revenues and costs, but as the project analysis is
refined, data from marketing, purchasing, engineering, accounting, and finance functions are
collected and put together.
2.4.3 Budgeting approval and authorisation
Projects included in the capital budget are authorised, allowing further fact gathering and
analysis, and approved, allowing expenditures for the projects. In some firms, the projects are
authorised and approved at the same time. In others, a project must first be authorised,
requiring more research before it can be formally approved. Formal authorisation and approval
procedures are typically used on larger expenditures; smaller expenditures are at the discretion of
management.
2.4.4 Project tracking
After a project is approved, work on it begins. The manager reports periodically on its
expenditures, as well as on any revenues associated with it. This is referred to as project tracking,
the communication link between the decision makers and the operating management of the firm.
For example: tracking can identify cost over-runs; it can also identify that more marketing
research is needed to better focus on the target market.
2.4.5 Post-completion audit
Following a period of time, perhaps two or three years after approval, projects are reviewed to see
whether they should be continued. This re-evaluation is referred to as a post-completion audit.
Thorough post-completion audits are not usually performed on every project since that would be
too time consuming. Rather, they are performed on selected projects, usually the largest projects
in a given year's budget for the firm or for each division. Post-completion audits enable the firm's
management to see how well the cash flows realised correspond with the cash flows forecasted
several years earlier.
Activity 2.1
1) Define the capital budgeting process and explain how it helps managers achieve their
goal.
2) Outline the objectives of evaluating investments.
3) Discuss the financial manager’s goal in selecting investment projects for the firm.
4) Distinguish between capital budgeting and security valuation.
2.5 Investment Appraisal Techniques

To ensure that the investment projects selected have the best chance of increasing the value of
26
the firm, financial managers need tools to help them evaluate the merits of individual projects
and to rank competing investments. A number of techniques are available for performing such
analyses. The preferred approaches integrate time value procedures, risk and return
considerations, and valuation concepts to select capital expenditures that are consistent with
the firm’s goal of maximising owners’ wealth. In this section, we look at six techniques that
are commonly used by firms to evaluate investments in long-term assets.
An evaluation technique should:
consider all the future incremental cash flows from the project;
consider the time value of money;
consider the uncertainty associated with future cash flows; and
have objective criteria by which to select a project.
Projects selected using a technique that satisfies all the above criteria will, under most general
conditions, maximise owners' wealth. In addition to judging whether each technique satisfies
these criteria, we will also look at which ones can be used in special situations, such as when a
dollar limit is placed on the capital budget.
2.5.1 Payback period
The payback period for a project is the time from the initial cash outflow to invest in it until
the time when its cash inflows add up to the initial cash outflow. In other words, how long it
takes to get your money back. The payback period is also referred to as the payoff period or
the capital recovery period.
Decision criteria
When the payback period is used to make accept–reject decisions, the following decision
criteria apply:
If the payback period is less than the maximum acceptable payback period, accept the
project.
If the payback period is greater than the maximum acceptable payback period, reject
the project.
The length of the maximum acceptable payback period is determined by management. This
value is set subjectively on the basis of a number of factors, including the type of project
(expansion, replacement or renewal, other), the perceived risk of the project, and the perceived
relationship between the payback period and the share value. It is simply a value that
management feels, on average, will result in value-creating investment decisions.
Example 2.1
Suppose a firm is considering Investments A and B, each requiring an investment of $1
million today (we are considering today to be the last day of the year 2012) and promising
cash flows at the end of each of the following five years. How long does it take to get your $1
million investment back given the cash flows in Table 2.1?
27
Table 2.1 Estimated Cash Flows for Investments A and B
Expected cash flow
Year Investment A Investment B
2013 ($ 1 000 000) ($ 1 000 000)
2014 $ 400 000 $ 100 000
2015 $ 400 000 $ 100 000
2016 $ 400 000 $ 100 000
2017 $ 400 000 $ 1 000 000
2018 $ 400 000 $ 1 000 000
Table 2.2
End of year Expected cash flow Accumulated cash
flow
2013 $ 400 000 $ 400 000
2014 400 000 800 000
2015 400 000 1 200 000
2016 400 000 1 600 000
2017 400 000 2 000 000
200000 1
The payback period for investment A = 2 = 2 years
1000000 5
By the end of 2014, the full $1 million is not paid back, but by 2015, the accumulated cash flow
hits and exceeds $1 million.
700000 7
The payback period for investment B is 3 = 3 years. It is not until the end of 2017
1000000 10
that the $1 million original investment (and more) is paid back.
When the project cash flows are annuities, the payback period can be determined using the
formula:
Initial.investment
Payback period =
Annual.cashflow
Payback period decision rule

Is Investment A or B more attractive? A shorter payback period is better than a longer
payback period. There is no clear-cut rule for how short is better. Investment A provides a
quicker payback than B. But that does not mean it provides the better value for the firm. All we
know is that A "pays for itself' quicker than B. We do not know in this particular case whether
quicker is better.
Each firm has its tolerant payback and will accept projects that do not exceed this tolerant
period.
In addition to having no well-defined decision criteria, payback period analysis favours
investments with "front-loaded" cash flows: an investment looks better in terms of the
payback period the sooner its cash flows are received no matter what its later cash flows look
like.
28
Advantages of the payback period
1. The payback period is popular for its computational simplicity and intuitive appeal.
2. By measuring how quickly the firm recovers its initial investment, the payback
period also gives implicit consideration to the timing of cash flows and therefore to
the time value of money. Because it can be viewed as a measure of risk exposure,
many firms use the payback period as a decision criterion or as a supplement to
other decision techniques. The longer the firm must wait to recover its invested
funds, the greater the possibility of a calamity. Hence, the shorter the payback period
the lower the firm’s risk exposure.
Disadvantages of the payback period
The major weakness of the payback period is that the appropriate payback period is
merely a subjectively determined number. It cannot be specified in light of the
wealth maximisation goal because it is not based on discounting cash flows to
determine whether they add to the firm’s value. Instead, the appropriate payback
period is simply the maximum acceptable period of time over which management
decides that a project’s cash flows must break even (that is, just equal to the initial
investment).
Activity 2.2
(1) Describe how the payback period of a project can be determined.
(2) Discuss the weaknesses commonly associated with the use of the payback period as a
project appraisal method.
(3) ABC Limited is considering a capital expenditure that requires an initial investment of
$42 000 and returns after-tax cash inflows of $7 000 per year for 10 years. The firm has
a maximum acceptable payback period of 8 years.
(a) Determine the payback period for this project.
(b) Should the company accept the project? Why or why not?
(4) ZMC Limited has a 5-year maximum acceptable payback period. The firm is
considering the purchase of a new machine and must choose between two alternative
ones. The first machine requires an initial investment of $14 000 and generates annual
after-tax cash inflows of $3 000 for each of the next 7 years. The second machine
requires an initial investment of $21 000 and provides an annual cash inflow after taxes
of $4 000 for 20 years.
(a) Determine the payback period for each machine.
(b) Comment on the acceptability of the machines, assuming that they are independent
projects.
(c) Which machine should the firm accept? Why?
(d) Do the machines in this problem illustrate any of the weaknesses of using payback?
Discuss.
29
(5) Tanaka has the opportunity to invest in project A that costs $9 000 today and promises
to pay annual end-of-year payments of $2 200, $2 500, $2 500, $2 000, and $1 800 over
the next 5 years. Or, Tanaka can invest $9 000 in project B that promises to pay annual
end-of-year payments of $1 500, $1 500, $1 500, $3 500, and $4 000 over the next 5
years.
(a) How long will it take for Bill to recoup his initial investment in project A?
(b) How long will it take for Bill to recoup his initial investment in project B?
(c) Using the payback period, which project should Bill choose?
(d) Do you see any problems with his choice?
2.5.2 Discounted payback period

The discounted payback period is the time needed to pay back the original investment in
terms of discounted future cash flows. Each cash flow is discounted back to the beginning of
the investment at a rate that reflects both the time value of money and the uncertainty of the
future cash flows. This rate is the cost of capital, that is, the return required by the suppliers
of capital (creditors and owners) to compensate them for time value of money and the risk
associated with the investment. The more uncertain the future cash flows, the greater the cost
of capital.
Returning to Investments A and B, suppose that each has a cost of capital of 10%. The first
step in determining the discounted payback period is to discount each year's cash flow to the
beginning of the investment (the end of the year 2012) at the cost of capital (see Table 2.3).
Table 2.3
Cash flow Cash flow
Investment PVIF@10% Investment PVIF@10%
A B
Year End of year Value at Accumulated End of Value at the Accumulated

cash flow the end of present year cash end of present
2012 value flow 2012 value
2013 $400 000 $363 636 $363 640 $100 000 $90 909 $90 909
2014 400 000 330 579 694 220 100 000 82 644 173 553
2015 400 000 300 526 994 750 100 000 75 131 248 684
2016 400 000 273 205 1 267 955 1 000 000 683 013 931 697
2017 400 000 248 369 1 516 324 1 000 000 620 921 1 552 618
How long does it take for each investment's discounted cash flows to pay back its $1 million
investment?
5250
The discounted payback period for A is 3 = 3.0053 years. The discounted payback
1000000
68303
period for B is 4 = 4.0683 years.
1000000
Discounted payback decision rule

It appears that the shorter the payback period, the better, whether using discounted or non-
discounted cash flows. Using the length of the payback as a basis for selecting investments, A is
preferred to B. But we have ignored some valuable cash flows for both investments.
30
2.5.3 Net present value
The net present value (NPV) is the present value of all expected cash flows, that is:
Net present value = Present value of all expected cash flows.
The word "net" in this term indicates that all cash flows (both positive and negative) are
considered. Often the changes in operating cash flows are inflows and the investment cash
flows are outflows. Therefore, we tend to refer to the net present value as the difference
between the present value of the cash inflows and the present value of the cash outflows.
We can represent the net present value using summation notation, where t indicates any
particular period, CFt represents the cash flow at the end of period t, i represents the cost of
capital, and N the number of periods comprising the economic life of the investment:
N
CFt
NPV = ∑ − CF0
t =1 (1 + i ) t
Cash inflows are positive values of CFt and cash outflows are negative values of CFt .
Example 2.2
A project is expected to have the following cash flows:
Year Cash Flow

0 ($800 000)
1 250 000
2 350 000
3 400 000
4 420 000
If the discount rate is 20%, the NPV would be calculated as follows:

Year Cash Flow PVIF Present Value
0 ($800 000) 1.0000 ($800 000)
1 250 000 0.8333 208 325
2 350 000 0.6944 243 040
3 400 000 0.5787 231 480
4 420 000 0.4823 202 566
NPV = $85 411
(a) Year zero is the period immediately before implementation of the project.
(b) Cash flows are assumed to occur at the end of the year.
31
Let us take another look at our previous example, Investments A and B. Using a 10% cost of
capital, the present values of inflows given in Table 2.4.
Table 2.4
Investment A CF*PVIF@10% Investment B CF*PVIF@10%
Year End of Year Value at the End of 2012 End of Year Cash Value at the End of
Cash Flow Flow 2012
2012 ($1 000 000) ($1 000 000) ($1 000 000) ($1 000 000)
2013 400 000 363 636 100 000 90 909
2014 400 000 330 579 100 000 82 645

400 000
2015 300 526 100 000 75 131
400 000
2016 273 206 1 000 000 683 013
400 000
2017 248 369 1 000 000 620 921
NPV $516 315 $552 620
These NPVs tell us that if we invest in A, we expect to increase the value of the firm by $516 315.
If we invest in B, we expect to increase the value of the firm by $552 620.
(a) NPV decision rule

A positive net present value means that the investment increases the value of the firm, that is,
the return is more than sufficient to compensate for the required return of the investment. A
negative net present value means that the investment decreases the value of the firm, that is,
the return is less than the cost of capital. A zero net present value means that the return just
equals the return required by owners to compensate them for the degree of uncertainty of the
investment's future cash flows and the time value of money. We summarise this in Table 2.5:
Table 2.5 NPV Decision Rule
If… this means that... and you …

NPV > 0 should accept the project
the investment is expected to
increase shareholder wealth
NPV < 0 the investment is expected to should reject the project
decrease shareholder wealth
NPV = 0 the investment is expected not to should be indifferent between
change shareholder wealth accepting or rejecting the project
Investment A increases the value of the firm by $516 315 and B increases it by $552 620. If these are
independent investments, both should be taken on because both increase the value of the firm. If A
and B are mutually exclusive, such that the only choice is either A or B, then B is preferred since it
has the greater NPV. Projects are said to be mutually exclusive if accepting one precludes the
acceptance of the other.
(b)The investment profile

We may want to see how sensitive is our decision to accept a project to changes in our cost of capital.
32
We can see this sensitivity in how a project's net present value changes as the discount rate changes by
looking at a project's investment profile, also referred to as the net present value profile. The
investment profile is a graphical depiction of the relation between the net present value of a project
and the discount rate: the profile shows the net present value of a project for each discount rate, within
some range.
The net present value profile for Investment A is shown in Figure 2.1 for discount rates from 0% to
40%. Investment A increases owners' wealth if the cost of capital on this project is less than 28.65%
and decreases owners' wealth if the cost of capital on this project is greater than 28.65%.
$1 400 000
NPV=$516 315 if cash flows are
$1 200 000 discounted at 10%
$1 000 000
NPV=$196 245 if cash flows are
discounted at 20%
$800 000
$600 000
NPV NPV=$0 if cash flows
$400 000 are discounted at 28.65%
$200 000
$
0% 4% 8% 12% 16% 20% 24% 28% 32% 36% 40%
($200 000)
Discount Rate
($400 000)
Figure 2.1: Investment Profile of Investment A

(Source: Gitman and Zutter, 2012)
Let us impose A's NPV profile on the NPV profile of Investment B, as show in Figure 2.2. If
A and B are mutually exclusive projects (we invest in only one project). Figure 2.2 shows that
the project we invest in depends on the discount rate. For higher discount rates, B's NPV falls
faster than A's. This is because most of B's present value is attributed to the large cash flows
four and five years into the future. The present value of the more distant cash flows is more
sensitive to changes in the discount rate than is the present value of cash flows nearer the
present.
33
Crossover rate of 12.07%
A’s NPV=B’s NPV=$439 413.53
If the discount rate is 22.79%,

$1 500 000 investment B’s NPV is zero
If the discount rate is 28.65%,
investment A’s NPV is zero
$1 000 000
$500 000
$0
0% 4% 8% 12% 16% 20% 24% 28% 32% 36% 40%
($500 000)
Figure 2.2: Investment Profiles of Investments A and B

(Source: Gitman and Zutter, 2012)
If the discount rate is less than 12.07%, B increases wealth more than A. If the discount
rate is more than 12.07% but less than 28.65%, A increases wealth more than B. If the
discount rate is greater than 28.65%, we should invest in neither project, since both would
decrease wealth. The 12.07% is the crossover discount rate, which produces identical NPVs
for the two projects. If the discount rate is 12.07%, the net present value of both
investments is $1 439 414 – 1 000 000 = $439 414.
For Investments A and B, the cross-over rate is the rate i that solves:
⎡ 400,000 400,000 400,000 400,000 400,000 ⎤
⎢− $1,000,000 + + + + + ⎥
⎣ (1 + i)1 (1 + i ) 2 (1 + i) 3 (1 + i) 4 (1 + i) 5 ⎦
= ⎡⎢− $1,000,000 + 100,000 + 100,000 + 100,000 + 1,000,000 + 1,000,000 ⎤⎥

⎣ (1 + i)1 (1 + i) 2 (1 + i) 3 (1 + i) 4 (1 + i) 5 ⎦
Combining like terms (those with the same denominators) as you would in simple algebra, we obtain:
⎡ 400,000 − 100,000 400,000 − 100,000 400,000 − 100,000 400,000 − 1,000,000 400,000 − 1,000,000 ⎤ or
⎢ + + + + ⎥ = $0
⎣ (1 + i )1
(1 + i ) 2
(1 + i ) 3
(1 + i ) 4
(1 + i ) 5
⎦
⎡ 300,000 300,000 300,000 − 600,000 − 600,000 ⎤

⎢ (1 + i)1 + (1 + i ) 2 + (1 + i)3 + (1 + i ) 4 + (1 + i)5 ⎥ = $0
⎣ ⎦
This last equation is in the form of a yield problem: the crossover rate is the rate of return of
the differences in cash flows of the investments. The i that solves this equation is 12.07%, the
crossover rate. You can solve for the crossover rate using trial and error or a financial
calculator. It should be noted that the net present value technique considers all expected
future cash flows, the time value of money, and the risk of the future cash flows.
34
Activity 2.3
(1) Calculate the net present value (NPV) for the following 20-year projects. Comment on
the acceptability of each. Assume that the firm has an opportunity cost of 14%.
(a) Initial investment is $10,000; cash inflows are $2,000 per year.
(b) Initial investment is $25,000; cash inflows are $3,000 per year.
(c) Initial investment is $30,000; cash inflows are $5,000 per year.
(2) ZMC Limited is evaluating a new fragrance-mixing machine. The machine requires
an initial investment of $24 000 and will generate after-tax cash inflows of $5 000 per
year for 8 years. For each of the costs of capital listed, (1) calculate the net present
value (NPV), (2) indicate whether to accept or reject the machine, and (3) explain
your decision, if:
(a) the cost of capital is 10%;
(b) the cost of capital is 12%;
(c) the cost of capital is 14%.
(3) XYZ has three projects under consideration. The cash flows for each project are
shown in the following table. The firm has a 16% cost of capital.
Project A Project B Project C
Initial Investments(CF0) ($40,000) ($40,000) ($40,000)
Year (t) Cash Inflows (CFt)
1 13,000 7,000 19,000
2 13,000 10,000 16,000
3 13,000 13,000 13,000
4 13,000 16,000 10,000
5 13,000 19,000 7,000
(a) Calculate each project’s payback period. Which project is preferred according to this
method?
(b) Calculate each project’s net present value (NPV). Which project is preferred
according to this method?
(c) Comment on your findings in parts (a) and (b), and recommend the best project.
Explain your recommendation.
2.5.4 Profitability index

The profitability index (PI) is the ratio of the present value of change in operating cash
inflows to the present value of investment cash outflows:
PI = present value of change in cash inflows

present value of cash outflows
Instead of the difference between the two present values, PI is the ratio of the two present
35
values. Hence, PI is a variation of NPV. By construction, if the NPV is zero, PI is one.
Looking at Investments A and B, the PI for A = $1 516 315/$1 000 000 = 1.5163 and the PI of
B = $1 552 620/$1 000 000 = 1.5526. The PI of 1.5163 means that for each $1 invested in A,
we get approximately $1.52 in value; the PI of 1.5526 means that for each $1 invested in B, we
get approximately $1.55 in value.
The PI is often referred to as the benefit-cost ratio, since it is the ratio of the benefit from an
investment (the present value of cash inflows) to its cost (the present value of cash outflows).
Profitability index decision rule

The profitability index tells us how much value we get for each dollar invested. If the PI is
greater than one, we get more than $1 for each $1 invested and if the PI is less than one, we
get less than $1 for each $1 invested. Therefore, a project that increases owners' wealth has a
PI greater than one. This is summarised in Table 2.6.
Table 2.6: Profitability Index Decision Rule
If … This means that… And you…

PI>1 the investment returns more than $1 in Should accept the project
present value for every $1 invested
PI<1 The investment returns less than $1 in Should reject the project
present value for every $1 invested
PI=1 The investment returns $1 in present Are indifferent between accepting

value for every $1 invested or rejecting the project
As long as we do not have to choose among projects, so that we can take on all profitable projects,
using PI produces the same decision as NPV. If the projects are mutually exclusive and they are
of different scales, PI cannot be used. If there is a limit on how much we can spend on capital
projects, PI is useful. Limiting the capital budget is referred to as capital rationing. Consider the
projects in Table 2.7.
Table 2.7: Capital rationing
Project Investment NPV PI
X $10 000 $6 000 1.6
Y $10 000 $5 000 1.5
Z $20 000 $8 000 1.4
If there is a limit of $20 000 on what we can spend, which project or group of projects is best in
terms of maximising the owners' wealth? If we base our choice on NPV, choosing the projects
with the highest NPV, we would choose Project Z whose NPV is $8 000. If we base our choice on
PI, we would choose Projects X and Y, that is, those with the highest PI, providing a NPV of
$6 000 + 5 000 = $11 000.
36
Our goal in selecting projects when the capital budget is limited is to select those projects that
provide the highest total NPV, given our constrained budget.
2.5.5 Internal rate of return

An investment's internal rate of return (IRR) is the discount rate that makes the present value of
all expected future cash flows equal to zero. We can represent the IRR as the rate that solves:
n
CFt
$0 = ∑ − CF0
T = 0 (1 + IRR )
t
Simplified to
n
CFt
∑ (1 + IRR)
T =0
t
= CF0
Let us return to Investments A and B that we used in the previous reading (see Table 2.8).
Table 2.8: Calculation of IRR

Investment A Investment B
End of year Expected Cash Flow Expected Cash Flow
2012 -$1 000 000 -$1 000 000
2013 $ 400 000 $ 100 000
2014 400 000 100 000
2015 400 000 100 000
2016 400 000 1 000 000
2017 400 000 1 000 000
The IRR for Investment A is the discount rate that solves:

400,000 400,000 400,000 400,000 400,000
$0 = −$1000,000 + + + + +
(1 + IRR) 1
(1 + IRR) 2
(1 + IRR) 3
(1 + IRR) 4
(1 + IRR) 5
or, combining like terms and rearranging,
$1,000,000 N 1
=∑
$400,00 t =1 (1 + IRR )
t
which gives us a factor that we can use to solve for i (the IRR) with the help of the present value
annuity tables:
⎛ present.value.annuity. factor ⎞
2.5 = ⎜⎜ ⎟⎟
⎝ N = 5, i = ? ⎠
Using the present value annuity factor table, we see that the discount rate that solves this equation is
approximately 30% per year. Using a calculator or a computer, we get the more precise answer of
28.65% per year. IRR for B is between 20% and 25%. Using a calculator or computer, the precise
value of IRR is 22.79% per year.
By interpolation IRR can be approximated by the following formula:
NPV p
IRR = p + (q − p)
NPV p − NPVq
37
Where p is the discount rate which gives a positive NPV p
q is the discount rate which gives a negative NPVq
Because we are subtracting a negative NPV the formula becomes:
NPV p
IRR = p + (q − p)
NPV p + NPVq
Looking back at the investment profiles of Investments A and B, you will notice that each
profile crosses the horizontal axis (where NPV = $0) at the discount rate that corresponds to the
investment's internal rate of return. This is no coincidence: by definition, the IRR is the discount
rate that causes the project's NPV to equal zero.
Internal rate of return decision rule

The internal rate of return is a yield, that is, what we earn, on average, per year. Let us revisit
Investments A and B and the IRRs we just calculated for each. If, for similar risk
investments, owners earn 10% per year, then both A and B are attractive. They both yield
more than the rate owners require for the level of risk of these two investments.
Example 2.3
A project with a cost of capital of 20% is expected to have the following cash flows:
Year Cash Flow
0 ($750 000)
1 200 000
2 250 000
3 300 000
4 320 000
5 350 000
Using the cost of capital of 20% and a hypothetical discount rate of 28% the NPVs of the project
are calculated as follows:
Year Cash Flow PVIF (20%) PVIF (28%)
0 -$750 000 -$750 000 -$750 000

1 200 000 166 667 156 250
2 250 000 173 611 152 587
3 300 000 173 611 143 051
4 320 000 119 209
5 350 000 140 657 101 863
NPV $ 58 866 -$77 040
38
The project would therefore be accepted as the IRR is more than the cost of capital. The decision
rule for the internal rate of return is to invest in a project if it provides a return greater than the
cost of capital. The cost of capital, in the context of the IRR, is a hurdle rate, that is, the
minimum acceptable rate of return. For independent projects and situations in which there is no
capital rationing, we summarise the decision rules for IRR in Table 2.10.
Table 2.10: Decision Rule for IRR
If … this means … and you …
IRR> cost of capital the investments is expected to should accept the project
increase shareholder wealth
IRR < cost of capital the investment is expected to should reject the project
decrease shareholder wealth
IRR=cost of capital the investment is not should be indifferent

expected to change between accepting or
shareholder wealth rejecting the project
The IRR and mutually exclusive projects

Project A has a higher IRR than B therefore we accept A since the IRR is greater than the cost
of capital. When evaluating mutually exclusive projects, the one with the highest IRR may
not be the one with the best NPV. The IRR may give a different decision than NPV when
evaluating mutually exclusive projects because of the reinvestment assumption:
• NPV assumes cash flows reinvested at the cost of capital.
• IRR assumes cash flows reinvested at the internal rate of return.

This reinvestment assumption may cause different decisions in choosing among mutually
exclusive projects when:
• the timing of the cash flows is different among the projects

• there are scale differences (that is, very different cash flow amounts)
• the projects have different useful lives
Multiple internal rates of return

A typical project usually involves only one large negative cash flow initially, followed by a
series of future positive cash flows. But that is not always the case since negative cash flows
may be experienced after the inception date. Suppose we are considering a project that has
cash flows as in Table 2.11.
39
Table 2.11: Multiple Internal Rates of Return
Period End of Period Cash Flow
0 ($100)
1 +$474
2 ($400)
What is this project's IRR?

One possible solution is IRR= 10%, yet another possible solution is IRR = 2.65 or 265%.
Investment profile of a project with an initial cash outlay of $100, a first period cash inflow of
$474, and a second period cash outflow of $400, resulting in multiple internal rates of return
Figure 2.3 Multiple IRRs (Source: Gitman and Zutter, 2012)

Multiple solutions to the yield on a series of cash flows occurs whenever there is more than
one change from positive to negative or from negative to positive in the sequence of cash
flows. For example, the cash flows in the example above followed a pattern of negative to
positive. There are two sign changes: from minus to plus and from plus to minus. There are
also two possible solutions for IRR, one for each sign change.
If there are multiple solutions, there is no unique internal rate of return. And if there is no
unique solution, the solutions we get are worthless as far as making a decision based on IRR
is concerned. This is a strike against the IRR as an evaluation technique.
Modified Internal Rate of Return (MIRR)

MIRR is the rate that solves:
N
N
COFt ∑ CIF (1 + RR)
t
t
∑
t = 0 (1 + RR )
t
= t =0
(1 + MIRR) N
Present value present value of

=
of cash outflows cash inflows reinvested at RR
which we can rearrange to be:
40
N
∑ CIF (1 + RR)
t
t
(1 + MIRR) t = t =0
N
COFt
∑ (1 + RR)
t =0
t
FV .of . inf lows

(1 + MIRR )t =
PV .of .outflows
Let us calculate the MIRR for Investments A and B, assuming reinvestment at the 10% cost of
capital.
Step 1: Calculate the present value of the cash outflows. In both A's and B's case, this is $1 000 000.
Step 2: Calculate the future value by figuring the future value of each cash flow as of the end
of 2017 (see Table 2.12).
Table 2.12: MIRR
Year End of Year FV2017 of End of Year FV2017 of

Cash Flow Cash Flow Cash Flow Cash Flow
2013 $400 000 $585 640 $100 000 $146 410
2014 400 000 532 400 100 000 133 100
2015 400 000 484 000 100 000 121 100
2016 400 000 440 000 1 000 000 1 100 000
2017 400 000 400 000 1 000 000 1 000 000
FV $2 442 040 $2 500 610
Step 3: For A, solve for the rate that equates $2 442 040 in five years with $1 000 000 today:
$2,442,040 = $1,000,000(1 + MIRR )
5
(1 + MIRR) 5 = 2.4420
1
(1 + MIRR) = (2.4420) 5
MIRR = 0.1955 or 19.55% per year.

Following the same steps, the MIRR for Investment B is 20.12% per year.
Modified internal rate of return decision rule

The modified internal rate of return is a return on the investment, assuming a particular return on
the reinvestment of cash flows. As long as the MIRR is greater than the cost of capital, the project
should be accepted. If the MIRR is less than the cost of capital, the project does not provide a
return commensurate with the amount of risk of the project. This is summarised in Table 2.13.
41
Table 2.13: Decision Rule for Multiple IRR
If … this means … and you …
MIRR > cost of capital the investment is expected should accept the project
to return more than required
MIRR < cost of capital the investment is expected should reject the project
to return less than required
MIRR=cost of capital the investment is expected are indifferent between accepting

to return what is required or rejecting the project
2.6 Comparing Techniques

If we are dealing with mutually exclusive projects, the NPV method leads us to invest in
projects that maximise wealth, that is, capital budgeting decisions consistent with owners'
wealth maximisation. If we are dealing with a limit on the capital budget, the NPV and PI
methods lead us to invest in the set of projects that maximise wealth.
An evaluation technique should:

• consider the time value of money;
• consider the uncertainty associated with future cash flows;
• have objective criteria by which to select a project;
• be simple, easy to use and to understand;
• use cash flows and not profits;
• be a good indicator of liquidity;
• be a good indicator of profitability;
• be easily adjusted or used in circumstances of risk, especially cataclysmic risk;
• be easily adjusted or used in circumstances of inflation;
• be consistent;
• be used under the circumstances of capital rationing; and
• be used when the projects have different lives.
Projects selected using a technique that satisfies all the criteria will, under most general
conditions, maximise owners' wealth. In addition to judging whether each technique satisfies
these criteria, we will also look at which ones can be used in special situations, such as when a
dollar limit is placed on the capital budget.
2.6.1 Which approach is better?

Many companies use both the NPV and IRR techniques because current technology makes them
easy to calculate. But it is difficult to choose one approach over the other because the theoretical
and practical strengths of the approaches differ. Clearly, it is wise to evaluate NPV and IRR
techniques from both theoretical and practical points of view.
(b) Theoretical view

On a purely theoretical basis, NPV is the better approach to capital budgeting as a result of
several factors. Most important, the NPV measures how much wealth a project creates (or
destroys if the NPV is negative) for shareholders. Given that the financial manager’s objective is
42
to maximise shareholder wealth, the NPV approach has the clearest link to this objective and,
therefore, is the “gold standard” for evaluating investment opportunities.
(b) Practical view

Evidence suggests that in spite of the theoretical superiority of NPV, financial managers use the
IRR approach just as often as the NPV method. The appeal of the IRR technique is due to the
general disposition of business people to think in terms of rates of return rather than actual dollar
returns. Because interest rates, profitability, and so on are most often expressed as annual rates
of return, the use of IRR makes sense to financial decision makers. They tend to find NPV less
intuitive because it does not measure benefits relative to the amount invested. Because a variety
of techniques are available for avoiding the pitfalls of the IRR, its widespread use does not imply
a lack of sophistication on the part of financial decision makers. Clearly, corporate financial
analysts are responsible for identifying and resolving problems with the IRR before the decision
makers use it as a decision technique.
Activity 2.4
1. Define the internal rate of return (IRR) on an investment.
2. Describe the acceptance criteria for IRR.
3. Does the assumption concerning the reinvestment of intermediate cash inflow tend to
favour NPV or IRR? In practice, which technique is preferred and why?
4. Mutually exclusive projects Fitch Industries is in the process of choosing the better of
two equal-risk, mutually exclusive capital expenditure projects—M and N. The relevant
cash flows for each project are shown in the following table. The firm’s cost of capital is
14%.
Project M Project N
Initial Investments (CF0) ($28 500) ($27 000)
Year (t) Cash inflows (CFt)
1 10 000 $11 000
2 10 000 $10 000
3 10 000 $9 000
4 10 000 $8 000
(a) Calculate each project’s payback period.

(b) Calculate the net present value (NPV) for each project.
(c) Calculate the internal rate of return (IRR) for each project.
(d) Summarise the preferences dictated by each measure you calculated, and indicate which
project you would recommend. Explain why.
(e) Draw the net present value profiles for these projects on the same set of axes, and explain
the circumstances under which a conflict in rankings might exist.
5. Froogle Enterprises is evaluating an unusual investment project. What makes the project
unusual is the stream of cash inflows and outflows shown below:
Year Cash Flows

0 $200 000
1 ($920 000)
2 1 582 000
3 (1 205 200)
4 343 200
43
Required:
(a) Why is it difficult to calculate the payback period for this project?
(b) Calculate the investment’s net present value at each of the following discount rates: 0%,
5%, 10%, 15%, 20%, 25%, 30%, 35%.
(c) What does your answer to part (b) tell you about this project’s IRR?
(d) Should Froogle invest in this project if its cost of capital is 5%? What if the cost of
capital is 15%?
(e) In general, when faced with a project like this, how should a firm decide whether to
invest in the project or reject it?
2.7 Summary
In this unit, we evaluated the techniques that are used to appraise projects on the basis of their
cash flows. These techniques include the payback period, the discounted payback period, the net
present value, the profitability index, the internal rate of return, and the modified internal rate of
return. We noted that the payback period and the discounted payback period are measures of
how long it takes the future cash flows to pay back the initial investment. We also described the
net present value as the difference between the present value of the future operating cash flows
and the present value of the investment cash flows. The profitability index was described as the
ratio of the present value of the future operating cash inflows to the present value of the
investment cash flows. Like the net present value, the profitability index tells us whether or not
the investment would increase the owners' wealth. The internal rate of return was described as
the yield on the investment; that is, the discount rate that causes the net present value to be equal
to zero. Each technique we look at offers some advantages and disadvantages. The discounted
cash flow techniques, that is, the NPV, PI, IRR and MIRR are superior to the non-discounted
cash flow techniques, which are the payback period and the accounting rate of return.
44
References
Block, S.B. and Hirt, G.A. (1994). Foundations of Financial Management. (6th Edition). Boston: Irwin.
Education, Inc.
Kwesu, I. and Chikwava, M. (2002). Business Management. Harare: ZOU.
Levy, H. and Sarnat, M.. (1991). Capital Investments and Financial Decisions. (4th Edition) New
York: Prentice Hall.
45
Unit 3
Advanced Capital Budgeting
3.0 Introduction
Capital budgeting is now considered at a higher level, hence issues like the different duration
of projects, inflation, risk, tax shields and capital rationing will now be incorporated into the
analysis. In this unit, we will cover aspects involved in appraising capital projects against the
background of different duration of projects, inflation, risk, tax shields, and capital rationing
situation.
3.1 Objectives
• appraise capital projects when different duration of projects, inflation, risk, tax shields
and capital rationing situations are considered
• calculate NPV and IRR using the LCM technique
• compute NPV to infinity and the uniform annual series
• determine the viability of the project when dealing with real and nominal cash flow, real
and nominal discount rate
• appraise projects using sensitivity analysis, decision tress, and adjusted discount rate
3.2 Different Life Projects

Financial managers must often select the best of a group of unequal-lived projects. If the projects
are independent, the length of the project lives is not critical. But when unequal-lived projects
are mutually exclusive, the impact of differing lives must be considered because the projects do
not provide service over comparable time periods. This is especially important when continuing
service is needed from the project under consideration. The discussions that follow assume that
the unequal-lived, mutually exclusive projects being compared are ongoing. If they were not, the
project with the highest NPV would be selected. Projects with different lives are those projects
that have different duration. Methods that can be used to evaluate projects with unequal lives
include replacement chain and equivalent annual annuity approach.
3.2.1 Replacement chains
Assume that the firm can repeat projects for a period equal to the lowest common multiple
period or infinity. The Lowest Common Multiple approach is best used if the project cash flows
change during the life of the project. For the projects it is of utmost importance to determine the
LCM of the alternative investments and then repeat the projects for the LCM period. Meanwhile
the infinity method assumes that projects can be repeated forever and generate the same cash
flows forever.
46
Example 3.1
The following projects have cash profiles that do not change even if projects are repeated
forever:
Year Project A Project B
0 ($120 000) ($90 000)
1 67 500 67 500
2 75 000 90 000
3 90 000
Cost of capital 30% 30%
IRR 39.54% 44.30%
NPV $17 266.73 $15 177.51
It is expected that each time that a project is repeated, the initial investment will increase by 10%
and each annual cash flow by 20% for both projects. Use the (a) LCM technique and (b) the
Infinity method to determine the viability of the two projects.
(a) The LCM Technique
Initially considering project A we have:
Year 0 1 2 3 4 5 6
Initial Investment (120 000) (132 000)
Cash flow 67 500 75 000 90 000 81 000 90 000 108 000
Net cash flow (120 000) 67 500 75 000 (42 000) 81 000 90 000 108 000
Therefore Net Present Value of project A = $32 159.80

IRR of project A = 41.44%
Analysis of project B:
Year 0 1 2 3 4 5 6
Initial Investment (90 000) (99 000) (108 900)
Cash flow 67 500 90 000 81 000 108 000 97 200 129 600
Net cash flow (90 000) 67 500 (9 000) 81 000 (900) 97 200 129 600
Net Present Value of project B = $46,179.80

IRR of Project B = 49.38%
47
Using the LCM technique Project B is accepted because it has the highest IRR and NPV.
(b) The Infinity Method
Net Present Value using the infinity method is computed as follows:
⎛ [1 + k ] n ⎞
NPV (infinity) = NPV ⎜⎜ ⎟⎟
⎝ [1 + k ] − 1 ⎠
n
Project A
⎛ [1 + 0.30]3 ⎞
NPV (infinity) = 17,266.73⎜⎜ ⎟⎟ = $31,691.73
⎝ [1 + 0.30] − 1 ⎠
3
Project B
⎛ [1 + 0.30] 2 ⎞
NPV (infinity) = 15,177.51⎜⎜ ⎟⎟ = $37,173.90
⎝ [1 + 0.30] − 1 ⎠
2
Project B should be accepted since it has the higher NPV.
3.2.2 The Uniform Annual Series (UAS)

The UAS calculates an annuity amount that will result in the Net Present Value equivalent to
the one achieved by the uneven cash flows. The decision criterion is to accept the project with the
higher UAS which is derived as follows:
NPV = UAS × PVIFA (k%, n years)
Therefore,
NPV
UAS =
PVIFA(k %, n. years)
Project A
17,266.73 17,266.73
UAS = = = $9,507.59
PVIFA(30%,3 years) 1.8161
Project B
15,177.51 15,177.51
UAS = = = $11,152.55
PVIFA(30%,2 years) 1.3609
Project B is accepted because it has the higher UAS.
48
Activity 3.1
The following projects have cash profiles that do not change even if projects are repeated
forever:
Year Project A Project B
0 ($150 000) ($80 000)
1 80 000 80 000
2 90 000 95 000
3 100 000
Cost of capital 20% 20%
It is expected that each time that a project is repeated, the initial investment would increase by 12%
and each annual cash flow by 30% for both projects. Use the (a) LCM technique and (b) the
Infinity method (c) the UAS to determine the viability of the two projects.
3.3 Inflation and Capital Budgeting

According to Fisher (1930), interest rate quoted on risk-free assets such as treasury bills fully
reflects anticipated inflation. Note that interest rates quoted on securities are known as
nominal or money interest rates whereas real rates represent the rate of interest that could be
required in the absence of inflation. It is impossible to evaluate nominal cash flows with real
discount rate. We therefore convert real discount rate to nominal rate if we are using
nominal cash flows or convert nominal cash flows to real cash flows if we are to use real
discount rate. Fisher proposed the following equation to convert real into nominal rates:
(1 + nominal rate) = (1 + real rate) × (1 + expected

inflation).
Nominal rate = (1 + real rate) × (1 + expected inflation) -

1.
To be specific:
• Change cash flows into real cash flows when given a real discount rate
• Convert real cash flows into nominal cash flows when given a nominal discount rate
• Change real discount rate into a nominal discount rate in order to discount nominal
cash flows
3.3.1 Change nominal cash flows into real cash flows

Nominal cash flows are deflated into real cash flows by using the following formula:
49
NCFt
Real cash flows ( RCFt ) =
It
Where NCFt = nominal cash flow at time “t”
I t = Inflation index in year “t”
If the rate of inflation is expected to remain constant, the inflation index is derived as
follows:
Inflation index ( I t ) = (1 + i ) t
When dealing with different annual rates of inflation, the inflation index is derived as
follows:
Inflation index in year 1 = (1+i1)
Inflation index in year 2 = (1+i1)(1+i2)
Inflation index in year 3 = (1+i1)(1+i2)(1+i3) and so on.
Example 3.2
A two-year project has an initial investment of $30 000 and annual cash flows of $22 500 and
$30 000 in years 1 and 2 respectively. The inflation rate is expected to be 18% in the first
year and 20% in the second year. Given that the real discount rate is 12%, determine the NPV
of the project.
Year NCF Inflation Index RCF PVIF (12"/0,n PV (RCF)

(I,) years)
0 ($30 000) 1.0000 ($30 000.00) 1.0000 ($30 000.00)
1 22 500 1.1800 19 067.80 0.8929 17 025.64
2 30 000 1.4160 21 186.44 0.7972 16 889.83
NPV 3 915.47
Since the project has a positive NPV, it should be accepted.

3.3.2 Converting real cash flows into nominal cash flows
The real cash flows can be inflated into nominal cash flows and discounted at the nominal discount
rate using the following formula:
Nominal cash flow = Real cash flow inflation index in year't'.
Example 3.3
A two-year project with an initial investment of $18 000 has real cash flows of $12 000 in the
following respective years. Given that the nominal discount rate is 28% and the inflation rate is
expected to be 18% annually. Determine the NPV of the project.
50
Year RCFt, (It) NCFt PVIF (28%,n PV (RCF,)
years)
0 ($18 000) 1.0000 ($18 000) 1.0000 ($18 000)
1 12 000 1.1800 14 160 0.7812 11 061.79
2 12 000 1.3924 16 708.80 0.6104 10 199.05
NPV 3 260.84
The project should be implemented since the NPV is positive.

3.3.3 Changing real discount rate into nominal discount rate
The real discount rate can be changed to a nominal discount rate in order to discount nominal
cash flows.
Example 3.4
A project that costs $275 000 is expected to realize after tax nominal cash flows of $110 000 per
annum for the next five years. The real discount rate is 10% and the inflation rate is expected to
average 20% for the whole period. Compute the NPV of the project.
The nominal discount rate = (1.10)(1.20) - 1 = 32%
Therefore NPV = (275 000) + 110 000 PVIFA (32%, 5 years)
= (275 000) + 110 000(2.3452) = ($17 028).
The project should not be implemented because the NPV is negative.
3.4 Inflation, Tax Shields and Capital Budgeting

Capital allowances do not change with inflation because they are based on historical data,
hence we must remove the capital allowance tax shields before we inflate the cash flows. The
purchasing power of the capital allowance tax shields is however affected by the time value
of money, therefore should be discounted at the nominal discount rate.
Example 3.5
A machine with a life of four years costs $35 000 with no residual value. Incremental after
tax cash flow in present value terms generated by the machine is $17 500 per year. Given that
the cash flows include SIA at current rates, the tax rate is 35%, inflation rate is 30%, and the
real discount rate is 6%; compute the NPV of the project.
SIA in year 1 = $35 000 (0.50) = $17 500
SIA tax shield in year 1 = $17 500 (0.35) = $6 125
SIA in years 2 and 3 = $35 000 (0.25) = $8 750
SIA tax shield in year 2 and 3 = $8 750 (0.35) = $3 062.50
Therefore:
Cash flow without tax shield in year 1 = $17 500 – 6 125 = $11 375
Cash flow without tax shield in years 2 and 3 = $17 500 – 3 062.50 = $14 437.50.
51
The nominal discount rate is computed as follows:
Nominal discount rate = (1.30)(1.06) - 1 = 37.8%
After tax cash flows are calculated in the table below:
Year RCFt It NCFt SIA Tax Shield After Tax CF

1 $11 375.00 1.3000 $14 787.50 $6 125.00 $20 912.50
2 14 437.50 1.6900 24 399.38 3 062.50 27 461.88
3 14 437.50 2.1970 31 719.19 3 062.50 34 781.69
4 17 500.00 2.8561 49 981.75 - 49 981.75
NPV = ($35 000) + 20 912.50(1.378)-1 + 27 461.88(1.378)-2 + 34 781.69(1.378)-3 +

49 981.75(1.378)-4 = $21 792.12
Accept the project because the NPV is positive.
Activity 3.2
1. A three-year project has an initial investment of $50 000 and annual cash flows of $40
000, $55 000 and $30 000 in years 1, 2 and 3 respectively. The inflation rate is
expected to be 16% in the first year, 22% in the second year and 25% in the third year.
Given that the real discount rate is 15%, calculate the NPV of the project.
2. A four-year project with an initial investment of $20 000 has real cash flows of $15
000 in the following respective years. Given that the nominal discount rate is 30% and
the inflation rate is expected to be 20% annually; compute the NPV of the project.
3. A project that costs $300 000 is expected to realize after tax nominal cash flows of
$180 000 per annum for the next five years. The real discount rate is 15% and the
inflation rate is expected to average 22% for the whole period. Compute the NPV of
the project.
4. A machine with a life of four years costs $50 000 with no residual value. Incremental
after tax cash flow in present value terms generated by the machine is $25 500 per
year. Given that the cash flows include SIA at current rates, the tax rate is 40%,
inflation rate is 20%, and the real discount rate is 5%, compute the NPV of the
project.
3.5 Risk and Capital Budgeting

It is assumed that firms are risk averse in that, if a firm is faced with two investment
opportunities with equal returns, it will select the project with the lower risk profile. The
methods of dealing with risk in capital budgeting include, certainty equivalent analysis, the
risk-adjusted discount rate technique, payback method, sensitivity analysis and decision trees.
3.5.1 Sensitivity analysis
The aim of sensitivity analysis is to seek out which variables of a project could have the most
adverse effect on the overall outcome of an appraisal if they were to fall short of their own
expected outcomes. For example, the significant variables of a project include initial outflow,
52
project life, annual sales, selling price and variable costs and cost savings. Your analysis
would aim to test the effect on the basic NPV calculation of various changes from the base
case assumptions, for example:
Initial outflow 5% greater than expected

Project life 2 years shorter than expected
Sales or selling price 10% lower than expected
Cost savings 10% lower than expected
In reality, sensitivity analysis is particularly suited to computer spreadsheets, as a
considerable number of variations can be tested to find which could have any seriously
damaging effect on the outcome. In effect, you are seeking out the weakest links in your
chain of assumptions, bearing in mind that a relatively low percentage change in a particular
variable may have such an impact as to create a negative NPV from what may have been a
satisfactorily positive base case.
3.5.2 Decision trees
In appraisal situations where uncertainty can apply to more than one variable and values of
the variables can be interdependent, many different outcomes are possible. The decision tree
is a useful tool for reviewing a multiplicity of choices and outcomes. Imagine the trunk of the
tree as representing a project to be appraised, perhaps a new product to be added to a range,
then the first branches (of which there may be two, three or more) may represent alternative
predictions as to expected cash flows to each of which probabilities are assigned. The
probabilities of each branch sequence are then multiplied and the joint probabilities thus
obtained are applied in turn to each sequential set of values to give a series of pay-off or
outcomes.
Example 3.6
XYZ has a two year project which requires an initial investment of $20 000 000. The annual
cash returns of the project depend on whether there will be drought in the first year or/and in
the second year.
• There is 30% chance that there will be drought in the first year. If there is drought in
the first year, there is 40% chance of another drought in the second year.
• If there is no drought in the first year there is 50% chance of drought in the second
year of operation.
• If there is no drought in the first year, annual cash flow will be $18 000 000.
• If there is drought in the first year annual cash flow will be $10 000 000.
• If there is a successive drought annual cash flow will be $12 000 000 (that is, in the
second year).
• If there is no drought for two successive years annual cash flow will be $15 000 000.
• If there is drought in the first year and no drought in the second year annual cash flow
will be $18 000 000.
• If there is no drought in the first year and drought in the second year, annual cash flow
will be $9 000 000.
53
The cost of capital is 22% and there is no salvage value.
A decision tree below can illustrate the above scenario:
40%
$15 000 000
$18 000 000
70% 60%
$9 000 000
($20 000 000)
50%
$18 000 000
30%
$10 000 000
50% $12 000 000
Using the decision tree above expected NPV can be obtained using the formula below:
Expected NPV = ∑ ( NPV ) b ( jp ) b
Where NPVb = NPV of each branch
( jp ) b = joint probability of each branch
Expected NPV =
[-20 000 000 + 18 000 000(0.8197) + 15 000 000(0.6719)](0.7)(0.4) + [-20 000 000 + 18 000 000(0.8197) +
9 000 000(0.6719)](0.7)(0.6) + [-20 000 000 + 10 000 000(0.8197) + 18 000 000(0.6719)](0.3)(0.5) +
[-20 000 000 + 10 000 000(0.8197) + 12 000 000(0.6719)(0.3)(0.5) = $1 172 632
Since the NPV is positive the project should be accepted.

3.5.3 Certainty equivalents
Suppose that in testing the sensitivity assumptions regarding our variables we find that there
is an evident risk of our cash inflows falling short of base case predictions, possibly by, say,
20% in the first year of a project. If we want a high degree of safety, it seems prudent to
assume that the following years, by being further in the future, will show still higher
percentage-falls from the base case. By applying safety factors of, say, 20%, 30% and 40%
reductions of base net inflows, we arrive at new figures called certainty equivalents for those
years.
54
Let us compare possible outcomes in table below:
Year Base Cash Discount Base PV $ % of Base Certainty PV ($)
Flow $ Factor 10% Equivalents
0 (10 000) 1.000 (10 000) (10 000) (10 000)
1 6 000 0.909 5 454 80% 4 800 4 363
2 5 000 0.826 4 130 70% 3 500 2 891
3 4 000 0.751 3 004 60% 2 400 1 802
2 588 (944)
Clearly with the new inflows, what seems a satisfactory NPV for the project base case has
turned into a negative with certainty equivalents. A risk-averse management is likely to reject
the project.
The danger of using certainty equivalents lies in the high level of subjective judgment
required from the decision-taker, while it could also be argued that a risk-averse management
might be better off using a high cut-off rate. Nevertheless, certainty equivalents represent a
useful tool in the investment appraisal armory, especially in assessing cases where an
apparently small change in a key variable can interact with others to create significant falls in
inflows, with a possible cumulative effect over the life of the project.
3.5.4 Adjusted discount rate
A further way of allowing for risk is to add a premium to the cut-off rate whereby more
marginal projects would be less likely to have a positive NPV.
Adjusted discount rate = risk free rate + risk premium.

Risk free rate component takes into account the time value of money while the risk
premium penalizes the cash flow for risk.
3.5.5 Payback period: accounting for money at risk
One of the attractions of the payback period is that it provides some measure of the "money at
risk". At the start of the project, we are presented with a lot of uncertainty about future cash
flows, and the economic environment and our cash flows may turn out more or less
favourable than we initially anticipated, with uncertainty being larger for those cash flows in
the more distant future. Pay back does not measure but allows cataclysmic risk arising from
factors such as drought, war, farm invasion and mass stay away.
3.6 Capital Rationing

Situations may occur where there are insufficient funds available to enable a firm to undertake all
those projects that yield a positive NPV. This situation is called capital rationing. Capital rationing
occurs whenever there is a budget ceiling or a market constraint on the amount of funds that can be
invested during a specific period of time. Soft capital rationing is often used to refer to situations
where, for various reasons, the firm internally imposes a budget ceiling on the amount of capital
expenditure. On the other hand, where the amount of capital constraint is external such as
55
inability to obtain funds from the financial market, the term hard capital rationing is used.
Wherever capital rationing exists, this should allocate the limited available capital in a way that
maximises NPV subject to the constraint of pursuing goals that are necessary to maintain the
coalition of the various interest groups. Thus, it is necessary to rank all investment opportunities so
that the NPV can be maximised from the use of the available funds. The analytical techniques
used thus, therefore should be capable of ranking the various alternatives or of determining
the optimal combination of investments that meet the constraint of limited capital. Ranking in
terms of absolute NPV will normally give incorrect results since this method leads to the
selection of large projects, each of which has a high NPV but that have, in total, a lower NPV
than a large number of small projects with lower individual NPVs.
If projects are divisible and financially exhaustive, PI is the ideal criteria for evaluating the
mutually exclusive projects.
Example 3.7
A company that operates under the constraint of capital rationing has identified 7 independent
investments from which to choose. The company has $200 000 available for capital investment
during the current period. Which project should the company choose?
Projects Initial Capital PV NPV PI (%) Rank NPV Rank PI
A 25 000 32 500 7 500 1.30 6 2
B 100 000 108 250 8 250 1.08 5 6
C 50 000 75 750 25 750 1.51 1 1
D 100 000 123 500 23 500 1.23 2 3
E 125 000 133 500 8 500 1.07 4 7
F 25 000 30 000 5 000 1.20 7 4
G 50 000 59 000 9 000 1.18 3 5
The aim is to select the projects in descending order of profitability until the investment funds of
$200 000 have been exhausted. If we use NPV, the projects are ranked as follows:
Projects Selected in Order of Rank, Using NPV Method
Project NPV Investment cost
C 25 750 50 000
D 23 500 100 000
G 9 000 50 000
58 250
56
Projects Selected in Order of Rank, Using PI
Project NPV Investment Cost
C 25 750 50 000
A 7 500 25 000
D 23 500 100 000
F 5 000 25 000
61 750
Activity 3.3
XYZ Limited is considering a proposed project for its capital budget. The company estimates
the project’s NPV is $12 million. This estimate assumes that the economy and market
conditions will be average over the next few years. The company’s CFO, however, forecasts
there is only a 50% chance that the economy will be average. Recognising this uncertainty,
she has also performed the following scenario analysis:
Economic Scenario Probability of Outcome NPV

Recession 0.05 ($70 000 000)
Below average 0.20 (25 000 000)
Average 0.50 12 000 000
Above average 0.20 20 000 000
Boom 0.05 30 000 000
What is the project’s expected NPV, its standard deviation, and its coefficient of variation?
3.7 Summary
In this unit, we discussed that financial analysts should be able to deal with different life projects,
inflation, tax shields, risk and capital rationing situations in the capital budgeting process. Not all
capital budgeting projects have the same level of risk as the firm’s existing portfolio of projects.
The financial manager must adjust projects for differences in risk when evaluating their
acceptability. Without such an adjustment, management could mistakenly accept projects that
destroy shareholder value or could reject projects that create shareholder value. To ensure that
neither of these outcomes occurs, the financial manager must make sure that only those projects
that create shareholder value are recommended. Risk-adjusted discount rates provide a
mechanism for adjusting the discount rate so that it is consistent with the risk–return preferences
of market participants. Firms commonly operate under capital rationing—they have more
acceptable independent projects than they can fund. In theory, capital rationing should not exist.
Firms should accept all projects that have positive NPVs (or IRRs the cost of capital). The
objective of capital rationing is to select the group of projects that provides the highest overall net
present value and does not require more dollars than budgeted. As a prerequisite to capital
rationing, the best of any mutually exclusive projects must be chosen and placed in the group of
independent projects.
57
References
Education, Inc.
Hall.
McLaney, E.J. (2000). Business Finance: Theory and Practice. New York: Prentice Hall.
58
BLANK PAGE
Unit 4
Theory of Capital Structure
4.0 Introduction
Capital structure is one of the most complex areas of financial decision making because of its
interrelationship with other financial decision variables. Poor capital structure decisions can
result in a high cost of capital, thereby lowering the NPVs of projects and making more of
them unacceptable. Effective capital structure decisions can lower the cost of capital,
resulting in higher NPVs and more acceptable projects—and thereby increasing the value of
the firm. In this unit, we focus our discussion on the various theories advanced to explain the
capital structure of a firm.
4.1 Objectives
• determine types of capital
• explain why debt capital is relatively cheaper than equity capital
• define capital structure
• discuss the optimal capital structure
• determine the value of the firm
• analyse the cost of geared and un-geared firm
4.2 Corporate Valuation and Capital Structure

Ehrhardt and Brigham (2011) point out that a firm’s financing choices obviously have a direct
effect on the weighted average cost of capital (WACC). Financing choices also have an
indirect effect on the costs of debt and equity because they change the risk and required
returns of debt and equity. Financing choices can also affect free cash flows if the probability
of bankruptcy becomes high. In this unit we focus on the debt–equity choice and its effect on
value.
A firm’s mixture of debt and equity is called its capital structure. Although actual levels of
debt and equity may vary somewhat over time, most firms try to keep their financing mix
close to a target capital structure. A firm’s capital structure decision includes its choice of a
target capital structure, the average maturity of its debt, and the specific types of financing it
decides to use at any particular time. As with operating decisions, managers should make
capital structure decisions that are designed to maximise the firm’s intrinsic value.
The value of a firm’s operations is the present value of its expected future free cash flows
(FCF) discounted at its weighted average cost of capital (WACC):
∞
FCFt
Vop = ∑
t =1 (1 + WACC ) t
59
The WACC depends on the percentages of debt and common equity ( wd and ws ), the cost of
debt ( rd ), the cost of stock ( rs ), and the corporate tax rate (T):
WACC = wd (1 − T )rd + ws rs
As these equations show, the only way any decision can change a firm’s value is by affecting
either free cash flows or the cost of capital. Discussed below are some of the ways that a
higher proportion of debt can affect WACC and/or FCF.
4.2.1 Debt increases the cost of stock, rs
Debt-holders have a claim on the company’s cash flows that is prior to shareholders, who are
entitled only to any residual cash flow after debt-holders have been paid. The “fixed” claim of
the debt-holders causes the “residual” claim of the stockholders to become riskier, and this
increases the cost of stock, rs .
4.2.2 Debt reduces the taxes a company pays

Imagine that a company’s cash flows are a pie and that three different groups get pieces of the
pie. The first piece goes to the government in the form of taxes, the second goes to debt-
holders, and the third to shareholders. Companies can deduct interest expenses when
calculating taxable income, which reduces the government’s piece of the pie and leaves more
pie available to debt-holders and investors. This reduction in taxes reduces the after-tax cost
of debt, as shown in the equation below:
WACC = wd (1 − T )rd + ws rs
4.2.3 The risk of bankruptcy increases the cost of debt, rd
As debt increases, the probability of financial distress, or even bankruptcy, goes up. With
higher bankruptcy risk, debt-holders will insist on a higher interest rate, which increases the
pre-tax cost of debt, rd .
4.2.4 The net effect on the weighted average cost of capital

Given that the WACC is a weighted average of relatively low-cost debt and high-cost equity:
If we increase the proportion of debt, then the weight of low-cost debt ( wd ) increases and the
weight of high-cost equity ( ws ) decreases. If all else remained the same, then the WACC
would fall and the value of the firm would increase. However, it is known that all else doesn’t
remain the same: both rd and rs increase. It should be clear that changing the capital structure
affects all the variables in the WACC equation, but it is not easy to say whether those changes
increase the WACC, decrease it, or balance out exactly and thus leave the WACC unchanged.
4.2.5 Bankruptcy risk reduces free cash flow
As the risk of bankruptcy increases, some customers may choose to buy from another
company, which affects sales. This, in turn, decreases net operating profit after taxes, thus
reducing FCF. Financial distress also affects the productivity of workers and managers, who
spend more time worrying about their next job than attending to their current job. Again, this
reduces net operating profit after taxes and FCF. Finally, suppliers tighten their credit
60
standards, which reduces accounts payable and causes net operating working capital to
increase, thus reducing FCF. Therefore, the risk of bankruptcy can decrease FCF and reduce
the value of the firm.
4.2.6 Bankruptcy risk affects agency costs
Higher levels of debt may affect the behaviour of managers in two opposing ways. First,
when times are good, managers may waste cash flow on perquisites and unnecessary
expenditures. This is an agency cost. The good news is that the threat of bankruptcy reduces
such wasteful spending, which increases FCF.
But the bad news is that a manager may become gun-shy and reject positive-NPV projects if
they are risky. From the stockholder’s point of view, it would be unfortunate if a risky project
caused the company to go into bankruptcy, but note that other companies in the stockholder’s
portfolio may be taking on risky projects that turn out to be successful. Since most
stockholders are well diversified, they can afford for a manager to take on risky but positive-
NPV projects. But a manager’s reputation and wealth are generally tied to a single company,
so the project may be unacceptably risky from the manager’s point of view. Thus, high debt
can cause managers to forgo positive-NPV projects unless they are extremely safe. This is
called the underinvestment problem, and it is another type of agency cost. Notice that debt
can reduce one aspect of agency costs (wasteful spending) but may increase another
(underinvestment), so the net effect on value is not clear.
4.2.7 Issuing equity conveys a signal to the marketplace
Managers are in a better position to forecast a company’s free cash flow than are investors,
and this is called informational asymmetry. Suppose a company’s stock price is $50 per
share. If managers are willing to issue new stock at $50 per share, investors reason that no
one would sell anything for less than its true value. Therefore, the true value of the shares as
seen by the managers with their superior information must be less than or equal to $50. Thus,
investors perceive an equity issue as a negative signal, and this usually causes the stock price
to fall. In addition to affecting investors’ perceptions, capital structure choices also affect
FCF and risk, as discussed earlier. The following section focuses on the way that capital
structure affects risk.
4.2.8 Business risk and financial risk
Business risk and financial risk combine to determine the total risk of a firm’s future return
on equity, as we explained in the next sections.
(a) Business risk
Business risk is the risk inherent in the firm’s operations if it uses no debt. A firm will have
little business risk if the demand for its products is stable, if the prices of its inputs and
products remain relatively constant, if it can adjust its prices freely, if costs increase, and if a
high percentage of its costs are variable and hence will decrease if sales decrease. Other
things the same, the lower a firm’s business risk, the higher its optimal debt ratio.
(b) Financial Risk
Financial risk is the additional risk placed on the common stockholders as a result of the
decision to finance with debt. Conceptually, stockholders face a certain amount of risk that is
inherent in a firm’s operations (business risk). If a firm uses debt (financial leverage), then,
61
the business risk is concentrated on the common stockholders.
Activity 4.1
1. Briefly describe some ways in which the capital structure decision can affect the
WACC and FCF.
2. Discuss the major benefit of debt financing.
3. Discuss how debt financing affects the firm’s cost of debt.
4. Define business risk and financial risk.
5. Explain how the two types of risk mentioned in question 4 above influence the firm’s
capital structure decisions.
6. Briefly describe the agency problem that exists between owners and lenders.
7. Explain what happens to the cost of debt, the cost of equity and WACC when the
firm’s financial leverage increases from zero.
4.3 Traditional and Modern Theory of Capital Structure

Academics and practitioners have developed a number of theories of capital structure. The
following sections examine several of these theories.
Traditional theory assumes that an optimal capital structure does exist and depends on the
level of gearing. The company cannot maximise wealth unless the optimal weighted average
cost of capital (WACC) is achieved. Because debt has a lower after tax cost than equity, as it
is moderately increased, the WACC falls. The moderate increase in debt does not increase the
overall risk of the firm and therefore the firm does not have to offer a higher return to
shareholders to compensate for the increased risk. As debt capital is further increased, the
WACC will continue to fall up to a certain point. After this optimal level is reached, any
further increase in debt capital will increase the risk of the firm and shareholders will demand
a higher yield.
The modern theory of capital structure was put forward by Miller and Modigliani (1958,
1963) and it proposes that there is no optimal structure of capital because the advantages of
debt would be exactly counteracted by an increase in cost of equity, such that WACC will
always equal business risk.
Miller and Modigliani argued that the cost of capital is independent of the capital structure,
and hence the value of the firm is independent of the proportion of total debt to total
capitalisation. As debt finance increases, the initial effect would be to lower the weighted
average cost of capital, thus increasing the value of the firm. The model however argues that
increased gearing results in shareholders requiring an increased return to equate the increased
risk. The change in the required equity return will just offset any possible saving or loss on
the interest change. As gearing increases, the WACC will remain constant and so no optimal
level of capital gearing exists.
• The equilibrium factor in the MM theory is the arbitrage process. The arbitrage
process takes place where two firms of identical income and risk exist, and where one
of the firms has a temporary higher value due to the different debt/equity ratios of the
62
two firms. The investors would arbitrage so as to bring the values of the companies
into equality.
• If the firms have different values because the geared firm has a higher value, this is
mispricing and the geared firm will be overpriced.
• The mispricing is not expected to last long in perfect markets because there will be
arbitrage opportunities between the firms.
• The arbitrage process will result in the value of the two firms being equal as investors
sell their investment in overvalued firm and invest funds in the undervalued firm
• MM argue that the apparent increase in the value of a geared firm caused by cheaper
debt finance can be replicated by investors through home made gearing. Investors can
gear themselves in the same way as the firm by borrowing at the same terms and
achieving the same gearing ratio. This will result in the investors receiving the same
increased return.
4.4 Initial Assumptions of the Modigliani-Miller Model

The assumptions included the following:
• Business risk can be measured by earnings before interest and taxes (EBIT), and firms
with the same degree of business risk are said to be in a homogeneous risk class.
• Investors have homogeneous expectations about expected future corporate earnings

and the riskiness of those earnings. This assumption implies symmetric information,
where managers and all investors have the same set of information about a firm.
• Stocks and bonds are traded in perfect capital markets that is, there are no brokerage
costs and investors, both individuals and institutions, can borrow at the same rate as
corporations.
• The debt of firms and individuals is riskless so the interest rate on debt is the risk-free
rate.
• All cash flows are perpetuities, that is, the firm is a zero-growth firm with an
exceptionally constant EBIT, and its bonds are perpetuities.
4.4.1 Modigliani and Miller without (corporate or personal) taxes
Proposition 1
MM Proposition I concerns the irrelevancy of the value to capital structure. Notice that, in what
follows, financial instruments are assumed to take only two forms: stocks and bonds. In this set up,
the value of a firm is defined as:
V=B+S
where B is the market value of the firm's debt and S is the market value of the firm's equity.
63
Example 4.1
Suppose a firm has a $10 million debt and 5 million shares of stock. Assuming the stock sells
at a market price of $20, then:
V = 10 000 000 + (5 000 000 × 20) = $110 000 000
The value of the levered firm, VL, must be equal to the value of the unlevered firm, VU.
Suppose a firm earns $100 in perpetuity. It is all-equity with 100 shares of stock. If each sells
for $10, the value is:
VU = 100 × $10 = $1 000
Now assume the CEO suddenly decided the firm should issue $500 dollars of debt. The
equilibrium price of the stock will drop to $5 per share and so the value of the levered firm is:
VL = 500 + (100 × 5) = $1 000, the same as before.
Modigliani and Miller argue that the value of any firm is derived by capitalising its expected
net operating income (EBIT when tax is equal to zero) using the following formula:
EBIT EBIT
VL = VU = =
WACC KU
where V L = value of the levered or geared firm, VU = value of the unlevered firm, and K U =
cost of equity of the un-geared firm.
Since no taxes have been assumed, the operating income (EBIT) is equivalent to the net
EBIT
income which is all paid out as dividends. Thus, the value of the firm is equal to .
ka
4.4.2 Proposition 2
Since the value of the firm is equal to the sum of the value of the debt and equity,
V=D+E
then
k uV = k u ( D + E )
and
E D
k u = k eg ( ) + kd ( )
D+E D+E
Substituting the last equation into the preceding equation and solving for k s yields:
D
k eg = k u + (k u − k d )
E
where k eg is the cost of equity of the geared firm, k u is the cost of equity of the unlevered
64
firm, k d is the cost of debt, D is the value of debt, and E is the value of equity.
Thus, k eg must go up as debt is added to the capital structure.
Keg
%
WACC
Kd
Debt/Equity
Figure 4.1: Debt-Equity (Source: Gitman and Zutter, 2012)
To prove their point, Modigliani and Miller assumed two identical firms, an unlevered firm
(all equity) and a levered firm with $4 million of debt carrying an interest rate of 7.5%, both
firms generating an operating income (EBIT) of $900 000 annually. They adopted the
assumption that stockholders of both firms would have the same required rate of return of
10% which, as previously mentioned, was the standard assumption at the time (that the cost
of equity was constant regardless of capital structure).
Unlevered Firm Levered Firm

EBIT $ 900 000 $ 900 000
Less Interest 300 000
Income $ 900 000 $ 600 000
Since the required rate of return of shareholders is 10% in both cases, we have:
Unlevered Firm Levered Firm
Value of Equity $900,000 $600,000

= $9,000,000 = $6,000,000
0.10 0.10
Value of Debt $0 $4 000 000
Total value of the firm $9 000 000 $10 000 000
65
If this were true, then someone who owns 10% of the levered firm would have income of $60
000 (that is, $600 000 × 10%) and could sell it for $600 000 (that is, $6 million × 10%). With
this $600 000 the individual could borrow another $300 000 at 7.5% and buy 10% of the
unlevered firm for $900 000 (that is, $9 million × 10%). What would this individual's income
be now?
EBIT $90 000 ($900 000×10%)

Less interest $22 500 ($300 000×7.5%)
Income $67 500
Thus, the income would increase by buying the unlevered firm's stock and borrowing money
to finance the purchase. As other individuals see this opportunity, they also will sell the stock
of the levered firm (driving its price down) and buy the stock of the unlevered firm (using
some borrowed money) and thereby driving the value of the unlevered firm's stock up. As the
price of the unlevered firm is bid up, the value of the unlevered firm increases above $9
million while the selling of the levered firm's stock drives the equity value below $6 million
(which decreases the total firm value, including the $4 million debt, below $10 million) until
the two firms' values, in equilibrium, are equal and no opportunity to arbitrage the difference
exists. Consequently, if the total value of the two firms is equal, then the average cost of
capital must be equal. And if the average cost of capital is equal, then it must be true that the
cost of equity rises in such a manner as to exactly offset the increased use of cheaper debt
financing (and we end up with the previous graph showing this).
As a firm increases its use of debt, the risk to the stockholder increases and, as a consequence,
the stockholder's required rate of return will increase. Modigliani and Miller simply defined
how the stockholder's required rate of return should increase with increased financial
leverage. The lesson that is intended by this is that simply substituting one form of financing
for another cannot create value.
4.5 Modigliani and Miller with Corporate Taxes

4.5.1 Proposition 1
It was pointed out that corporate taxes have an impact on the valuation. Without going through
the mathematics, suffice it to say that the result was that the value of the firm increased with
increased leverage. Specifically,
VL = VU + t × D
EBIT (1 − T )
= +t×D
ku
The fact that the government is a "partner" in the business results in a subsidy when debt
financing is used and a deductible expense (unlike equity payments). When corporate taxes
were taken into account, the average cost of capital was found to decrease with increased
leverage. This implies that a firm should use as much debt as possible. Yet, we do not see
companies using 100% debt.
66
4.5.2 Proposition 2
The cost of equity of the geared firm is given by the following formula:
D
k eg = k u + (k u − k d )(1 − T )
E
As shown in Figure 4.1, the cost of equity will increase with gearing, and weighted average
cost of capital (WACC) will remain the same at whatever debt/equity ratio.
Example 4.2
You have collected the following information regarding ZZ Ltd:
Sales 23 400 000

Operating costs 15 000 000
EBIT 8 400 000
Interest 1 600 000
6 800 000
Tax 2 720 000
Net income 4 080 000
The corporate tax rate is 40%. The cost of equity of an equivalent un-geared firm in the same
risk class is 24%. Debt capital has a yield of 16%.
a) Determine the value of the firm according to MM Proposition 1.
b) Determine the cost of equity of the geared firm (ke) according to MM Proposition 2.
c) Determine the value of the firm according to MM with corporate taxes.
d) Determine the cost of equity of the firm according to MM Proposition 2 adjusted for
corporate taxes.
Solution
EBIT 8,400,000
a) Value of the firm = = = $35,000,000
WACC 0.24
D
b) k eg = k u + (k u − k d )
E
10,000,000
= 0.24 + (0.24 − 0.16) = 27.2%
25,000,000
1,600,000
NB: The value of debt = = 10,000,000
0.16
But the value of the firm = $10 000 000 + $25 000 000 = $35 000 000
a) The value of the firm = VL = VU + t × D
67
EBIT (1 − T )
= +t×D
ku
8,400,000 × 0.6 1,600,000 × 0.40

= +
0.24 0.16
= 21 000 000 + 4 000 000
= $25 000 000
D
b) k eg = k u + (k u − k d )(1 − T )
E
10,000,000
= 0.2 4 + (0.24 - 0.16)(1- 0.40) = 27.2%
15,000,000
4.6 Miller with Corporate and Personal Taxes
Miller included both corporate and personal taxes and concluded that there was no optimal
capital structure. Additional assumptions included were:
a. Investors had a tax rate of zero on equity because they can avoid dividends by selling
their shares cum dividend and buying them back ex-dividend.
b. At equilibrium, an investor's personal tax rate on debt must be equal to the corporate
tax rate. If this is not the case, either the firm will derive no benefit from issuing debt
due to a lack of a tax shield or investors will find no benefit from investing in debt
because they can invest in tax-free equity. Therefore the value of the levered firm ( VL )
with personal and corporate taxes is given by:
⎡ (1 − Tc )(1 − Te ) ⎤ EBIT (1 − Tc )(1 − Te )
VL = VU + ⎢1 − ⎥ D , where VU =
⎣ (1 − Td ) ⎦ kU
and Te = personal tax rate on equity investments, Td = personal tax rate on debt
investments.
Note that:
If Te = Td , (1 − Te ).and .(1 − Td ) would cancel out leaving only Tc , and the MM 1963
model is restored.
If (1 − Tc )(1 − Te ) = (1 − Td ), the entire term in brackets goes to zero, and the value of
using leverage becomes zero.
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Example 4.3
By referring to Example 4.2, find the value of the firm using Miller's valuation.
⎡ (1 − Tc )(1 − Te ) ⎤ EBIT (1 − Tc )(1 − Te )

VL = VU + ⎢1 − ⎥ D , where VU =
⎣ (1 − Td ) ⎦ kU
⎡ (1 − 0.40)(1 − 0.20) ⎤
= 16,800,000 + ⎢1 − ⎥10,000,000 = $19,942,857.14
⎣ (1 − 0.30) ⎦
8,400,000(1 − 0.40)(1 − 0.20)
Where, VU = = $16,800,000
0.24
4.7 Implications of the MM Theory

The market value of a levered firm equals the market value of an unlevered firm plus the
present value of interest tax shields. In order to get the simple expression above, we have
assumed that the debt is perpetual. More generally, the tax shield term would be the present
value of the interest tax shields.
The implication of the model with corporate taxes is that the value of the firm is maximised
when it is financed entirely by debt. This is not a very attractive implication for the model.
Clearly, no firm is financed 100% by debt. There are a number of real world constraints that
need to be considered. First, there are institutional and legal restrictions (some institutions
will not purchase stock of a firm that has a debt-equity ratio that exceeds some cut-off).
Second, there are costs imposed for going bankrupt that might persuade the firm's
management not to increase the debt-equity ratio too high. Third, the interest tax shield may
exhaust taxable income (this suggests an upper bound on the amount of debt). Finally, there
may be conflicts of interest between stockholders and bondholders. Therefore the actual
value of the firm is less than what is envisaged by the MM model hence the value is given
by:
⎡ (1 − Tc )(1 − Te ) ⎤
VL = VU + ⎢1 − ⎥ D, (PV of financial distress costs + PV of agency-
⎣ (1 − Td ) ⎦
rated costs + and so on).
Each of these points suggests that the 100% debt policy may not be optimal for a firm. This
empirical evidence suggests that the 100% debt policy is clearly not what is observed. The
wide range of debt-equity ratios in the market could indicate that the original proposition
about the irrelevance of the capital structure may have more merit than we initially gave it.
69
Activity 4.2
1. MWZ Limited is currently in this situation:
EBIT = $4.7 million;
Tax rate = 40%;
Value of debt = $2 million;
rd = 10%;
rs = 15%;
Shares of stock outstanding, n = 600 000;
Stock price = $30.
The firm’s market is stable and it expects no growth, so all earnings are paid out as
dividends. The debt consists of perpetual bonds.
(a) Determine the total market value of the firm’s stock, and the firm’s total
market value.
(b) Compute the firm’s weighted average cost of capital.
(c) Suppose the firm can increase its debt so that its capital structure has 50%
debt, based on market values (it will issue debt and buy back stock). At this
level of debt, its cost of equity rises to 18.5% and its interest rate on all debt
will rise to 12% (it will have to call and refund the old debt).
i. Determine the WACC under this capital structure.
ii. Compute the total value of the firm.
iii. How much debt will it issue, and what is the stock price after the repurchase?
iv. How many shares will remain outstanding after the repurchase?
2. GMZ Limited has no debt outstanding, and its financial position is given by the
following data:
Assets (book = market) $3 000 000
EBIT $500 000
Cost of equity, 10%
Stock price, $15
Shares outstanding, 200 000
Tax rate, 40%
The firm is considering selling bonds and simultaneously repurchasing some of its
stock. If it moves to a capital structure with 30% debt based on market values, its
cost of equity, rs, will increase to 11% to reflect the increased risk. Bonds can be
sold at a cost, rd, of 7%. GMZ is a no-growth firm. Hence, all its earnings are paid
out as dividends. Earnings are expected to be constant over time.
a) Explain the effect of the use of leverage on the value of the firm.
b) Determine the price of GMZ’s stock.
c) Discuss what happens to the firm’s earnings per share after the recapitalisation.
70
4.8 Summary
In this unit, we examined the concept of corporate valuation and capital structure. A firm’s
optimal capital structure is the mix of debt and equity that maximises the stock price. At any
point in time, management has a specific target capital structure in mind, presumably the
optimal one, although this target may change over time. Several factors influence a firm’s
capital structure. The major ones include business risk and financial risk. Business risk is
the risk inherent in the firm’s operations if it uses no debt. A firm will have little business
risk if the demand for its products is stable, if the prices of its inputs and products remain
relatively constant, if it can adjust its prices freely if costs increase and if a high percentage
of its costs are variable and hence will decrease if sales decrease. Other things the same, the
lower a firm’s business risk, the higher its optimal debt ratio. Financial leverage is the
extent to which fixed-income securities (debt and preferred stock) are used in a firm’s
capital structure. Financial risk is the added risk borne by stockholders as a result of
financial leverage. Modigliani and Miller showed that if there are no taxes, then the value of
a levered firm is equal to the value of an otherwise identical but unlevered firm: VL = VU . If
there are only corporate taxes, Modigliani and Miller showed that a firm’s value increases
as it adds debt due to the interest rate deductibility of debt: VL = VU + TD . If there are
⎡ (1 − Tc )(1 − Ts ) ⎤
personal and corporate taxes, Miller showed that VL = VU + ⎢1 − ⎥D .
⎣ (1 − Td ) ⎦
71
References
Education, Inc.
Hall.
72
Unit 5
Dividend Policy and Theory
5.0 Introduction
In this unit, we will look at issues of dividends and dividend policy. Corporations have to
make a decision concerning the amount they pay out as dividend and the amount they retain
for reinvestment. Dividend information is also important in share valuations. This
information can give an indication of the performance of the company. Dividend decisions
are connected to the other two decisions, namely investment and financing decisions.
5.1 Objectives
• define the terms 'dividend' and payout policy
• state different types of dividends
• discuss the various theories on dividend payouts
• explain the implications of dividend payouts on share prices, investment and financing
decisions
• relate theoretical frameworks to real life situations
• outline the considerations to be looked at when making a dividend decision
5.2 Definitions
5.2.1 Payout policy

This refers to the decisions that firms make about whether to distribute cash to shareholders,
how much cash to distribute, and by what means the cash should be distributed.
5.2.2 Dividend
A dividend is a portion of net profits paid by a company to its shareholders. It is usually
presented as a dividend per share (DPS), that is, total dividend divided by number of shares
in issue. If a company declares $1 million in dividends when issued shares are one million,
the DPS will be $1.
5.2.3 Dividend cover

This refers to how many times the dividend is covered by earnings. In the above example,
assume the total earnings for the year stood at $3 million, then the dividend cover will be 3
times.
5.2.4 Dividend yield
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A dividend yield is calculated as DPS divided by the share price. This can give an indication
of the value of the share. The higher the yield is, then the higher the share value.
5.2.5 Dividend payout ratio

The dividend payout ratio refers to the amount of dividend as a proportion of net profit.
1
From the above example, dividend payout ratio is . It shows what proportion of earnings
3
will be retained, that is, reinvested in the company and not distributed to shareholders. In
harsh economic environments, many companies resort to passing dividends, that is, not
paying dividends. Some pass dividends if they have major capital expansion programmes.
5.2.6 Share repurchase

Dividends are not the only means by which firms can distribute cash to shareholders. Firms
can also conduct share repurchases, in which they typically buy back some of their
outstanding common stock through purchases in the open market.
5.3 Dividend Payment Procedures

The decision to pay a dividend rests in the board of directors. The company usually
announces the dividend in the press when it presents its corporate results. The board meets
and passes a resolution to pay the dividend. If the declaration date is not indicated, we can take
the date when the results were signed as the declaration date. An example of dividend
announcement is shown below:
On the 30th of May 2012, the board resolved to declare a final dividend number 45 of 60
cents. The dividend will be payable to shareholders registered in the company's books by 8
June 2012. Dividend warrants will be posted on or about 27 July 2012.
Several dates need to be noted when a company announces a dividend.
5.3.1 Declaration date
This is the date when the board declares a dividend. In the case above, 30 May 2012 is the
declaration date.
5.3.2 Record date

This is the last date by which one needs to be registered in the company's books in order to
participate in the dividend. In our example above, 8 June 2012 is the record date.
5.3.3 Ex-dividend date

The record date above is 8 June but because of the settlement process, brokerage firms
require at least four days before the record date for someone to be entitled to the dividend. In
the above example, the ex- dividend date will be 4 June. Anyone buying the dividend on or
after 4 June will lose the 60 cents dividend. Thus, an individual buying the share before that
date will be entitled to the dividend while another buying after that date will not be entitled to
the dividend. Before this date, the share will be trading cum-dividend.
5.3.4 Payment date

This is the actual date on which the company mails the dividend payment to the shareholders
registered by the record date.
74
5.4 Share Repurchase Procedures
Share repurchase is another way firms can distribute cash to shareholders. Two methods
usually employed by firms in share repurchase are open-market share repurchase and tender
offer repurchase. In an open-market share repurchase, firms simply buy back some of their
outstanding shares on the open market. This method gives firms great flexibility regarding
when and how they execute these open-market purchases. Some firms make purchases in
fixed amounts at regular intervals, while other firms try to behave more opportunistically,
buying back more shares when they think the share price is relatively low and fewer shares
when the price is high. In a tender offer, a firm announces the price it is willing to pay to buy
back shares and the quantity of shares it wishes to repurchase. The tender offer price is
usually set at a significant premium above the current market price. Shareholders who want to
participate let the firm know how many shares they would like to sell back to the firm at the
stated price. If shareholders do not offer to sell back as many shares as the firm wants to
repurchase, the firm may either cancel or extend the offer. If the offer is oversubscribed,
meaning that shareholders want to sell more shares than the firms wants to repurchase, then
the firm typically repurchases shares on a pro rata basis.
5.5 Forms of Dividend

Dividends come in various forms and these are discussed below:
5.5.1 Cash dividend
The most common form of dividend is cash. Shareholders receive a dividend in the form of
cash, for example, 60 cents per share.
5.5.2 Scrip dividend
Shareholders receive their dividend in the form of the company's shares. If a company pays
dividend in the form of shares, the shares are usually offered at a discount. If a company
declares a DPS of 60 cents and a shareholder has 1 000 shares, this entitles the shareholder to
$600, disregarding tax. If the company's share is trading at 250 cents, the company can offer
the shares at 200 cents as opposed to paying out cash. In this case, the investor will be entitled
to 300 shares. A combination of cash and scrip is also possible. Barclays Bank, in 1999
offered a combination of cash and scrip.
5.5.3 Dividend in specie
This is similar to scrip dividend since shareholders receive shares. When TA listed Zimnat
on the ZSE, TA shareholders were offered a dividend in specie of 567 Zimnat shares for
every 1 000 TA shares held as at 27 April 2001.
5.5.4 Bonus issue
When reserves accumulate, a company may decide to issue free shares to its shareholders.
This can be regarded as a form of dividend not paid in cash.
5.5.5 Dividend in kind
This is not a common form of dividend in Zimbabwe. A company can decide to give
shareholders some of its products as a dividend instead of shares or cash. A company
producing wines can decide to give shareholders cases of wine as a dividend. This can be
75
done when a company intends to conserve cash.
Activity 5.1
1. Below is an extract from a company’s annual report.
December 2011 2012
$000 $000
Profit before tax 279 528 266 981
Taxation 96 347 97 293
Attributable earnings 181 393 169 688
Retained profits 120 803 109 098
No. of shares in issue 336 613 179 336 613 179
Share price (cents) 150 200
From the above information:

calculate the total annual dividend for the two years;
calculate the dividends per share (DPS);
calculate the dividend yield;
calculate the payout ratio; and
calculate the dividend cover.
2. Suppose the company had capital expenditures amounting to $150 million in each of
the two years. In your view, is the dividend policy the right one in this situation?
Why?
3. Discuss the ways that firms can use to distribute cash to shareholders.
4. Explain why do rapidly growing firms generally pay no dividends?
5. The dividend payout ratio equals dividends paid, divided by earnings. How would you
expect this ratio to behave during an economic boom and during a recession?
5.6 Dividend Policy Theories

Several theories have been put forward to explain dividend policies. Companies with the
same earnings can declare different dividend amounts depending on their different policies.
The question facing management is whether the dividend is an active variable or a passive
residual. Does the dividend decision have any effect on the value of the company?
5.6.1 Residual Theory Dividends
This approach contends that dividends are a passive parameter and do not matter in decision-
making. They are 'what is left over after decisions regarding investment and financing have
been made'. This means that dividends can only be paid after the company has invested in all
projects that offer a return greater or equal to their required rate of return. In this approach,
the firm treats the dividend decision in three steps:
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Step 1: The firm will have to determine its optimal level of capital expenditures, which
would be the level that exploits all of the firm’s positive NPV projects.
Step 2: Using the optimal capital structure proportions, the firm should estimate the total
amount of equity financing needed to support the expenditures generated in Step 1.
Step 3: Because the cost of retained earnings, rr, is less than the cost of new common stock,
rn, the firm should use retained earnings to meet the equity requirement determined in Step 2.
If retained earnings are inadequate to meet this need, sell new common stock. If the available
retained earnings are in excess of this need, distribute the surplus amount—the residual—as
dividends.
According to this approach, as long as the firm’s equity need exceeds the amount of retained
earnings, no cash dividend is paid. The argument for this approach is that it is sound
management to be certain that the company has the money it needs to compete effectively.
This view of dividends suggests that the required return of investors, rs, is not influenced by
the firm’s dividend policy—a premise that in turn implies that dividend policy is irrelevant in
the sense that it does not affect firm value.
5.6.2 The Dividend Irrelevance Theory

Modigliani and Miller, in 1961, argued that dividends were irrelevant, thereby supporting the
residual dividend theory. They argued that dividends do not affect the wealth of shareholders
and as such they do not matter to shareholders. They further argued that the firm’s value is
determined solely by the earning power and risk of its assets (investments) and that the
manner in which it splits its earnings stream between dividends and internally retained (and
reinvested) funds does not affect this value. They put forward the following assumptions:
• perfect markets
• no floatation costs
• a given investment policy
• perfect certainty (they dropped this assumption latter)
5.6.3 Dividend Relevance Theory

Myron Gordon and John Lintner (1963) argue that dividends are important. They argue that
investors prefer current dividends and there is a direct relationship between dividend policy
and share value. Investors are risk averse and they attach less risk to current dividend than to
future dividend or capital growth. This is known as the bird-in-hand argument (“A bird in the
hand is worth two in the bush.” The argument is that investors would prefer current dividend
as they can then reinvest the money in the market. Since future growth is uncertain, investors
would rather receive a certain dividend now rather than a future uncertain cash flow.
Companies paying higher dividends will be discounted at a lower rate thereby enhancing their
value. As such, it is argued that the higher the dividends, the higher the firm's value.
Conversely, if dividends are reduced, uncertainty increases, raising the required return and
lowering the share value.
Empirical studies fail to provide conclusive evidence in support of dividend relevance theory.
In practice, finance managers and shareholders tend to be of the view that dividend policy
affects the value of a share.
77
5.6.4 Tax-based Theories
If the dividend tax is lower than capital gains tax then the argument would be that the firm
should pay all of its income as a dividend as this reduces the tax, paid by shareholders on
their income.
5.6.5 Signal Hypothesis

Studies have shown that large changes in dividends do affect share price. Increases in
dividends result in increased share price, and decreases in dividends result in decreased share
price. One interpretation of this evidence is that it is not the dividends per se that matter but
rather the informational content of dividends with respect to future earnings. In other words,
investors view a change in dividends, up or down, as a signal that management expects future
earnings to change in the same direction. Investors view an increase in dividends as a positive
signal, and they bid up the share price. They view a decrease in dividends as a negative signal
that causes investors to sell their shares, resulting in the share price decreasing.
5.6.6 Clientele Effect

Investors in equity can be placed into different clientele groups. The main clientele groups are
those investors who prefer dividends and those who prefer capital gains. Investors might
prefer dividends because they pay no tax or a lower tax on dividend income as compared to
capital gains. Some shareholders prefer dividends because they invest in equity to obtain a
regular income. Other investors prefer capital gains. This clientele group is made up of those
who pay no tax or a lower rate of tax on capital gains income. In addition, those investors
who invest in equity as long term investment will prefer capital gains as opposed to
dividends.
5.6.7 Agency Cost Theory

Agency costs are costs that arise due to the separation between the firm’s owners and its
managers. Managers sometimes have different interests than owners. Managers may want to
retain earnings simply to increase the size of the firm’s asset base. There is greater prestige
and perhaps higher compensation associated with running a larger firm. Shareholders are
aware of the temptations that managers face, and they worry that retained earnings may not
be invested wisely. The agency cost theory says that a firm that commits to paying dividends
is reassuring shareholders that managers will not waste their money. Given this reassurance,
investors will pay higher prices for firms that promise regular dividend payments (Gitman
and Zutter, 2012).
Activity 5.2
1. Contrast the basic arguments about dividend policy advanced by Miller and
Modigliani (M and M) and by Gordon and Lintner, and give your views on what
happens in practice.
2. Does following the residual theory of dividends lead to a stable dividend? Is this
approach consistent with dividend relevance?
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5.7 Factors Affecting Dividend Policy
A dividend policy represents a plan of action to be followed by a firm whenever it makes a
dividend decision. Firms develop policies consistent with their goals. There are several
factors that firms consider in establishing a dividend policy and these are discussed below:
5.7.1 Legal requirements
Common law rules determine the amount that can be distributed as dividends. The rules are:
• dividends may not be paid from share capital
• book value must exceed liabilities
• dividends may be paid from profits without providing for depreciation
• losses and depreciation in working capital must be considered
• losses in previous years may be disregarded
• realised profits from the sale of fixed assets may be distributed
• unrealised profits on sale of assets may be available in certain circumstances
These capital impairment restrictions are generally established to provide a sufficient equity
base to protect creditors’ claims.
5.7.2 The information content of dividends

Investors use the dividend information to judge the performance of the company. When a
company announces a high dividend, this will be viewed by investors as indicating that
management is confident about the company's future earnings. If the dividend is cut, that could be a
signal of bad things to come. Therefore, investors use dividend information to forecast on future
earnings.
5.7.3 Contractual obligations

Often the firm’s ability to pay cash dividends is constrained by restrictive provisions in a loan
agreement. Generally, these constraints prohibit the payment of cash dividends until the firm
achieves a certain level of earnings, or they may limit dividends to a certain dollar amount or
percentage of earnings. Constraints on dividends help to protect creditors from losses due to
the firm’s insolvency.
5.7.4 Internal constraints
A firm's ability to pay dividends may be influenced by the availability of cash. Some
companies are profitable, but they lack cash due to the accrual concept.
5.7.5 The nature of shareholders

Shareholders are attracted to companies that satisfy their needs with regards to cash income
and capital growth. This is the clientele effect. The nature of the company's shareholders
should influence the dividend policy. Investors who are in need of cash require high dividend
payout while those in high tax brackets may prefer capital gains. The policy must maximise
shareholder's wealth.
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5.7.6 Market considerations
One of the more recent theories proposed to explain firms’ payout decisions, is called the
catering theory. According to the catering theory, investors’ demands for dividends fluctuate
over time. For example, during an economic boom accompanied by a rising stock market,
investors may be more attracted to stocks that offer prospects of large capital gains. When the
economy is in recession and the stock market is falling, investors may prefer the security of a
dividend. The catering theory suggests that firms are more likely to initiate dividend
payments or to increase existing payouts when investors exhibit a strong preference for
dividends. Firms cater to the preferences of investors.
5.7.7 Owners' investment opportunity

The company should not retain funds to invest in projects yielding lower returns than the
owners could obtain from external investments of equal risk. If external investments offer a
higher return, then a higher dividend must be paid.
5.7.8 Growth prospects

A firm’s financial requirements are directly related to how much it expects to grow and what
assets it will need to acquire. It must evaluate its profitability and risk to develop insight into
its ability to raise capital externally. In addition, the firm must determine the cost and speed
with which it can obtain financing. Generally, a large, mature firm has adequate access to
new capital, whereas a rapidly growing firm may not have sufficient funds available to
support its acceptable projects. A growth firm is likely to have to depend heavily on internal
financing through retained earnings, so it is likely to pay out only a very small percentage of
its earnings as dividends. A more established firm is in a better position to pay out a large
proportion of its earnings, particularly if it has ready sources of financing (Gitman and Zutter,
2012).
5.8 Types of Dividend Policies

A firm’s dividend policy must be formulated with two basic objectives in mind: providing for
sufficient financing and maximising the wealth of the shareholders. Three different dividend
policies are described in the following sections. A particular firm’s cash dividend policy may
incorporate elements of each.
5.8.1 Constant payout-ratio dividend policy

A constant portion of earnings is paid out as dividends. A company might decide to
constantly pay out 30% of earnings regardless of the level of earnings. This can be given as a
fixed dividend cover. Shareholders can easily calculate how much they will get in dividends
since the payout is constant. The problem with this policy is that if the firm’s earnings drop or
if a loss occurs in a given period, the dividends may be low or even not declared at all.
Because dividends are often considered an indicator of the firm’s future condition and status,
the firm’s stock price may be adversely affected.
5.8.2 Regular dividend policy

This allows the company to pay fixed dollar amounts each period. For example, a company
pays 40 cents per share each year. The dividend can only be increased after an increase in
earnings is viewed as sustainable. Under this policy, dividends are almost never decreased.
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5.8.3 Low-regular-and-extra dividend policy
Some firms establish a low-regular-and-extra dividend policy, paying a low regular dividend,
supplemented by an additional (“extra”) dividend when earnings are higher than normal in a
given period. By calling the additional dividend an extra dividend, the firm avoids setting
expectations that the dividend increase will be permanent. This policy is especially common
among companies that experience cyclical shifts in earnings. By establishing a low regular
dividend that is paid each period, the firm gives investors the stable income necessary to build
confidence in the firm, and the extra dividend permits them to share in the earnings from an
especially good period. Firms using this policy must raise the level of the regular dividend
once proven increases in earnings have been achieved. The extra dividend should not be a
regular event; otherwise, it becomes meaningless. The use of a target dividend payout ratio in
establishing the regular dividend level is advisable (Gitman and Zutter, 2012).
Activity 5.3
1. Describe a constant-payout-ratio dividend policy, a regular dividend policy, and a low-
regular-and-extra dividend policy.
1. Discuss the key factors involved in establishing a dividend policy.
2. Evaluate the three basic types of dividend policies.
3. MYZ Limited has earnings available for common stockholders of $2 million and has 500
000 shares of common stock outstanding at $60 per share. The firm is currently
contemplating the payment of $2 per share in cash dividends.
(a) Calculate the firm’s current earnings per share (EPS) and price/earnings (P/E) ratio.
(b) If the firm can repurchase stock at $62 per share, how many shares can be purchased in
lieu of making the proposed cash dividend payment?
(c) How much will the EPS be after the proposed repurchase? Why?
(d) If the stock sells at the old P/E ratio, what will the market price be after repurchase?
(e) Compare and contrast the earnings per share before and after the proposed repurchase.
(f) Compare and contrast the stockholders’ position under the dividend and repurchase
alternatives.
5.9 Summary
Payout policy refers to the cash flows that a firm distributes to its common stockholders. A
share of common stock gives its owner the right to receive all future dividends. The present
value of all those future dividends expected over a firm’s assumed infinite life determines the
firm’s stock value. Corporate payouts not only represent cash flows to shareholders but also
contain useful information about the firm’s current and future performance. Such information
affects the shareholders’ perception of the firm’s risk. A firm can also pay stock dividends,
initiate stock splits, or repurchase stock. All of these dividend-related actions can affect the
firm’s risk, return, and value as a result of their cash flows and informational content.
Although the theory of relevance of dividends is still evolving, the behaviour of most firms
81
and stockholders suggests that dividend policy affects share prices. Therefore financial
managers try to develop and implement dividend policy that is consistent with the firm’s goal
of maximising stock price.
82
References
Education, Inc.
Hall.
83
BLANK PAGE
Unit 6
Working Capital Management
6.0 Introduction
The concept of working capital management originated with the Old Yankee peddler, who
would borrow to buy inventory, sell the inventory to pay off the bank loan and then repeat the
cycle. The general concept been applied to more complex businesses and the cash flow cycle
concept is used for analysing the effectiveness of a firm's working capital management. It
should be noted on the onset that the faster a business expands, the more cash it will need for
working capital and investment. Good management of working capital will generate cash that
will help improve profits and reduce risks. Bear in mind that the cost of providing credit to
customers and holding stocks can represent a substantial proportion of a firm's total profits.
6.1 Objectives
• define working capital management
• differentiate working capital from net working capital
• explain the importance of cash operating cycle to the firm
• compute the cash operating cycle
• develop a banking policy for the firm
• apply the Baumol model and the Miller Orr cash management models
• formulate credit policy using credit standards, credit terms, collection and control
concepts
• manage the working capital of the firm in order to maximise the value of the firm
6.2 Importance of Working Capital Management across Disciplines

Accounting personnel analyse credit terms from suppliers and decide whether to take or give
up cash. Management will decide whether to aggressively or conservatively finance the firm's
funds requirements. The information systems analyst designs financial information systems
that will help enhance the effectiveness of short-term financial management. The marketing
department is concerned because sales will be affected by the availability of credit to debtors,
which depends on the firm's short-term financing. The operations section is also concerned because
inventory levels will be affected by management's financing decisions.
6.3 Definition of Terms

The following are definitions of terms:
6.3.1 Short-term financial management
This is the management of current liabilities and current assets.
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6.3.2 Working capital
This is referred to as current assets, which represent the portion of investment that circulates
from one firm to another in the day-to-day running of the business.
6.3.3 Net working capital
It is the difference between the firm's current assets and its current liabilities.
6.3.4 Technically insolvent
It is a term that describes a firm that is unable to pay its bills as they come due.
6.3.5 Risk of technical insolvency
It is the probability that a firm will be unable to pay its bills as they fall due.
6.3.6 Factoring accounts receivables
It involves their outright sale at a discount to a factor or other financial institutions to obtain
funds.
6.3.7 Floating inventory lien
It is the lender's claim on the borrower's general inventory as collateral for a secured loan
6.4 Financing Needs of an Enterprise

An enterprise's financing needs can be divided into permanent and seasonal needs. The
permanent needs consist of the fixed assets plus the permanent portion of the current assets;
these remain unchanged throughout the current year. The seasonal needs consist of the
temporary current assets that fluctuate during the year.
6.4.1 Aggressive financing strategy

With an aggressive financing strategy, the enterprise finances its seasonal needs and possibly
some of its permanent requirements with short-term financing and permanent needs for funds
with long-term financing. With an aggressive strategy, the short-term financing period is
planned to meet the period of seasonal needs exactly. Thus, the financing period matches the
period for which seasonal funds are needed. The cost of this strategy will become more
meaningful when it is compared with the cost of the conservative financing strategy.
6.4.2 Risk considerations in the aggressive financing strategy

The aggressive financing strategy uses the minimum net operating capital because only the
permanent portion of the need for funds is financed with long-term funds. This means that the
enterprise must rely heavily on its short-term source of funds in order to cope with the
seasonal funding. If a problem were to arise in the functioning of the operating cycle, the
enterprise might experience cash flow problems because the supply of short-term funds
would be limited (for example, bank overdraft) and long-term funds take time to organise.
85
6.4.3 Conservative financing strategy
With a conservative financing strategy, the enterprise finances all its needs for funds with
long-term financing, and only uses the short-term financing for emergencies and unexpected
cash outflow. It is difficult to imagine how this method will work since it is almost
impossible to avoid spontaneous short- term credit completely.
6.4.4 Risk factor in the conservative financing strategy

Because all the funds are financed in the long-term, and the enterprise is not expected to use
any of its short-term financing sources, there is much less risk of technical bankruptcy than in
the case of aggressive financing strategy. This is a position where there is no money to settle
debts, but where the total assets still exceed the total liabilities.
6.4.5 Aggressive strategy versus conservative strategy

Unlike the aggressive strategy, interest must be paid on unused funds in the case of the
conservative strategy. The lower cost of the aggressive strategy thus makes it a more
profitable strategy, but it also carries a higher risk. Therefore, for an acceptable strategy, most
enterprises will opt for a medium strategy.
6.5 Cash Management Model

Cash in the firm is analogous to the blood of the human body. Blood gives life and strength to
the human body, and cash imparts life and strength (profits and solvency) to the corporation.
Planning and controlling cash is of utmost importance to the viability of the firm's operations.
Hence an adequate cash balance at all times should be maintained to ensure that the flow of
funds is neither stopped nor slowed down. Cash management includes the formulation and
promulgation of cash policies and procedures and the control of cash.
Control of cash in a firm is imperative since there is a moral, legal, and economic obligation
on the part of management to meet its commitments.
6.5.1 Rationale for holding cash
(a) Transaction motive
A firm will hold cash in order to meet day-to-day transactions.
(b) Precautionary motive
A firm will hold cash in order to meet unforeseen contingencies.
(c) Speculative motive
Cash is used for investment purposes.
(d) Bank requirements
A positive cash balance is required by banks in order to ensure that a firm be able to
meet its future obligations such as a loan repayment.
(e) Future obligations
Dividend payment and debt will be met in the future
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Other factors which affect the cash resources held by a firm include, the size of the firm,
industry in which the firm operates, the seasonality of the firm's business, the overdraft
facilities that are available to the firm, the status of the firm's debtors, and the status of the
inventory.
6.5.2 Sources of cash
Sources of additional working capital include the following:
• existing cash reserves
• profits (when you secure it as cash)
• creditors (credit from suppliers)
• new equity or loans from shareholders
• bank overdrafts or lines of credit
• long-term loans
If you have insufficient working capital and try to increase sales, you easily over-stretch the
financial resources of the business. This is called overtrading. Early warning signs include:
• pressure on existing cash
• exceptional cash generating activities, for example, offering high discounts for early
cash payment
• bank overdraft exceeds authorised limit
• seeking greater overdrafts or lines of credit
• part-paying suppliers or other creditors
• paying bills in cash to secure additional supplies
• management pre-occupation with surviving rather than managing
6.5.3 Cash operating cycle (COC)

There are two elements in the business cycle that absorb cash: inventory (stocks and work-in-
progress) and receivables (debtors owing you money). The main sources of cash are payables
(your creditors) and equity and loans. Each component of working capital (namely inventory,
debtors and creditors) has two dimensions, that is, time and money. When it comes to
managing working capital, time is money. If you can get money to move faster around the
cycle (for example, collect money due from debtors more quickly) or reduce the amount of
money tied up (for example, reduce inventory levels relative to sales), the business will
generate more cash or it will need to borrow less money to fund working capital. As a
consequence, you could reduce the cost of bank interest or you will have additional free
money available to support additional sales growth or investment. Similarly, if you can
negotiate improved terms with suppliers, for example, get longer credit or an increased credit
limit, you effectively create free finance to help fund future sales.
Table 6.1: Cash Operating Cycle
• Collect receivables (debtors) faster You release cash from the cycle
• Collect receivables (debtors) slower Your receivables soak up cash
• Get better credit (in terms of duration or amount) from suppliers You increase your cash resources
• Shift inventory (stocks) faster You free up cash
• Move inventory (stocks) slower You consume more cash
Cash operating cycle is important because it represents the time that the cash is tied up in the
operations of the firm, that is, the period from when the firm pays cash for raw materials, to
when cash is actually received. The cash operating cycle is shown below:
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Cash
Debtors
Raw materials
Finished goods
Work in progress
Figure 6.1: Cash Operating Cycle

In order to calculate the cycle there is a need to consider the conversion periods as follows:
• Raw material conversion time (RMCT) (turnover of raw material stock): is the
average period the day of purchase of raw materials to when they actually enter into
the production system.
• Creditor's conversion time (CCT) (average credit period): is the period from
purchase of raw materials on credit to when the firm actually makes cash payment.
• Work in progress conversion time (WIPCCT): is the average time it takes to

convert a unit of raw materials into a finished product.
• Finished goods conversion time (FGCCT): this is the average time that it takes to
sell goods that have come from the production process.
• Debtors conversion time (DCCT): is the average time that it takes to sell goods that
have come through the production process
Therefore the cash operating cycle (COC) is computed as follows:
COC = RMCT - CCT + WIPCCT + FGCCT + DCCT
The creditors conversion time is deducted in calculating the cash operating cycle because
during the period the firm has not yet paid cash for the raw materials. The conversion periods
are estimated using the following equations:
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Conversion Ratio
Raw material conversion period Value of raw materials in stock__

Raw materials consumed per day
Creditors conversion time Value of creditors_________

Purchase of raw materials per day
WIP conversion time Value of WIP in stock________

Cost of goods manufactured per day
Finished goods conversion time Value of finished goods in stock

Cost of goods sold per day
Debtors conversion time Value of debtors__

Value of sales per day
It should be noted that the shorter the COC the lower the opportunity cost of tying funds in
business operations.
Activity 6.1
From the following information, calculate the cash operating cycle of the firm for the two
years:
31-12-2011 31-12-2012
$ $
Sales 4 000 000 5 000 000
Purchases of raw materials 1 200 000 2 000 000
Raw materials consumed 1 000 000 1 500 000
Cost of goods manufactured 2 000 000 3 000 000
Cost of sales 1 900 000 2 900 000
Debtors 600 000 900 000

Creditors 200 000 400 000
Stock:
Raw material 100 000 70 000
Work in progress 70 000 130 000
Finished goods 30 000 80 000
6.6 Banking Policy

Clear banking policy should be formulated by the firm, which includes:
• receipts and disbursements
• the criteria of selecting a bank
• determination of the optimal banking frequency
6.6.1 Management of cash receipts and disbursements

These include cash receipts and float management
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Cash receipts:
• address the issue of who opens the mail, receives cheques, and accepts cash payments
• how, where and by whom they are recorded
• banking procedure
Cash disbursement
• the origination of payments
• requisition procedures must be in place
• disbursement of cheques
• accounting for funds
• control on the bank account of the firm
Choice of bank
• Factors to consider include:
• credit facilities available
• international structure of the bank
• the service charge and structure
• consider the size of the bank in relation to that of the company
• issue of goodwill, that is, reputation of the bank.
Optimal banking frequency
Optimal banking frequency refers to the number of times that the firm should be involved in
banking transactions. The firm's strategy should be to minimise as much as possible the
banking frequency and on the other hand when cash is banked it either reduces an overdraft
interest or it either earns interest. Therefore the firm should come up with a policy, which
minimises banking costs and maximizes interest income.
6.6.2 Float management
When cheques are used to make payments, this results in a float period, which is the period
from when a cheque is posted to when the payee realises the cheques proceeds.
Total float = mail float + process float + clearing float
Float can be negative or positive
Negative float is when the firm receives a cheque and has to wait for the float period to have
the cheques proceeds realised. When a firm is making payment to suppliers, float is positive
because it takes time to have the firm's bank account debited.
Example 6.1
A firm based in Harare has sales valued at $30 000 000 in Mutare and we are given that the
current mail float is 4 days, process float is 2 days and clearing float is 21 days. If a firm uses
a sales office in Mutare to receive sale proceeds in the form of cheques, mail float will be 2
days, process float zero and a clearing float of 7 days will be experienced. For the sales office
to be situated in Mutare, it will cost $100 000. Sale proceeds received will be used to reduce
the company's overdraft that attracts an interest of 25%. Should the firm implement the
proposal?
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Solution
The current float = 4 + 2 + 21 =27 days
Float arising from the proposal = 2 + 0 + 7 = 9 days
Therefore reduction in float 27 -9 = 18 days
reduction.in. float
Hence, interest saved = × sales × int erest.on.overdraft
365
18 30,000,000 0.25
= × × = $369,863.01
365 1 1
Net benefit/savings = $369 863.01 – 100 000= $269 863.01. Since the net benefit is positive,
the firm should implement the proposal.
Activity 6.2
A firm based in Harare has sales valued at $20 000 000 in Bulawayo and we are given that
the current mail float is 3 days, process float is 1 day and clearing float is 21 days. If a firm
uses a sales office in Bulawayo to receive sale proceeds in the form of cheques, mail float
will be 1 day, process float zero and a clearing float of 7 days will be experienced. The sales
office to be situated in Bulawayo will cost $500 000. Sale proceeds received will be used to
reduce the company's overdraft that attracts an interest of 10%. Should the firm implement
the proposal? Give reasons.
6.7 Cash Management Models

We discuss the Baumol Model and the Miller Orr models.
6.7.1 The Baumol Model
The Baumol cash management model is a method used to determine a firm’s optimal cash
balance levels, assuming that cash disbursements are spread evenly over time, the opportunity
cost of holding cash is constant, and the firm pays a fixed transactions cost each time it
converts securities to cash. Another assumption of the model is that a firm can predict its
future cash requirements with certainty. The cash balances over time under the Baumol model
will follow a saw-tooth pattern as depicted in Figure 6.1 below.
When cash balances in the firm’s current account reach zero, the firms sells C dollars worth
of marketable securities and deposits the funds in its current account. Cash balances then
decrease uniformly to zero as the firm spends cash and the process repeats itself. Holding
cash balances has an opportunity that is equal to i(C/2) where i is the interest rate that
represents the opportunity cost of funds and C/2 is the average cash balance over time. The
firm also incurs a transaction cost when it sells marketable securities. If the firm needs to
deposit a total of T dollars in its current account each year and each deposit is for C dollars,
the total number of deposits will be T/C. If the firm incurs a fixed transaction cost of b dollars
per transaction, the annual transactions cost will be bT/C.
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Cash
Balance
Average
Cash
Balance
Deposits
Figure 6.2: Optimal Cash Balance: Baumol Model (Source: Gitman and Zutter, 2012)
Baumol: consider the trade-off between a fixed cost of raising cash by selling marketable
securities and the opportunity cost of holding cash.
F= the fixed cost of selling marketable securities to raise cash
T= the total amount of new cash needed
K= the opportunity cost of holding cash, that is, the interest rate
As we transfer $C each period we incur a trading cost of F each period. If we need T in total
T
over the planning period we will pay $F, T ÷ C times. The trading cost is × F
C
The objective of the Baumol model is to minimise opportunity costs as well as trading costs
as shown in the diagram.
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C T
Total cost= ×K + ×F
2 C
C
Opportunity costs ×K
2
T
Trading costs ×F
C
C* Size of cash balance
The optimal cash balance is found where the opportunity costs equal the trading costs.
C T 2T
× K = × F ≈ C* = ×F
2 C K
Figure 6.3: Baumol Model 2 (Source: Gitman and Zutter, 2012)
Example 6.2
A firm holds its monetary resources in the form of either cash or marketable resources and has
an average cash disbursement of $1 500 000 per year. The marketable securities carry an interest
rate of 25% and it costs the firm $20 to convert marketable securities into cash. What is the
optimal amount of marketable securities that the firm has to convert into cash on each sale of
marketable securities?
2 × 1,500,000 × 20
C* = = $15 491.93
0.25
The firm will have to sell marketable securities that are worth $15 491.93 whenever cash is
required. However, there are problems that are inherent in the use of the Baumol model. The
model makes assumptions that do not hold in real life and it should be noted that the use and the
receipt of cash is a random process. We cannot depict it through instantaneous replenishment
and gradual use of cash. Hence a stochastic model, that is, the Miller Orr model is needed
which is based on the assumption of random movement of cash.
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Activity 6.3
A firm holds its monetary resources in the form of either cash or marketable resources and
has an average cash disbursement of $2 800 000 per year. The marketable securities carry an
interest rate of 30% and it costs the firm $50 to convert marketable securities into cash. What is
the optimal amount of marketable securities that the firm has to convert into cash on each sale
of marketable securities?
6.7.2 The Miller Orr Model
The objectives of the Miller Orr model are to:
• determine the amount of money market securities the firm should purchase when the
upper limit of cash (H) is reached and the amount is calculated as follows:
The amount = Upper limit (H) - Return point (Z).
• derive the amount of money market securities, we should sell whenever the firm
reaches the lower limit of cash (L), we use:
The amount = Return point (Z) - lower limit (L).
The lower limit is usually given; hence there is a need for the computation of the return
point and the upper limit. The random movement of cash is shown in Figure 6.4 below.
Optimal Cash Balance: Miller-Orr Model
The company allows its cash balance to wander randomly between upper and lower
control limits. When the cash balance reaches the upper control limit H cash is invested
elsewhere to get us to the target cash balance Z.
H
When the cash
balance reaches the
lower control limit,
L, investments are
Z sold to raise cash to
get us up to the
L target cash balance
Figure 6.4: Optimal cash balance: Miller-Orr Model (Source: Gitman and Zutter, 2012)
The difference between the upper and the lower limits of cash is referred to as the spread
and is computed as follows:
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1
⎡3 ⎤3
⎢ 4 × Transaction.Cost × Daily.Variance.of .Cashflows ⎥
Spread = 3⎢ ⎥
⎢ Daily.Interest.Rate ⎥
⎢⎣ ⎥⎦
The spread is then used to derive the upper limit of cash and the return point as shown
below:
Maximum cash = Minimum cash + spread
spread
Return point = Lower limit + 3
Example 6.3
Assume we are given the following information:
Minimum cash balance = $20 000
Variance of daily cash flows = 30 000 000
Daily interest rate = 0.00035
Transaction costs = $25
How much marketable securities should the firm sell or buy when the need arises?
Solution
1
⎡3 ⎤3
⎢ 4 × 25 × 30,000,000 ⎥
Spread = 3 ⎢ ⎥ = $35,140.35
⎢ 0.00035 ⎥
⎣⎢ ⎦⎥
The upper limit = $20 000 + $35 140.35 = $55 140.35
35,140.35
And the return point = $20 000 + = $31,713.45
3
The above calculations imply that:
The value of money market securities the firm should acquire whenever it reaches the upper
cash limit is given by:
The amount = Upper limit (H) – Return point (Z)
= 55 140.35 – 31 713.45
= $23 426.90
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The value of money market securities the firm should dispose of whenever it reaches the
lower cash limit is given by:
The amount = Return point (Z) – Lower limit (L)
= 31 713.45 – 20 000
=$11 713.45
Activity 6.4
(1)Define the following terms:
• Annual cash disbursement
• Upper limit of cash
• Return point
• Lower limit of cash
• The spread
(2) Assume we are given the following information:
Minimum cash balance = 440,000
Variance of daily cash flows = 50,000,000
Daily interest rate = 0.00035
Transaction costs = $40
What is the value of marketable securities that the firm should sell or buy when the
need arises?
6.8 Planning and Controlling Debtors

Debtors constitute a major component of working capital, hence require the same type of
planning and control as cash. A firm's credit and collection policies, the organisation of credit
and collection function, credit policy formulation, collection policy formulation and control
of debtors have an impact on the maximisation of the firm's value. With this background, a
firm should come up with a credit policy, which requires decision to be made on the
following:
• credit standards
• credit terms
• collection and control
6.8.1 Credit standards

Whether the firm should offer credit or not is influenced by the following factors:
• the level of competition within the industry, if industry is highly competitive the firm
may decide to offer credit
• the tradition of the industry
• competitors
If the firm decides to offer credit, it must formulate credit standards. The aim of credit
standards must be to grant credit to customers who will pay on time, refuse credit to
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customers who will become bad debts, and only grant credit to slow paying customers if the
net return is positive. In order to analyse the credit worthiness of the customer, there is a need
to consider the 5Cs, which are given below:
a) Character: willingness to pay
b) Capacity: the ability to pay
c) Capital: financial reserves, or the net worth of the customer
d) Collateral: pledged assets
e) Conditions: relevant economic conditions
Sources of information
Listed below are some of the sources of information used for assessment of creditworthiness:
• The customer
• Internal sources
• Accounting information
• Bank reference
• Credit rating agencies
• Press reports
Approaches used in the analysis of credit information
(i) Judgment method

(ii) Ratio analysis
(iii)A scoring system
(iv) Statistical analysis can only be used where the firm can calculate probabilities of
payment and receipt of orders from clients.
Example 6.4
Assume that a company received an order for 400 000 from a customer. The customer
requested for 80 day's credit. The probability of the customer to pay the order is 75%. The
firm's variable cost ratio is 60% and the cost of short-term financing is 22%. Determine
whether the firm should accept the order given that this does not affect any of the other
current orders.
Solution
If the customer pays:

Contribution = 400 000 × 0.40 = $160 000
Variable = 400 000 × 0.60 = $240 000
But there are debtor carrying costs associated with the order which are computed as follows:
80
Debtor carrying costs = × 520,000 × 0.22 = $25,073.97
365
Therefore, the net benefit if we accept the order is:
160 000 – 25 073.97 = $134 926.03
If the customer does not pay:
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The firm will incur a loss equivalent to the variable costs for the order which is $240 000.
Therefore, the expected net benefit is:
Expected net benefit = (134 926.03 × 0.75) - (240 000 × 0.25)
Expected net benefit = $41 194.52
Since the expected net contribution is positive, the firm should accept the order.
6.8.2 Credit terms

Credit terms should be determined in the light of two important considerations, the needs of
the firm and the standard credit terms of the industry. The firm has current obligations to
meet, and it is essential that the flow of cash be synchronised with these needs. Credit terms
are made up of the credit period and cash discount.
Pricing and credit period

The pricing of goods must take into account the credit period offered by the firm.
Credit price charged = Cash + Credit Period × Cost of funds × Cash price
365
Pricing and cash discount
The firm should determine the amount of discount after careful analysis. The acceptability of
a discount term is based on the effective rate of offering cash discount computed as follows:
Effective rate of offering cash discount =
Discount % 365
×
100% − Discount % TotalCreditPeriod − DiscountPeriod
If the firm cannot achieve a higher rate of return on invested funds than the effective rate, then
the firm should not adopt the cash discount term.
6.8.3 Collection procedures

The collection procedures may be as follows:
• Send a reminder to the defaulting customer
• Make use of collection agency
• Take legal action
• Declare bad debt
Working capital requirements are significantly influenced by credit and collection policies.
When properly formulated and executed, credit and collection policies reduce the need for
working capital to sustain business operations. With well-designed credit terms, the flow of
cash from debtors is synchronised to liquidate current expenses without requiring additional
funds from short-term sources.
Good credit and collection policies aid in sales promotion. Credit policies serve as a guide to
determine the lowest category of customers from a risk standpoint for which profit on sales is
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equal to or exceeds the bad losses. Soundly conceived and executed, credit and collection
policies tend to reduce the cost of doing business. Credit and collection policies are necessary
for the maintenance of good customer relations, therefore for the firm's value to be enhanced,
the firm must develop and recommend broad credit and collection policies, supervise credit
and collection policies and procedures, direct research concerning all phases of credits and
collection.
The credit manager should supervise subordinates in performing the work of their respective
positions, plan and delegate to subordinates regular and special assignments and maintain
follow- ups to ensure proper performance of activities according to plan.
The credit manager should develop and recommend for approval by chief officer, policies
concerning regular and special credit terms, credit risks, cash discount terms, collections,
controls and credit reporting.
6.8.4 Control procedures

There must be a system of debtor control within a firm, to determine whether customers are
complying with the credit terms and whether there are any macro economic factors causing
customers not to comply with the credit terms.
Three approaches used are:
(a) ACP method
(b) Ageing method
(c) Payment pattern method
An effective collection policy serves as the guide in developing procedures for determining
delinquent accounts, developing collection correspondence dealing with suits for collection,
"adjustments" proceedings and liquidation proceedings. The success of any credit policy is
dependent upon the methods which are utilised to collect debtors. It is also important to note
that when poor credit policies are practiced, it is practically impossible to have effective
collection procedures.
Summary of practical ideas that may help the firm in collecting money from debtors:
• Develop appropriate procedures for handling late payments.
• Track and pursue late payers.
• Get external help if your own efforts fail.
• Do not feel guilty asking for money. It is yours and you are entitled to it.
• Make that call now and keep asking until you get some satisfaction.
• In difficult circumstances, take what you can now and agree terms for the remainder.
It lessens the problem.
• When asking for your money, be hard on the issue - but soft on the person. Do not
give the debtor any excuses for not paying.
• Make it your objective to get the money - not to score points or get even.
6.9 Inventory Management

Inventory investment constitutes a major chunk (40% to 60%) of a firm's current assets
holding. The importance of inventory is only next to that of debtors. Efficient inventory
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management is vital to get best mileage out of every dollar invested in working capital.
Inventories consist of:
• raw materials and components
• work in progress
• finished goods
• stores and spares
6.9.1 Basic functions of inventory

Inventory performs the following basic functions in an organisation:
• It decouples production and marketing, hence sales can be made from finished stock for
standard products. Adequate stocking also helps the company to meet peak season sales.
In case of fluctuating sales, inventory build up helps to meet sudden or unexpected
increase in demand.
• Production-inventory-sales are considered the three corner points of a triangle. Inventory

acts as a buffer between production and sales.
• Higher finished goods inventory ensures better level of customer service, hence the
marketing department insists on high finished goods inventory to avoid loss of sale
and gain of customer goodwill. This loss can be quantified as equivalent to profit lost
on sales and is termed stock out cost.
• Work in progress inventory permits efficient production scheduling and utilisation of

shop floor resources. The level of process inventory is a technical function of the
production process or production cycle.
• Raw material inventory provides flexibility in purchasing, and avoids hand-to-mouth

situations. It builds up sometimes due to the bulk purchasing done to avail quantity
discounts.
Spare-parts and tools-inventory is necessary to ensure against long spells of production hold
ups for lack of any important spare part or tool that cannot be procured immediately. Hence
these are called insurance spares.
We can summarise the advantages of inventories as:
• economies of production
• economies in purchasing
• quick delivery to customers
• flexibility
The disadvantages of inventory are:
• inventory investments: inventory represents the opportunity forgone to invest or
reinvest funds
• inventory related costs: when acquiring inventory, firms incur cost such as ordering
and carrying costs
The amount of materials that a firm holds depends on factors such as:
• frequency of use
• sources of supply
100
• lead time
• physical characteristics
• cost
• technical considerations
Inventory relevant cost
The inventory problem is one of balancing various costs so that total costs are minimised. The
relevant costs are:
a) ordering and acquisition cost
b) carrying costs
c) cost of under-stocking or stock-outs
Costs (a) and (b) help to optimise the number of orders and the quantity of inventory to be
ordered. These are real costs. Cost (c) helps to determine the service level that has to be maintained
by the inventory. This is considered as an opportunity cost.
Ordering acquisition cost
Cost of procurement of the items consists of stationery, follow-ups and communication
charges. Typically these costs include:
a) advertising
b) stationery, typing, dispatching of orders and reminders
c) travel, telephone, telegram costs for follow-ups
d) costs incurred by goods receiving bay, inspection and handling
e) rent and depreciation of space and equipment utilised by concerned purchasing personnel
f) salary and statutory payment for purchasing personnel
g) cost of source development
h) quantity discounts taken or lost
Carrying cost
Components of carrying costs are:
• Cost of capital on money invested. Inventory is largely financed by bank finance at a
cost (interest rate); if a company's internal funds are used, then the opportunity cost
criterion can be applied
• Cost of storage such as rent and depreciation of space (warehouses)
• Cost due to deterioration or spillage in storage, for example, volatile items such as petrol
are lost due to evaporation
• Salary and benefits to stores personnel
• Obsolescence cost due to scrapping of obsolete stock
• Insurance cost to protect against fire or related risks
Under-stocking costs
These are stock out costs, which arise due to non-stocking of inventory. Stock out cost is the
profit lost due to loss of production or sales and is usually measured in terms of opportunity
cost. In addition, other intangibles are also there. These include:
• loss of goodwill or impact on future sales
• loss of morale of work force
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Stock-out costs are used to measure or estimate safety stock levels.
Overstocking costs
This cost is the opportunity lost due to investment in inventory for longer periods than necessary.
For items that will be ultimately used, this cost can be equated to carrying cost. For items which
cannot be used after a certain period, this cost is the difference between the cost of the items
and their salvage value. To this amount the cost of ordering and carrying stock till it is salvaged
must be added.
6.9.2 Economic order quantity

The economic order quantity is a model that is used to determine the optimal order quantity that
will minimise ordering and carrying costs. The basic economic order quantity model is based
on the following assumptions:
• The annual demand for the stock item is known with certainty and is constant over the
period
• The lead-time that it takes to receive an order is known and is constant
• The cost of holding one unit of stock per period is constant
• There are no quantity discounts
• The receipt of inventory is instantaneous and arrives in one batch
• The only variable costs are ordering and carrying costs. These costs are constant per
purchase item
• There is no stock out or shortages.
The economic order quantity is determined using the formula:
2 × Annual × Ordering. cos t. per.order

Economic.order.quantity =
Carrying . cos t. per.unit. per. year
Example 6.5
Annual demand = 100 000 units
Ordering cost per order = $50
Average annual carrying cost = $10 per unit per year
Economic order quantity is given by:
2 × 100,000 × 50
EOQ= = 1 000 units
10
This means that the firm should order in batches of 1 000 units in order to minimize inventory cost.
The total ordering costs can be computed as follows:
Annual.inventory.demand Ordering. cos ts. per.order

Total ordering costs = ×
Number.of .units.in.each.order 1
102
Order.quantity Carrying . cos ts. per.unit. per. year
Total carrying costs = ×
2 1
Therefore:
Total inventory costs = Carrying costs + Ordering costs, which is the minimum inventory costs
given the EOQ assumptions.
Activity 6.5
Assume the following information is available:
Annual demand = 150 000 units
Ordering cost per order = $60
Average annual carrying cost = $12 per unit per year
Calculate the EOQ, total ordering costs, total carrying costs and total inventory costs.
6.9.3 Just-in-time (JIT) production

JIT is a management philosophy that strives to eliminate sources of manufacturing waste by
producing the right part in the right place at the right time. Waste results from any activity
that adds cost without adding value, such as moving and storing. JIT (also known as lean
production or stockless production) should improve profits and return on investment by:
• reducing inventory levels (increasing the inventory turnover rate)
• improving product quality
• reducing production and delivery lead times
• reducing other costs (such as those associated with machine setup and equipment
breakdown)
In a JIT system, underutilised (excess) capacity is used instead of buffer inventories to hedge
against problems that may arise. JIT applies primarily to repetitive manufacturing processes
in which the same products and components are produced over and over again. The general
idea is to establish flow processes (even when the facility uses a jobbing or batch process
layout) by linking work centres so that there is an even, balanced flow of materials
throughout the entire production process, similar to that found in an assembly line. To
accomplish this, an attempt is made to reach the goals of driving all queues toward zero and
achieving the ideal lot size of one unit.
6.10 Managing Creditors

Creditors are a vital part of effective cash management and should be managed carefully to
enhance the cash position.
Purchasing initiates cash outflows and an over-zealous purchasing function can create
liquidity problems. The firm should consider the following:
• Who authorises purchasing in your company - is it tightly managed or spread among a
number of people?
• Are purchase quantities geared to demand forecasts?
• Do you use order quantities, which take account of stock holding and purchasing
103
costs?
• Do you know the cost to the company of carrying stock?
• Do you have alternative sources of supply? If not, get quotations from major suppliers
and shop around for the best discounts, credit terms, and reduce dependence on a
single supplier.
• How many of your suppliers have a returns policy?
• Are you in a position to pass on cost increases quickly through price increases to your
customers?
• If a supplier of goods or services lets you down can you charge back the cost of the
delay?
• Can you arrange to have delivery of supplies staggered or on a just-in-time basis?
There is an old adage in business that if you can buy well then you can sell well. Management
of your creditors and suppliers is just as important as the management of your debtors. It is
important to look after your creditors - slow payment may create ill feeling and can signal
that your company is inefficient. Remember, a good supplier is someone who will work with
you to enhance the future viability and profitability of your company.
Activity 6.6
1. Discuss the role of the five C’s of credit in the credit selection activity.
2. Outline the basic trade-offs in a tightening of credit standards.
3. Why should a firm actively monitor the accounts receivable of its credit customers?
4. How are the average collection period and an aging schedule used for credit monitoring?
5. MNC Limited is trying to decide whether it should relax its credit standards. The firm
repairs 72 000 rugs per year at an average price of $32 each. Bad-debt expenses are 1%
of sales, the average collection period is 40 days, and the variable cost per unit is $28.
MNC expects that if it does relax its credit standards, the average collection period will
increase to 48 days and that bad debts will increase to 1½ % of sales. Sales will increase
by 4 000 repairs per year. If the firm has a required rate of return on equal-risk
investments of 14%, what recommendation would you give the firm? Use your analysis
to justify your answer. (Note: Use a 365-day year.)
6.11 Summary
In this unit we discussed that working capital management practices within organisations are
very critical to the success or failure of such organisations. The financing needs of firms are
usually classified into two major categories namely permanent and seasonal needs. Cash is
usually considered as the lifeblood of any organisation. As a result, good cash management
practices contribute immensely to the success or failure of many organisations. Two major
cash management models, namely, the Baumol Model and the Miller-Orr Model, have been
developed to assist firms in their cash management strategies. The Baumol model is derived
from the economic order quantity model and assumes that a firm can instantly replenish its
cash position and gradually use the available cash resources. The Miller-Orr model, on the
other hand, assists in the determination of the amount of money market securities that a firm
should purchase or sell in order to regulate its cash holdings. Working capital management
encompasses the management of both current assets and current liabilities. Working capital
management should be used to maximise shareholder's wealth and in the process avoid
liquidity risk by matching short-term liabilities with short-term assets.
104
References
Education, Inc.
Hall.
105
Unit 7
Short-Term Financing
7.0 Introduction
From the analysis of working capital in unit 6, it can be assumed that the firm has decided on
a proper proportion of short-term financing to other types of financing, that is, the maturity
composition of its debt. The firm should decide on issues concerning the types of short-term
financing that should be considered, including the composition of these sources of short
financing. In this unit, we examine critically alternative sources of short-term financing in
order to discover how they may be utilized to finance temporary seasonal and permanent
needs of a firm.
7.1 Objectives
• identify different sources of short-term financing
• examine critically each source of short-term financing giving advantages and
disadvantages in the process
• compare and contrast the different sources of short-term financing
7.2 Goals of Short-term Financing

A firm can finance its capital structure using short-term sources in order to achieve a number of
goals, which include flexibility. Therefore short term financing allows the firm to match its funds
against its requirements over an annual, seasonal or other cyclical period. Short-term financing
must be at the lowest possible cost in order to maximise shareholder's wealth. The firm embarks
on short-term financing in order to secure additional funds when it has reached its borrowing
capacity in relation to intermediate or long-term capital financing.
7.3 Short-term Financing Sources

A firm, which is stable and profitable, can borrow funds from short-term sources at
competitive interest rates, hence there is need to analyse the respective source in turn.
7.3.1 Short-term bank borrowing

Short-term capital needs should be financed as much as possible by short-term borrowing
from banks in the form of short-term loans or overdrafts. Bank borrowing is the most flexible
since when debt is no longer needed, it can be redeemed quickly, it is also comparatively
cheap because the risks to the lender are less hence the interest charges are lower on short-
term loans than on long-term loans. At this point it is worth noting that all loan interest is a
tax-deductible expense. In some cases short-term bank borrowing is secured to protect the
ordinary shareholder's interests of the bank by establishing a floating lien on the firm's current
assets. The cost of either the bank short-term loan or the overdraft may be computed as
follows:
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Cost of short term-borrowing = interest paid + establishment/arrangement fee when the
advance is negotiated.
7.3.2 Trade credit (Accounts payable)
Trade credit is one of the most important forms of short-term financing in an economy, which
is extended by one firm to another on the purchase and sale of goods and services. The use of
credit has risen in recent years because of the credit squeeze. Firms have been unable to
obtain short-term loans and overdrafts facilities from banks since some firms are failing to
redeem short-term loans advanced to them within the required duration. Trade credit should
be used if the supplier is offering no cash discounts but when a cash discount is offered, an
evaluation should be made to determine whether it is more beneficial to take the cash
discount or pay after the whole credit period.
Analysing credit terms
The credit terms that a firm is offered by its suppliers enable it to delay payments for its
purchases. Because the supplier’s cost of having its money tied up in merchandise after it is
sold is probably reflected in the purchase price, the purchaser is already indirectly paying for
this benefit. Sometimes a supplier will offer a cash discount for early payment. In that case,
the purchaser should carefully analyse credit terms to determine the best time to repay the
supplier. The purchaser must weigh the benefits of paying the supplier as late as possible
against the costs of passing up the discount for early payment.
Firms that sell on credit have a credit policy that includes their terms of credit. For example,
MYZ Limited sells on terms of 2/10, net 30. This means that the firm gives customers a 2%
discount if they pay within 10 days of the invoice date, but the full invoice amount is due and
payable within 30 days if the discount is not taken. The “true price” of the firm’s products is
the net price, or 0.98 times the list price, because any customer can purchase an item at that
price as long as payment is made within 10 days. If a buyer wants an additional credit period
beyond the 10-day discount period, the buyer will incur a finance charge of $2. Thus the list
price consists of two components:
List price = true price + finance charge
The question the buying firm must ask before it turns down the discount to obtain the
additional days of credit is this: Could credit be obtained at a lower cost from a bank or some
other lender?
Taking the cash discount

If a firm intends to take a cash discount, it should pay on the last day of the discount period.
There is no added benefit from paying earlier than that date.
Example 7.1
Lawrence Industries, operator of a small chain of video stores, purchased $1 000 worth of
merchandise on February 27 from a supplier extending terms of 2/10 net 30 EOM. If the firm
takes the cash discount, it must pay $980 [$1 000 – (0.02×1 000)] by March 10, thereby
saving $20.
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Giving up the cash discount
If the firm chooses to give up the cash discount, it should pay on the final day of the credit
period. There is an implicit cost associated with giving up a cash discount. The cost of giving
up a cash discount is the implied rate of interest paid to delay payment of an account payable
for an additional number of days. In other words, when a firm gives up a discount, it pays a
higher cost for the goods that it orders. The higher cost that the firm pays is like interest on a
loan, and the length of this loan is the number of additional days that the purchaser can delay
payment to the seller.
CD 365
Cost of giving up a cash discount = ×
100% − CD N
Where
CD = stated cash discount in percentage terms
N = number of days that payment can be delayed by giving up the cash discount
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Approximate cost of giving up cash discount = CD ×
N
Using the cost of giving up a cash discount in decision-making
The financial manager must determine whether it is advisable to take a cash discount. A primary
consideration influencing this decision is the cost of other short-term sources of funding. When a
firm can obtain financing from a bank or other institution at a lower cost than the implicit
interest rate offered by its suppliers, the firm is better off borrowing from the bank and taking the
discount offered by the supplier.
Activity 7.1
(1) Mason Products, a large building-supply company, has four possible suppliers, each
offering different credit terms. Otherwise, their products and services are identical.
The table below presents the credit terms offered by suppliers A, B, C, and D.
Supplier Credit Terms Approximate Cost of Giving Up a

Cash Discount
A 2/10 net 30 EOM ?
B 1/10 net 55 EOM ?
C 3/20 net 70 EOM ?
D 4/10 net 60 EOM ?
(a) Calculate the cost of giving up a cash discount from each supplier.
(b) If the firm needs short-term funds, which it can borrow from its bank at an interest
rate of 13%, and if each of the suppliers is viewed separately, which (if any) of the
suppliers’ cash discounts will the firm give up?
(2) The firm is considering credit terms of 2/10 net 60. Determine the rate of interest
implied by these terms. Comment on your answer.
(3) Compute the cost of trade credit if terms are 2/10 net 90. Comment on your answer.
(4) Considering a fixed credit period of 45 days and a discount period of 12 days compute
the cost of trade credit for discounts 2, 3, 4, 5 and 6 percent. Plot the forgone discount
rates versus the implied cost of trade credit in percentage.
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Example 7.2
A firm acquires goods valued at $2 400 000 annually at 3/10 net 30 and the annual rate of return
is 20%. Determine whether the firm should use trade credit financing or not.
Approach A
Cash discount benefit = discount % × annual purchase
= 3% × $2 400 000
= $72 000
Credit period benefit (CPB) is computed as follows:
Full.credit. period − discount. period annual. purchases opportunity. cos t.of . funds
CPB = × ×
365 1 1
30 − 10 $2,400,000 0.20
Therefore, CPB = × × = $26,301.37
365 1 1
The firm should take the cash discount and not the full credit period.
Approach B
With this approach an effective return (cost) is calculated which is the annualized return that
the firm receives from cash discount and is then compared with the annual rate of return as
follows:
Discount % 365
Effective rate = ×
100 − Discount % Full.credit. period − discount. period
3% 365
Hence, effective rate = × = 56.44%
100% − 3% 30 − 10
The effective rate is higher than the annual rate of 20% therefore the firm should take the
cash discount.
7.3.3 Accruals
Firms generally pay employees on a weekly, biweekly, or monthly basis, so the statement of
financial position will typically show some accrued wages. Similarly, the firm’s own
estimated income taxes, employment and income taxes withheld from employees, and sales
taxes collected are generally paid on a weekly, monthly, or quarterly basis. Therefore, the
statement of financial position will typically show some accrued taxes along with accrued
wages.
Accruals can be thought of as short-term, interest-free loans firms obtain from employees and
taxing authorities (accrued wages and tax payments). However, firms have no direct control
over these accruals, because the timing of wage payments is set by economic forces and
industry norms, while tax payments are established by law. Generally, firms use all the
accruals they can, but they have little control over the levels of these accounts.
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7.3.4 Factoring
Factoring is a process of raising funds on the security of the company's debts, so that cash is
received earlier than if the company waited for the debtors to pay. Factoring firms (factors)
provide their clients with services such as sales ledger accounting, credit insurance, the
collection of debts and the provision of finance. The client selects whichever services to use.
For example, a firm may hand over to a factoring firm, its sales ledger accounting and
collection of its debts, which would take the administrative responsibilities out of the
company's hands. In the process there will be saving of costs and problems which the client
firm cannot deal with. The two basic types of factoring are explained below:
(a) Confidential invoicing factoring
The procedure is that the factor sends a statement to the customer who acquired the goods
from the factor's client and the customer repays the factor. With confidential invoice
factoring, to be specific, the customer is not aware that the factor has intervened in the
transaction since no third party should be introduced. The client receives money in advance,
which is directly related to the copy invoices sent to the factor, and the client will still be
responsible for the collection of debt. When funds are advanced by the factor to the client
basing on copy invoices surrendered, the client becomes an agent for the factor in that the
agent sends the invoice to the customer, collects the debt and forwards the receipts, to the
extent of the advance, to the factor. Therefore the maximum to be advanced to the client
depends on its annual turnover and average collection period.
(b) Sales ledger factoring
With sales ledger factoring, the factor acquires all the client's invoiced debts and becomes
wholly responsible for credit control and collection of debts, and in the process takes on all
risks of possible default. Payments for the invoiced debts acquired are made to the client on a
calculated average settlement date, hence the client firm has an assured source of regular cash
inflows, which is instrumental in cash planning and budgeting. The client firm pays a
turnover commission in acknowledging the services provided by the factor firm, since the
client firm will save the administration costs (there is no need of administrative staff to
manage debts) and sound liquidity is realised through easier planning.
Advantages of short-term financing

1. A short-term loan can be obtained much faster than long-term credit. Lenders will
insist on a more thorough financial examination before extending long-term credit,
and the loan agreement will have to be spelled out in considerable detail because a lot
can happen during the life of a long-term loan. Therefore, if funds are needed in a
hurry, the firm should look to the short-term markets.
2. If a firm’s needs for funds are seasonal or cyclical, then a firm may not want to
commit itself to long-term debt. There are three reasons for this:
(a) Flotation costs are higher for long-term debt than for short-term credit.
(b) Although long-term debt can be repaid early (provided the loan agreement
includes a prepayment provision), prepayment penalties can be expensive.
Accordingly, if a firm thinks its need for funds will diminish in the near future, it
should choose short-term debt.
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(c) Long-term loan agreements always contain provisions, or covenants, that constrain
the firm’s future actions. Short-term credit agreements are generally less
restrictive.
3. Because the yield curve is normally upward sloping, interest rates are generally lower
on short-term debt. Thus, under normal conditions, interest costs at the time the funds
are obtained will be lower if the firm borrows on a short-term rather than a long-term
basis.
Disadvantages of short-term financing

Short-term debt is relatively riskier than long-term debt. Even though short-term rates are
often lower than long-term rates, using short-term credit is riskier for two reasons:
(a) If a firm borrows on a long-term basis then its interest costs will be relatively stable
over time, but if it uses short-term credit then its interest expense will fluctuate
widely, at times going quite high.
(b) If a firm borrows heavily on a short-term basis, a temporary recession may render it
unable to repay this debt. If the borrower is in a weak financial position then the
lender may not extend the loan, which could force the firm into bankruptcy.
Activity 7.2
1. Assume that short-term rates are almost always lower than long-term rates. Would
you finance your firm entirely with short-term funds? Give reasons.
2. Explain the purpose of using short-term financing as a bridge in periods of high
interest rates.
3. If a firm has seasonal financing requirements, why does it not merely secure enough
long-term financing to its total needs?
4. For short-term financing, would you expect the interest rate to be higher or lower for
secured financing in comparison to unsecured financing? Explain.
5. How should the rate of interest on short-term secured loan vary with the kind of goods
offered as collateral, that is, would the liquidity of the security matter?
7.4 Summary
Current liabilities represent an important and generally inexpensive source of financing for a
firm. The level of short-term (current liabilities) financing employed by a firm affects its
profitability and risk. Accounts payable and accruals are spontaneous liabilities that should be
carefully managed because they represent free financing. Notes payable, which represent
negotiated short-term financing, should be obtained at the lowest cost under the best possible
terms. Large, well-known firms can obtain unsecured short-term financing through the sale of
commercial paper. On a secured basis, the firm can obtain loans from banks or commercial
finance companies, using either accounts receivable or inventory as collateral. The financial
manager must obtain the right quantity and form of current liabilities financing to provide the
lowest-cost funds with the least risk. Such a strategy should positively contribute to the firm’s
goal of maximising the stock price
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References
Education, Inc.
Hall.
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BLANK PAGE
Unit 8
The Medium-term Financing
8.0 Introduction
In order to meet its medium and long-term financing, the firm has to choose whether to use
hire purchase, leasing option, issue debt, preference stock or equity. Based on the
characteristics of the respective sources of financing, the finance manager must weigh a
number of factors when choosing the mix of medium and long term financing. The entire unit
is designed to familiarise you the student with analytical and decision making aspects of
evaluating different sources of medium-term financing for the firm. The different types of
long-term debt were extensively covered in Business Finance I (BBFH202) Module, and are
therefore omitted in this unit.
8.1 Objectives
By the end of the unit, you should be able to:
• identify different sources of medium-term financing

• evaluate hire purchase
• identify the different types of leasing
• explain why leasing is a popular form of financing
• evaluate the lease-versus-purchase decision
• discuss the advantages and disadvantages of leasing
8.2 Hire Purchase

Hire purchase is considered to be the source of medium-term credit for fixed assets. The
parties involved are the hiree and the hire purchase firm. The hire purchase firm acquires the
fixed asset required by the hiree, and immediately can use the asset. The hiree makes regular
payments, which includes interest for an agreed period after which the hiree becomes the
owner of the fixed asset. The advantage that accrues to the hiree is that the firm will utilise
the fixed asset over the period of making the payments hence the hiree derives benefits from
using the equipment without incurring large capital outflows initially.
8.3 Leasing
A lease is a contract between the owner of an asset (lessor) and another party, called the
lessee, who makes periodic payments to the owner for the right to use the asset. Leasing
provides for the acquisition of assets and their complete financing simultaneously. If the
lessee does not meet his/her lease obligations, the lessor has a stronger legal right to take back
the assets because the lessor still legally owns the asset. Leasing is usually medium-term
financing since most equipment leases are for one to ten years. Leasing is an option that is
evaluated by a firm in place of debt finance.
8.3.1 Types of leases
The two basic types of leases that are available to a business are operating leases and
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financial leases (often called capital leases by accountants).
a) Operating leases
A cancellable contractual arrangement whereby the lessee agrees to make periodic payments
to the lessor, often for five (5) or fewer years, to obtain an asset’s services; generally, the total
payments over the term of the lease are less than the lessor’s initial cost of the leased asset.
Operating leases are usually used for acquisition of assets such as office machines (computers,
copiers) display fixtures, furniture and so on. Such leases are generally cancellable at the
option of the lessee, who may be required to pay a penalty for cancellation. Assets that are
leased under operating leases have a usable life that is longer than the term of the lease.
Usually, however, they would become less efficient and technologically obsolete if leased for
a longer period. Computer systems are prime examples of assets whose relative efficiency is
expected to diminish as the technology changes. The operating lease is therefore a common
arrangement for obtaining such systems, as well as for other relatively short-lived assets such
as automobiles. If an operating lease is held to maturity, the lessee at that time returns the
leased asset to the lessor, who may lease it again or sell the asset. Normally, the asset still has
a positive market value at the termination of the lease. In some instances, the lease contract
gives the lessee the opportunity to purchase the leased asset. Generally, the total payments
made by the lessee to the lessor are less than the lessor’s initial cost of the leased asset.
b) Financial (or capital) leases

A financial (or capital) lease is a longer-term lease than an operating lease. Financial leases
are non-cancellable and obligate the lessee to make payments for the use of an asset over a
predefined period of time. Financial leases are commonly used for leasing land, buildings,
and large pieces of equipment. The non-cancellable feature of the financial lease makes it
similar to certain types of long-term debt. The lease payment becomes a fixed, tax-deductible
expenditure that must be paid at predefined dates. As with debt, failure to make the
contractual lease payments can result in bankruptcy for the lessee.
With a financial lease, the total payments over the term of the lease are greater than the
lessor’s initial cost of the leased asset. In other words, the lessor must receive more than the
asset’s purchase price to earn its required return on the investment.
Technically, under IASB (International Financial Accounting Standards Board) Statement

No. 13, “Accounting for Leases,” a financial (or capital) lease is defined as one that has any
of the following elements:
i. The lease transfers ownership of the property to the lessee by the end of the lease
term;
ii. The lease contains an option to purchase the property at a “bargain price.” Such an
option must be exercisable at a “fair market value.”
iii. The lease term is equal to 75 percent or more of the estimated economic life of the
property (exceptions exist for property leased toward the end of its usable economic
life).
iv. At the beginning of the lease, the present value of the lease payments is equal to 90
percent or more of the fair market value of the leased property.
The key features of the operating and capital leases are summarised below:
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Operating leases Capital/Financial leases
The lease payment do not necessarily The lease payments fully amortise the
amortise the cost of equipment and is cost of the property being leased
renewable
The lessor maintains the property The maintenance of the property is the
responsibility of the lessee
The lease agreement is cancellable The lease agreement is not cancellable
c) Sale-lease back
A firm may sell an asset it already owns to another party and then lease it back from the buyer.
In this way the firm can obtain cash and still have use of the asset. This arrangement is called a sale
and leaseback. Capital or capital leases (rather than operating leases) are virtually always used
in sale and leasebacks.
d) Full service lease
Under full service lease the lessor maintains and insures the assets and pays property taxes on
the asset. This is similar to a maintenance lease, which obligates the lessor to provide
maintenance services. A full service lease is the opposite of a net lease, under which the
rental payment is "net", that is, the lessee pays maintenance costs, insurance and property
taxes.
e) A leveraged or third party lease
This involves a third party (lender) in addition to the lessor and lessee. The lessor borrows
part of the asset's purchase price from the lender and the lease rentals are used to service the
loan, any excess going to the lessor.
8.3.2 Why leasing is popular

The decision to lease or not to lease is often based in practice on certain commonly held
notions about leasing. Below we examine these notions.
(a) Availability of cash
Leasing imposes less of a current cash drain on the firm than purchase, thus freeing capital
for other purposes. Already existing scarce resources can be diverted to alternative uses
simultaneously enjoying the use of the asset.
(b) Convenience
Leasing is a very convenient way to obtain the services of an asset for a medium period of
time. For firms with a medium term need for an asset, leasing is especially practical because
it involves fewer legal costs and lower taxes than purchase or resale. Purchase and resale
would require two transfers of title and perhaps state sales taxes on each transfer.
(c) Avoidance of restrictions on the firm
Lenders frequently impose restrictions on the firm with the idea of improving the firm's
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capacity to pay off the loan, for example limits on dividends, subordination clause and
restrictions on new investment or sale of the firm's property. Lease agreements may also
include such constraints, but they are less frequent and are often less restrictive. It should be
noted that the benefit to the lessee firm of no or fewer restrictions on its operations is
reflected in higher lease payments. Whether the lack of or the presence of fewer restrictions is
worth the added cost will depend on the situation.
(d) Shifting of risk of obsolescence
The lessee will escape the risk that the asset will become obsolete and worthless. The risk of
obsolescence may be shifted to the lessor, but the rental price on the asset will mirror the
costs borne by the lessor.
(e) Salvage value
The owner of the asset receives salvage value, but the higher the expected residual value, the
lower the lease rentals need be in order that the lessor earns a satisfactory return on its
investment. This advantage would make leasing more economical than purchase by the user
firm.
(f) Tax consideration
The lessor gets depreciation deductions and the investment tax deductions, but in a
competitive market the lessor will pass at least some of the tax benefits on to the lessee in the
form of lower rental charges. Also under the same tax code the lessor can let the lessee have
the investment tax deductions if this is agreed upon by the lessee and lessor, thus the firm
need not purchase the asset in order to get the investment tax deductions. In short, tax factors
encourage that choice between leasing and purchase that minimises the total taxes associated
with the asset's use and ownership.
(g) Different cost of capital for the lessor versus the user firm (lessee)
It can be argued that if the leasing firm has a lower cost of capital than the user firm, the
lower cost of capital will, in a competitive environment, result in a lease- rental whose costs
will be lower than the costs of owning by the user firm.
Activity 8.1
a) Discuss the different types of leases available to firms.
b) Compare and contrast operating lease and financial lease.
c) Discuss why leasing is a popular method of financing.
8.3.3 Lease-versus-purchase decision

Firms that are contemplating the acquisition of new fixed assets commonly confront the
lease-versus-purchase (or lease-versus-buy) decision. The alternatives available are:
a) lease the assets
b) borrow funds to purchase the assets
c) purchase the assets using available liquid resources
Alternatives (b) and (c), although they differ, are analysed in a similar fashion. Even if the
firm has the liquid resources with which to purchase the assets, the use of these funds is
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viewed as equivalent to borrowing. Therefore, we need to compare only the leasing and
purchasing alternatives.
It is important to recognise that the lower cost of one alternative over the other results from
factors such as the differing tax brackets of the lessor and lessee, different tax treatments of
leases versus purchases, and differing risks and borrowing costs for lessor and lessee.
Therefore, when making a lease-versus-purchase decision, the firm will find that inexpensive
borrowing opportunities, high lessor required returns, and a low risk of obsolescence increase
the attractiveness of purchasing. Subjective factors must also be included in the decision-
making process. Like most financial decisions, the lease-versus-purchase decision requires
some judgment or intuition.
Example 8.1
John is considering either leasing or purchasing a new Honda Fit that will cost $15 000. The 3-
year lease requires an initial payment of $1 800 and monthly payments of $300. Purchasing
requires a $2 500 down payment, sales tax of 5% ($750), and 36 monthly payments of $392. He
estimates the trade-in value of the new car will be $8 000 at the end of 3 years. Assuming
John can earn 4% annual interest on his savings and is subject to a 5% sales tax on purchases,
we can make a reasonable recommendation to John using the following analysis (for
simplicity, ignoring the time value of money).
Lease cost
Down payment $1 800
Total lease payments (36 months × $300/month) 10 800
Opportunity cost of initial payment (3 years × 0.04×$1 800) 216
Total cost of leasing $12 816
Purchase cost
Down payment $2 500
Sales tax (0.05×$15 000) 750
Total loan payments (36 months × $392/month) 14 112
Opportunity cost of down payment (3years×0.04×2,500) 300
Less: Estimated trade in value of car at end of loan (8 000)
Total cost of purchasing $9 662
Because the total cost of leasing of $12 816 is greater than the $9 662 total cost of
purchasing, John should purchase rather than lease the car.
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Activity 8.2
Peter is considering either leasing or purchasing a new car that has a manufacturer’s
suggested retail price of $33 000. The dealership offers a 3-year lease that requires a capital
payment of $3 300 ($3 000 down payment + $300 security deposit) and monthly payments of
$494. Purchasing requires a $2 640 down payment, sales tax of 6.5% ($2 145), and 36
monthly payments of $784. He estimates the value of the car will be $17 000 at the end of 3
years. He can earn 5% annual interest on his savings and is subject to a 6.5% sales tax on
purchases.
Make a reasonable recommendation to Peter using a lease-versus-purchase analysis that, for
simplicity, ignores the time value of money.
a) Calculate the total cost of leasing.

b) Calculate the total cost of purchasing.
c) Which should Peter do?
(a) Leasing from the perspective of the lessee
Example 8.2
A firm is weighing two options of financing the project, which are debt financing and lease
financing. They can finance the project using a four year, fully mortised bank loan of $50 000
at an interest rate of 16%. The current SIA rates will apply if the machinery is purchased.
The firm has been offered a four-year capital lease by a finance house, which requires
$15 000 to be paid as annual lease payments. Given that the tax rate is 35% and that the firm
has adequate taxable income to avail of the SIA, what is the best option for the firm?
Analysis of the borrowing option
The loan amortisation procedure is used in order to determine the interest tax shield and
initially the annual payment is calculated below:
PVA = a × PV1FA (r%, n years)
a = annual payment which amortizes the loan
PVA 50,000 50,000

a= = = = $17,869
PVIFA(r %, n. years) PVIFA(16%,4 years) 2.7982
Year 1 2 3 4
Balance c/d 50 000 40 131 28 683 15 403
Annual payment 17 869 17 869 17 869 17 869
Interest payment 8 000 6 421 4 589 2 464
Principal payment 9 869 11 448 13 280 15 405
Balance b/d 40 131 28 683 15 403 -2
SIA for year 1 = 0.50 × $50 000 = $25 000

SlA for year 2 and 3 = 0.25 × $50 000 = $12 500
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After tax cost of debt= 0.16 × (1- 0.35) = 10.4% (approximately 10%)
Year Loan Interest + Tax Net Cash PVIF PV

Repayment SIA Shield Flow (10%)
1 $17 869 33 000 11 550 -6 319 0.9091 -5 745
2 $17 869 18 921 6 622 -11 247 0.8264 -9 295
3 $17 869 17 089 5 981 -11 888 0.7513 -8 931
4 $17 869 2 464 862 -17 007 0.6830 -11 616
Sum -35 587
Analysis of the lease option
The lease tax shield is computed as follows:
The lease tax shield = $15 000 × 0.35 = $5 250
Year Lease Lease Tax Net Lease PVIF (10%) PV

Payment Shield Payment
0 -$15 000 -$15 000 1.0000 -$15 000
1 -15 000 $5 250 -9 750 0.9091 -8 864
2 -15 000 5 250 -9 750 0.8264 -8 057
3 -15 000 5 250 -9 750 0.7513 -7 325
4 5 250 5 250 0.6830 3 586
Sum -35 660
The company should use debt financing which is cheaper.
(b) Leasing from the perspective of the lessor

The lessor is obligated to compute minimum lease payments by considering the:
1. cost of the asset
2. present value of the terminal cash flows of the asset
3. present value of the wear and tear or special initial allowance tax shields
4. present value of maintenance expenses, by using the following formula:
C - PV(TCF)- PV(TS)+ PV(ME)= [1+ PVIFA(k%,n-1 years)]L t … (1)
Where:
C = Cost of the asset
PV(TCF) = Present value of the terminal cash flow of the respective asset
PV(TS) = Present value of wear and tear or special initial allowance tax shields
PV(ME) = Present value of the maintenance expenses after tax
k = Yield to maturity or the required rate of return
L t = After tax annual lease payment
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But the after-tax lease payment should be converted to the before-tax lease payment by
manipulating the following formula:
After- tax lease payment = Before - tax lease payment (1-t)
Where t = tax rate
Therefore:
After.tax.lease. payment
Before tax lease payment =
1− t
Example 8.3
A leasing company has acquired an asset at a cost of $6m and is interested in computing the
minimum lease payment payable by the lessee. The fixed asset will last for 5 years with a
salvage value of $1m. Maintenance expenses are expected to be $300 000 annually for the
fixed asset and the asset is exposed to wear and tear of 15% calculated on a diminishing
balance. The tax rate and the cost of financing are assumed to be 40% and 20% respectively.
Determine the minimum annual lease payment (Before tax lease payment) payable by the
lessee.
a) The present value of maintenance expenses:
Before maintenance expenses = $300 000, but the after tax maintenance expenses should be
considered, hence:
After tax maintenance expenses = $300 000(1-0.40) = $180 000. The after tax maintenance
expenses of $180 000 is an annuity, therefore there is a need to compute the present value of an
annuity (PVA) as follows:
PVA = $180 000 PVIFA (20%, 5years)
PVA = $180 000 (2.9906) = $538 308
b) The present value of wear and tear tax shield
1 2 3 4 5 6
Year Balance Wear and Tax PVIF(20,n years) PV
Tear Shield
$ (2) x 0.15 (3) x 0.40 (4) x (5)
1 6 000 000 900 000 360 000 0.8333 299 988
2 5 100 000 765 000 306 000 0.6944 212 486
3 4 335 000 620 250 248 100 0.5787 143 575
4 3 684 750 552 713 221 085 0.4823 106 629
5 3 132 038 469 808 187 923 0.4019 75 526
Total 3 307 771 838 204
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c) The present value of terminal cash flow:
Since the right hand side of the expression below is positive, we have scrapping allowance:
Scrapping allowance = Cost - capital allowance - sale proceeds
Scrapping allowance = $600 000 – 3 307 771 – 1 000 000 = $1 692 229
Therefore, terminal cash flows at the end of year 5 = Sale proceeds + scrapping allowance tax
shield = $1 000 000 + 676 892 = $1 676 892. Hence the present value of terminal cash flow
(PV) is calculated as follows:
PV (Terminal cash flow) = 1 676 892 PVIF (20%, 5 years) = 1 676 892 (0.4019) = $673 943
Substituting values in equation …… (1) above, we have:
6 000 000 – 673 943 – 838 204 + 538 308 =[1+ PVIFA(20%,4years)]Lt
5 026 161 =3.5887Lt

5,026,161
Lt= = 1,400,552.01
3.5887
1,400,552.01
Therefore Before tax lease payment = = $2,334,253.35
1 − 0.40
Activity 8.3
A firm is considering leasing a new machine for $25 000 per year. The lease arrangement
calls for a 5-year lease with an option to purchase the machine at the end of the lease for
$3 500. The firm is in the 34% tax bracket. What is the present value of the lease outflows,
including the purchase option, if lease payments are made at the end of each year and if the
after-tax cost of debt is 7%?
8.3.4 Advantages and disadvantages of leasing

Leasing has a number of commonly cited advantages and disadvantages that managers should
consider when making a lease-versus-purchase decision. These are given below:
Advantages
• The firm may avoid the cost of obsolescence. This is especially true in the case of
operating leases, which generally have relatively short lives.
• A lessee avoids many of the restrictive covenants (such as minimum liquidity,

subsequent borrowing, and cash dividend payments) that are normally included as part
of a long-term loan but are not normally found in a lease agreement.
• In the case of low-cost assets that are infrequently acquired, leasing—especially

operating leases—may provide the firm with needed financing flexibility. The firm
does not have to arrange other financing for these assets.
• Sale-leaseback arrangements may permit the firm to increase its liquidity by

converting an existing asset into cash. This can benefit a firm that is short of working
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capital or in a liquidity bind.
• Leasing allows the lessee, in effect, to depreciate land, which would be prohibited if
the land were purchased. Because the lessee who leases land is permitted to deduct the
total lease payment as an expense for tax purposes, the effect is the same as if the firm
had purchased the land and then depreciated it.
• Because leasing may not increase the assets or liabilities on the firm’s balance sheet,
leasing may result in misleading financial ratios. Understating assets and liabilities
can cause certain ratios, such as the total asset turnover, to look better than they might
be. With the adoption of FASB Statement No. 13, this advantage no longer applies to
financial leases, although it remains a potential advantage for operating leases.
• Leasing provides 100 percent financing. Most loan agreements for the purchase of
fixed assets require a down payment; thus the borrower is able to borrow only 90 to
95 percent of the purchase price of the asset.
• In the case of bankruptcy or reorganisation, the maximum claim of lessors against the
corporation is 3 years of lease payments. If debt is used to purchase an asset, the
creditors have a claim that is equal to the total outstanding loan balance.
Disadvantages
• In many leases the return to the lessor is quite high; the firm might be better off
borrowing to purchase the asset.
• The terminal value of an asset, if any, is realized by the lessor. If the lessee had
purchased the asset, it could have claimed its terminal value. Of course, an expected
terminal value when recognised by the lessor results in lower lease payments.
• The lessee is generally prohibited from making improvements on the leased property
or asset without the lessor’s approval. However, lessors generally encourage leasehold
improvements when these are expected to enhance the asset’s salvage value.
• If a lessee leases an asset that subsequently becomes obsolete, it still must make lease
payments over the remaining term of the lease. This is true even if the asset is
unusable.
(Source: Gitman, L., and Zutter, C.J., 2012)
Activity 8.4
Discuss the commonly cited advantages and disadvantages that should be considered when
deciding whether to lease or purchase.
8.4 Summary
In this unit we highlighted that in addition to the basic corporate securities such as stocks and bonds,
firms can use hire purchase and leasing in their funding activities. Leasing, particularly financial
leasing, enable firms to use the lease as a substitute for the debt-financed purchase of an asset, with
more attractive risk-return trade offs.
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References
Education, Inc.
Hall.
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BLANK PAGE
Unit 9
Merger Fundamentals
9.0 Introduction
Most corporate growth occurs by internal expansion, which takes place when a firm’s
existing divisions grow through normal capital budgeting activities. However, the most
dramatic examples of growth result from mergers. Firms sometimes use mergers to expand
externally by acquiring control of another firm. Whereas the overriding objective for a merger
should be to improve the firm’s share value, a number of more immediate motivations such as
diversification, tax considerations, and increasing owner liquidity frequently exist. Sometimes
mergers are pursued to acquire specific assets owned by the target rather than by a desire to
run the target as a going concern. In this unit, we discuss merger fundamentals - terminology,
motives, and types. We will also describe the related topics of leveraged buyouts (LBOs) and
divestitures and will review the procedures used to analyse and negotiate mergers.
9.1 Objectives
• define basic merger terminology
• discuss the motives for mergers
• describe the various types of mergers
• evaluate the three models used in merger valuation
• outline reasons why mergers and acquisitions failure
9.2 Basic Merger Terminology
The following discussion covers the terminology associated with mergers.
9.2.1 Mergers
A merger is the combination of two or more firms, in which the resulting firm maintains the
identity of one of the firms, usually the larger. Ordinarily, the assets and liabilities of the
smaller firm are merged into those of the larger firm.
9.2.2 Consolidation
This involves the combination of two or more firms to form a completely new corporation.
The new corporation normally absorbs the assets and liabilities of the companies from which
it is formed. In substance, mergers and consolidations are considered to be the same.
9.2.3 Holding company

A holding company is a corporation that owns sufficient stock in another firm to control it.
The holding company is also known as the parent company, and the companies that it
controls are called subsidiaries, or operating companies.
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9.2.4 Divestiture
A divestiture is the sale of some of a company’s operating assets. A divestiture may involve:
• selling an operating unit to another firm;
• spinning off a unit as a separate company;
• carving out a unit by selling a minority interest; and
• the outright liquidation of a unit’s assets.
9.2.5 Leveraged buyout

A leveraged buyout (LBO) is a transaction in which a firm’s publicly owned stock is acquired
in a mostly debt-financed tender offer, resulting in a privately owned, highly leveraged firm.
Often, the firm’s own management initiates the LBO.
9.2.6 Joint venture

A joint venture is a corporate alliance in which two or more companies combine some of their
resources to achieve a specific, limited objective.
9.2.7 Acquiring versus target companies

The firm in a merger transaction that attempts to acquire another firm is commonly called the
acquiring company. The firm that the acquiring company is pursuing is referred to as the
target company. Generally, the acquiring company identifies, evaluates, and negotiates with
the management and/or shareholders of the target company. Occasionally, the management of
a target company initiates its acquisition by seeking out potential acquirers (Gitman and
Zutter, 2012).
9.2.8 Friendly merger versus hostile takeovers

Mergers can be either friendly or hostile. Friendly mergers are consummated through a
negotiated process between the acquiring firm and the target firm. Ordinarily, the acquirer
initiates an acquisition discussion with the target firm. If the target management is receptive
to the acquirer’s proposal, it may endorse the merger and recommend shareholder approval. If
the stockholders approve the merger, the transaction is typically consummated either through
a cash purchase of shares by the acquirer or through an exchange of the acquirer’s stock, or
some combination of stock and cash for the target firm’s shares. However, in a hostile
takeover, there is no negotiation between the two entities. The acquirer can attempt to gain
control of the firm by buying sufficient shares of the target firm in the marketplace. This is
typically accomplished by using a tender offer, which is a formal offer to purchase a given
number of shares at a specified price. Clearly, hostile mergers are more difficult to
consummate because the target firm’s management acts to deter rather than facilitate the
acquisition. Regardless, hostile takeovers are sometimes successful (Gitman and Zutter,
2012).
9.2.9 Strategic versus financial mergers

According to Gitman and Zutter (2012), mergers are undertaken for either strategic or
financial reasons. Strategic mergers seek to achieve various economies of scale by
eliminating redundant functions, increasing market share, improving raw material sourcing
and finished product distribution, and so on. The main goal of strategic mergers is to achieve
synergies, thereby causing the performance of the merged firm to exceed that of the pre-
merged firms. On the other hand, financial mergers are based on the acquisition of companies
that can be restructured to improve their cash flow. The idea is to rationalise costs and sell off
unproductive or non-compatible assets to improve the target firm’s cash flow. Financial
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mergers are based not on the firm’s ability to achieve economies of scale but rather on the
acquirer’s belief that through restructuring, the firm’s unrealised value can be unlocked.
9.3 Rationale for Mergers
Primarily, firms should merge in order to maximise shareholder wealth. This suggests that a
merger would take place only if the value of the combined entity is more than the value of the
individual firms. More specific motives include growth or diversification, synergy, fund
raising, increased managerial skill or technology, tax considerations, increased ownership
liquidity, and defence against takeover. These motives should be pursued when they lead to
owner wealth maximisation.
9.3.1Growth
Instead of relying entirely on internal or “organic” growth, the firm may achieve its growth
objectives much faster by merging with an existing firm. Such a strategy is often less costly
than the alternative of developing the necessary production capacity. If a firm that wants to
expand operations can find a suitable going concern, it may avoid many of the risks
associated with the design, manufacture, and sale of additional or new products. Moreover,
when a firm expands or extends its product line by acquiring another firm, it may remove a
potential competitor (Gitman and Zutter, 2012).
9.3.2 Diversification
Managers often cite diversification as a reason for mergers. They contend that diversification
helps stabilise a firm’s earnings and thus benefits its owners. Stabilisation of earnings is
certainly beneficial to employees, suppliers, and customers, but its value to stockholders is
less certain. Why should Firm A acquire Firm B to stabilise earnings when stockholders can
simply buy the stocks of both firms? Indeed, research suggests that in most cases
diversification does not increase the firm’s value. In fact, many studies find that diversified
firms are worth significantly less than the sum of their individual parts. Of course, if you were
the owner-manager of a closely held firm, it might be nearly impossible to sell part of your
stock to diversify. Also, selling your stock would probably lead to a large capital gains tax.
So, a diversification merger might be the best way to achieve personal diversification for a
privately held firm (Ehrhardt and Brigham, 2011).
9.3.3 Synergy
Ehrhardt and Brigham (2011) contend that the primary motivation for most mergers is to
increase the value of the combined enterprise. If companies A and B merge to form company
C and if C’s value exceeds that of A and B taken together, then synergy is said to exist, and
such a merger should be beneficial to both A’s and B’s stockholders. If synergy exists, then
the whole is greater than the sum of the parts. Synergy is also called the “2 plus 2 equals 5
effect”. Synergistic effects can arise from five sources:
1. Operating economies, which result from economies of scale in management,
marketing, production, or distribution;
2. Financial economies, including lower transaction costs and better coverage by
security analysts;
3. Tax effects, in which case the combined enterprise pays less in taxes than the separate
firms would pay;
4. Differential efficiency, which implies that the management of one firm is more
efficient and that the weaker firm’s assets will be more productive after the merger;
and
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5. Increased market power due to reduced competition. Operating and financial
economies are socially desirable, as are mergers that increase managerial efficiency,
but mergers that reduce competition are socially undesirable and illegal.
9.3.4 Tax considerations

The tax benefit generally stems from the fact that one of the firms has a tax loss carry-
forward. This means that the company’s tax loss can be applied against a limited amount of
future income of the merged firm over 20 years or until the total tax loss has been fully
recovered, whichever comes first. Two situations could actually exist. A company with a tax
loss could acquire a profitable company to use the tax loss. In this case, the acquiring firm
would boost the combination’s after-tax earnings by reducing the taxable income of the
acquired firm. A tax loss may also be useful when a profitable firm acquires a firm that has
such a loss. In either situation, however, the merger must be justified not only on the basis of
the tax benefits but also on grounds consistent with the goal of owner wealth maximisation.
Moreover, the tax benefits described can be used only in mergers — not in the formation of
holding companies — because only in the case of mergers are operating results reported on a
consolidated basis (Gitman and Zutter, 2012).
9.3.5 Fund raising

Often, firms combine to enhance their fund-raising ability. A firm may be unable to obtain
funds for its own internal expansion but able to obtain funds for external business
combinations. Quite often, one firm may combine with another that has high liquid assets and
low levels of liabilities. The acquisition of this type of “cash rich” company immediately
increases the firm’s borrowing power by decreasing its financial leverage. This should allow
funds to be raised externally at lower cost (Gitman and Zutter, 2012).
9.3.6 Increased managerial or technology

Occasionally, a firm will have good potential that it finds itself unable to develop fully
because of deficiencies in certain areas of management or an absence of needed product or
production technology. If the firm cannot hire the management or develop the technology it
needs, it might combine with a compatible firm that has the needed managerial personnel or
technical expertise. Of course, any merger should contribute to maximising the owners’
wealth (Gitman and Zutter, 2012).
9.3.7 Increased ownership liquidity

The merger of two small firms or of a small and a larger firm may provide the owners of the
small firm(s) with greater liquidity. This is due to the higher marketability associated with the
shares of larger firms. Instead of holding shares in a small firm that has a very “thin” market,
the owners will receive shares that are traded in a broader market and can thus be liquidated
more readily. Also, owning shares for which market price quotations are readily available
provides owners with a better sense of the value of their holdings. Especially in the case of
small, closely held firms, the improved liquidity of ownership obtainable through merger
with an acceptable firm may have considerable appeal (Gitman and Zutter, 2012).
9.3.8 Breakup value

Some takeover specialists estimate a company’s breakup value, which is the value of the
individual parts of the firm if they were sold off separately. If this value is higher than the
firm’s current market value, then a takeover specialist could acquire the firm at or even above
its current market value, sell it off in pieces, and earn a profit (Ehrhardt and Brigham, 2011).
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9.3.9 Defence against takeover
Occasionally, when a firm becomes the target of an unfriendly takeover, it will acquire
another company as a defensive tactic. Such a strategy typically works like this: The original
target firm takes on additional debt to finance its defensive acquisition; because of the debt
load, the target firm becomes too highly leveraged financially to be of any further interest to
its suitor. To be effective, a defensive takeover must create greater value for shareholders
than they would have realised had the firm been merged with its suitor.
9.4 Types of Mergers
Economists classify mergers into four types, which are given below:
• horizontal merger
• vertical merger
• congeneric merger
• conglomerate
9.4.1 Horizontal merger

A horizontal merger results when two firms in the same line of business are merged. An
example is the merger of two machine tool manufacturers. This form of merger results in the
expansion of a firm’s operations in a given product line and at the same time eliminates a
competitor. The current trend in bank and building society mergers is a good example of this
type of integration.
9.4.2 Vertical merger

A vertical merger results from the acquisition of one company by another, which is at a
different level in the chain of supply. As an example, the merger of a machine tool
manufacturer with its supplier of castings is a vertical merger. The economic benefit of a
vertical merger stems from the firm’s increased control over the acquisition of raw materials
or the distribution of finished goods.
9.4.3 Congeneric merger

Congeneric means “allied in nature or action”, hence a congeneric merger involves related
enterprises but not producers of the same product (horizontal) or firms in a producer–supplier
relationship (vertical). An example is the merger of a machine tool manufacturer with the
manufacturer of industrial conveyor systems. The benefit of a congeneric merger is the
resulting ability to use the same sales and distribution channels to reach customers of both
businesses.
9.4.4 Conglomerate merger

A conglomerate results when two companies in unrelated businesses combine. Delta
Corporation is a conglomerate since its operations are diversified from manufacturing,
retailing and mining.
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Activity 9.1
(1) Define and differentiate among the members of each of the following sets of terms:
(a) mergers, consolidations, and holding companies
(b) acquiring company and target company
(c) friendly merger and hostile merger
(d) strategic merger and financial merger
(2) Discuss the various motives for corporate mergers.
(3) Describe the four economic types of mergers.
(4) (a) Is synergy a valid rationale for mergers?
(b) Describe several situations that might produce synergistic gains.
(5) Suppose your firm could purchase another firm for only half of its replacement value.
Would that be a sufficient justification for the acquisition? Explain your answer.
(6) Discuss the pros and cons of diversification as a rationale for mergers.
9.5 Valuation of Mergers
Ehrhardt and Brigham (2011) argue that the acquiring firm must be able to answer the
following two key questions before any merger transaction is consummated:
(a) How much would the target firm be worth after being incorporated into the acquirer?
This may be quite different from the target firm’s current value, which does not reflect
any post-merger synergies or tax benefits.
(b) How much should the acquirer offer for the target? A low price is obviously better for
the acquirer, but the target will not take the offer if it is too low. However, a higher
offer price is costly to the acquirer.
To answer the above two questions, the acquiring firm should estimate the value of the firm
to be acquired. There are three discount cash flow techniques used in merger valuation,
namely, corporate valuation model, the adjusted present value method, and the equity residual
method.
9.5.1 Corporate valuation model

This model involves computing the present value of a firm’s expected future free cash flows
discounted at the firm’s weighted average cost of capital (WACC). The formula is given
below:
Value of operations = Vop = present value of expected future free cash flows.
∞
FCFt
= ∑ (1 + WACC )
t =1
t
Where Vop = value of operations

WACC= weighted average cost of capital
FCFt = free cash flow from operations actually available for distribution to all
investors (shareholders and bond holders)
The terminal, or horizon, value is the value of operations at the end of the explicit forecast
period. It is also called the continuing value, and it is equal to the present value of all free
cash flows beyond the forecast period, discounted back to the end of the forecast period at the
weighted average cost of capital:
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FCFN +1 FCFN (1 + g )
Continuing value = Vop (at.time.N ) = =
WACC − g WACC − g
The corporate valuation model can be used to calculate the total value of a company by
finding the value of operations plus the value of non-operating assets.
Example 9.1
MPN Limited has never paid a dividend, and it is not known when the firm might begin
paying dividends. Its current free cash flow is $100 000, and this FCF is expected to grow at
a constant 7% rate. The weighted average cost of capital (WACC) is 11%. MPN Limited
currently holds $325 000 of non-operating marketable securities. Its long-term debt is
$1 000 000, but it has never issued preferred stock. MPN Limited has 50 000 shares of stock
outstanding.
(a) Calculate Watkins’s value of operations.

(b) Calculate the company’s total value.
(c) Calculate the intrinsic value of its common equity.
(d) Calculate the intrinsic per share stock price.
Solution
FCF (1 + g ) 100,000(1 + 0.07)

(a) Vop = = = $2,675,000
WACC − g 0.11 − 0.07
(b) Total value = value of operations + value of non-operating assets

= 2 675 000 + 325 000
= $3 000 000
(c) Value of equity = Total value – value of debt

= $3 000 000 - $1 000 000
= $2 000 000
(d) Price per share = value of equity ÷ number of shares

= 2 000 000 ÷ 50 000
= $40
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Activity 9.2
(1) HP Corporation is a fast-growing supplier of office products. Analysts project the
following free cash flows (FCFs) during the next 3 years, after which FCF is expected
to grow at a constant 7% rate. HP’s weighted average cost of capital is WACC = 13%.
Year
1 2 3
Free Cash Flow ($million) -$20 $30 $40
(a) What is HP’s terminal, or horizon, value? (Hint: Find the value of all free cash flows
beyond Year 3 discounted back to Year 3.)
(b) What is the current value of operations for HP Corporation?
(c) Suppose HP Corporation has $10 million in marketable securities, $100 million in
debt, and 10 million shares of stock. What is the intrinsic price per share?
(2) Brooks Enterprises has never paid a dividend. Free cash flow is projected to be $80
000 and $100 000 for the next 2 years, respectively; after the second year, FCF is
expected to grow at a constant rate of 8%. The company’s weighted average cost of
capital is 12%.
(a) What is the terminal, or horizon, value of operations? (Hint: Find the value of all free
cash flows beyond Year 2 discounted back to Year 2.)
(b) Calculate the value of Brooks’ operations.
9.5.2 The Adjusted Present Value (APV) Approach

The APV technique is especially useful for valuing acquisition targets. The method expresses
the value of operations as the sum of two components: (1) the unlevered value of the firm’s
operations plus (2) the present value of the interest tax savings (interest tax shield).
Voperations = Vunlevered + Vtax.shield
The value of an unlevered firm’s operations is the present value of the firm’s free cash flows
discounted at the unlevered cost of equity, and the value of the tax shield is the present value
of all of the interest tax savings (TS), discounted at the unlevered cost of equity, rsU .(Some
discount the interest tax shield at the cost of debt).
∞
FCFt
Vunlevered = ∑
t =1 (1 + rsU ) t
and
∞
TS t
VTax.shield = ∑
t =1 (1 + rsU ) t
Here is a detailed description of how to apply that approach in the APV model.
Step 1
Calculate the target’s unlevered cost of equity, rsU , based upon its current capital structure at
the time of the acquisition. In other words, you “unlever” the target’s cost of equity. A firm’s
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levered cost of equity, rsL , is a function of its unlevered cost of equity, its cost of debt ( rd ),
and the amount of debt (D) and equity (S) in its capital structure:
D
rsL = rsU + (rsU − rd )( )
S
Because the weights of debt and equity in a capital structure, wd and ws , are defined as D/(D
+ S) and S/(D + S), respectively, the ratio of D/S can be expressed as wd / ws .
Hence, rsU = ws rsL + wd rd
Keep in mind that; rsL , rd , wd , and ws are based upon the target’s capital structure
immediately before the acquisition.
Step 2
Project the free cash flows, FCFt and the annual interest tax savings, TS t . The tax savings
are equal to the projected interest payments multiplied by the tax rate:
Tax savings = (Interest expense)(Tax rate)
Step 3
Calculate the horizon value of an unlevered firm at Year N (HV U , N ), which is the value of all
free cash flows beyond the horizon discounted back to the horizon at the unlevered cost of
equity. Also calculate the horizon value of the tax shield at Year N (HV TS , N ), which is the
value of all tax shields beyond the horizon discounted back to the horizon at the unlevered
cost of equity. Because FCF and TS are growing at a constant rate of g in the post-horizon
period, we can use the constant growth formula:
FCFN +1 FCFN (1 + g )
Horizon value of unlevered firm= HVU , N = =
rsU − g rsU − g
and
TS N +1 TS N (1 + g )
Horizon value of tax shield = HVTS , N = =
rsU − g rsU − g
The unlevered horizon value is the horizon value of the company if it had no debt. The tax
shield horizon value is the contribution of the tax savings after Year N make to the horizon
value of the levered firm. Therefore, the horizon value of the levered firm is the sum of the
unlevered horizon value and the tax shield horizon value.
Step 4
Calculate the present value of the free cash flows and their horizon value. This is the value of
operations for the unlevered firm—that is, the value it would have if it had no debt. Also
calculate the present value of the yearly tax savings during the forecast period and the horizon
value of tax savings. This is the value that the interest tax shield contributes to the firm. The
sum of the value of unlevered operation and the value of the tax shield is equal to the value of
operations for the levered firm:
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N
FCFt HVU , N
VUnlevered = ∑ +
t =1 (1 + rsU ) t
(1 + rsU ) N
N
TS t HVTS , N
VTax.shield = ∑ +
t =1 (1 + rsU ) (1 + rsU ) N
Voperations = Vunlevered + VTax.shield
Step 5
To find the total value of the firm, add the value of operations to the value of any non-
operating assets, such as marketable securities. To find the value of equity, subtract the value
of the debt before the merger from the total value of the firm.
Unlevered value of operations
Add: Value of tax shield
Value of operations
Add: Value of non-operating assets
Total value of firm
Less: Value of debt
Value of equity
To find the stock price per share, divide the value of equity by the number of shares.
Activity 9.3
ABC Limited is considering an acquisition of CABS. CABS currently has a cost of
equity of 10%; 25% of its financing is in the form of 6% debt, and the rest is in
common equity. The tax rate is 40%. After the acquisition, ABC Limited expects
CABS to have the following FCFs and interest payments for the next 3 years:
FCF $10,000,000 $20,000,000 $25,000,000
Interest expense $28,000,000 $24,000,000 $20,280,000
After this, the free cash flows are expected to grow at a constant rate of 5%, and the
capital structure will stabilize at 35% debt with an interest rate of 7%.
a) (i) What is CABS’s unlevered cost of equity?
(ii) What are its levered cost of equity and cost of capital for the post-horizon
period?
b) Using the adjusted present value approach, what is CABS’s value of
operations to ABC Limited?
9.5.3 The Free Cash Flow to Equity Approach (Equity Residual Model)
Free cash flow is the cash flow available for distribution to all investors. However, free cash
flow to equity (FCFE) is the cash flow available for distribution to common shareholders, and
is therefore discounted at the cost of equity. FCFE may be used to pay common dividends,
repurchase stock, and purchase financial assets. In other words, the uses of FCFE include all
those of FCF except for distribution to debtors.
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FCFE can be computed as follows:
FCFE = Free cash flow – after tax interest expense – principal payments + newly issued debt
= Free cash flow – interest expense + interest tax shield + net change in debt
Alternatively, the FCFE can be calculated as:
FCFE = Net income – net investment in operating capital + net change in debt
Both calculations provide the same value for FCFE.
Given projections of FCFE, the value of a firm’s equity due to operations:
∞
FCFE t
VFCFE = ∑
t =1 (1 + rsL )
t
If we assume constant growth beyond the horizon, then the horizon value of the value of
equity due to operations:
FCFE N +1 FCFE N (1 + g )
HV FCFE , N = =
rsL − g rsL − g
The value of equity due to operations is the present value of the horizon value and the FCFE
during the forecast period:
FCFEt HVFCFE , N
VFCFE = +
(1 + rsL ) t
(1 + rsL ) N
The total value of a company’s equity, S, is the value of the equity from operations plus the
value of any non-operating assets:
S = V FCFE + Non.operating.assets
To get a per share price, simply divide the total value of equity by the shares outstanding.
Like the corporate valuation model, the FCFE model can be applied only when the capital
structure is constant.
Activity 9.4
(1)XYZ Limited is considering a merger with BPC Limited. BPC Limited is a publicly traded
company, and its beta is 1.30. BPC has been barely profitable, so it has paid an average of
only 20% in taxes during the last several years. In addition, it uses little debt; its target ratio is
just 25%, with the cost of debt 9%.
If the acquisition were made, XYZ would operate BPC as a separate, wholly owned
subsidiary. XYZ would pay taxes on a consolidated basis, and the tax rate would therefore
increase to 35%. XYZ also would increase the debt capitalisation in the BPC subsidiary to
wd = 40%, for a total of $22.27 million in debt by the end of Year 4, and pay 9.5% on the
debt. XYZ Limited’s acquisition department estimates that BPC, if acquired, would generate
the following free cash flows and interest expenses in Years 1–5:
134
Year Free Cash Flows Interest Expense
1 $1 300 000 $1 200 000
2 1 500 000 1 700 000
3 1 750 000 2 800 000
4 2 000 000 2 100 000
5 2 120 000 ?
In Year 5, BPC’s interest expense would be based on its beginning-of-year (that is, the end-
of-Year-4) debt, and in subsequent years both interest expense and free cash flows are
projected to grow at a rate of 6%.
These cash flows include all acquisition effects. XYZ Limited’s cost of equity is 10.5%, its
beta is 1.0, and its cost of debt is 9.5%. The risk-free rate is 6%, and the market risk premium
is 4.5%.
(a) What is the value of BPC Limited’s unlevered operations, and what is the value of
BPC’s tax shields under the proposed merger and financing arrangements?
(b) What is the dollar value of BPC’s operations? If BPC has $10 million in debt
outstanding, how much would XYZ be willing to pay for BPC?
(2) Vol-World Communications Inc., a large telecommunications company, is evaluating the

possible acquisition of Bulldog Cable Company (BCC), a regional cable company. Vol-
World’s analysts project the following post-merger data for BCC (in thousands of dollars,
with a year end of December 31):
2010 2011 2012 2013 2014 2015

Net sales $450 518 555 600 643
Selling & administrative expenses 45 53 60 68 73
Interest 40 45 47 52 54
Total net operating capital $800 850 930 1 005 1 075 1 150
Total rate after merger: 35%
Cost of goods sold as a percent of sales: 65%
BCC’s pre-merger beta: 1.40
Risk-free rate: 6%
Market risk premium: 4%
Terminal growth rate of free cash flows: 7%
If the acquisition is made, it will occur on January 1, 2011. All cash flows shown in the
income statements are assumed to occur at the end of the year. BCC currently has a capital
structure of 40% debt, which costs 10%, but over the next 4 years Vol-World would increase
that to 50%, and the target capital structure would be reached by the start of 2015. BCC, if
independent, would pay taxes at 20%, but its income would be taxed at 35% if it were
consolidated. BCC’s current market-determined beta is 1.4. The cost of goods sold is
expected to be 65% of sales.
a. What is the unlevered cost of equity for BCC?

b. What are the free cash flows and interest tax shields for the first 5 years?
c. What is BCC’s horizon value of interest tax shields and unlevered horizon value?
d. What is the value of BCC’s equity to Vol-World’s shareholders if BCC has $300,000 in
debt outstanding now?
135
9.6 Reasons Why Mergers and Acquisitions Fail
The following are some of the reasons why mergers and acquisitions sometimes fail:
a) The fit/lack of fit syndrome
There may be a good fit of products or services, but a serious lack of fit in terms of
management styles or corporate structure.
b) Lack of industrial or commercial fit

Failure can result from a horizontal or vertical takeover where the biddee may not
have the product range or industrial position that the acquirer anticipated. Usually in
the case where a customer or supplier is acquired, the acquirer knows a lot about the
biddee; even so, there may be aspects of the biddee's operations which may cause
unexpected problems for the acquirer, such that, even in these cases, a prospective
acquisition should be planned very carefully and not be based solely on experience
gained from a direct relationship with the biddee.
c) Lack of goal congruence

This may apply not only to the biddee but, more dangerously, to the acquirer, whereby
disputes over the treatment of the biddee might well take away the benefits of an
otherwise excellent acquisition.
d) 'Cheap' purchases
The 'turnaround' costs of an acquisition purchased at what seems to be a bargain price
may well turn out to be a high multiple of that price. In these situations, the amount of
resources in terms of cash and management time could well also damage the bidder's
core business. In preparing a bid, a would-be acquirer should always take into account
the likely total cost of an acquisition, including the input of its own resources, before
deciding on making an offer or setting an offer price.
e) Paying too much

The fact that a high premium is paid for an acquisition does not necessarily mean that
it will fail. Failure would result only if the price paid is beyond that which the acquirer
considers acceptable to increase satisfactorily the long-term wealth of its shareholders.
f) Failure to integrate effectively

An acquirer needs to have a workable and clear plan of the extent to which the biddee
is to be integrated, and the amount of autonomy to be granted. At best, the plan should
be negotiated with the biddee's management and staff, but its essential requirements
should be fairly, but firmly carried out. The plan must address such problems as
differences in management styles, incompatibilities in data information systems, and
continued opposition to the acquisition by some of the biddee's staff. Failure to plan
can - and often does- lead to failure of an acquisition, as it leads to drift and
demotivation, not only within the biddee's organisation, but also within the acquirer
itself.
136
Activity 9.5
Explain the possible causes for failure of mergers and acquisitions, and suggest ways how
these failures can be avoided.
9.7 Summary
Financial managers are sometimes involved in corporate restructuring activities, which
involve the expansion and contraction of the firm’s operations. In this unit, we have covered
mergers. A merger occurs when two firms combine to form a single company. A variety of
motives could drive a firm toward a merger, but the overriding goal should be maximisation
of the owners’ wealth. Mergers can provide economic benefits through economies of scale
and through placing assets in the hands of more efficient managers. However, mergers also
have the potential for reducing competition, and for this reason they are carefully regulated
by government agencies. Before any merger transaction is executed, there is need for the
acquiring firm to determine the value of the target firm. Three models are used in merger
valuation, namely, the corporate valuation model, the adjusted present value approach, and
the equity residual model.
137
References
Education, Inc.
Hall.
138

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Bachelor of Commerce in

Module BBFH 209

Content Reviewer: O. Chiwira

Editor: Constance Kadada

Revised by: Kernell Madzirerusa

Editor: Cuthbert Muza

P.O. Box MP1119

The Zimbabwe Open University is a distance teaching and open

Year: August 2013

Reprinted: November 2013

Cover design: T. Ndhlovu

Printers : ZOU Press

Typeset in Times New Roman, 12 point on auto leading

© Zimbabwe Open University. All rights reserved. No part of this

As a progressive university that is forward

The six hour tutorials should be so structured that the

Session I (Two Hours)

Session II (Two Hours)

Session III (Two Hours)

Conclusion for this course, but also to prepare yourself to

1.2 Major Cash Flow Components

Operating Cash Inflows

$5 000 $7 000 $8 000 $8 000 $10 000

$4 000 $6 000 $7 000 $8 000 $9 000

Figure 1.1: Time Line for Major Cash Flow Components

1.3 Expansion versus Replacement Decisions

Initial investment Initial investment need to After tax cash inflows

Operating cash Operating cash inflows Operating cash inflows

Figure 1.2: Relevant Cash Flows for Replacement Decisions: Calculation

1.4 Sunk Costs and Opportunity Costs

1.6 The Nature of Project Cash Flows

• equipment and any articles used by the taxpayer in trade

• purchase of articles, implements machinery whether new or second hand

1.7 Beginning of Project Cash Flow in General

• cost of acquisition/cost of the fixed asset

• change in working capital

Cost of acquisition 1 000 000

Installation costs 150 000

Additional working capital 100 000

Basic cost 1 250 000

1.7.2 Beginning of project cash flows for replacement investment

Cost of the new asset 1 000 000

Installation cost 500 000

Additional working capital 210 000

Proceeds from sale of old machinery 300 000

Tax on scrapping allowance 40 000

Initial investment 1 370 000

1.8 Annual Cash Flows

2 400 000 2 400 000 2 400 000

Less tax @ 40% $150 000

After tax annual cash flows $250 000

Less wear and tear allowance $ 62 500

Taxable income $312 500

Less tax @ 40% $125 000

Add wear and tax allowance $ 62 500

After tax annual cash flows $250 000

Example 1.5: Wear and Tear Allowance on Movables

1.8.3 Annual cash flows of replacement investment

Special Initial Allowance for the two machines is calculated below:

Annual Cash Flow for Year 2

Annual Cash Flow for Year 3

Annual Cash Flow for Year 4

• the estimate salvage value of the asset

Salvage value of the asset 500 000